Inventory Valuation Methods: How To Pick One & Best Practices

Key Takeaways

Tax-Saving Sage: Choosing the right inventory valuation method can help you save on taxes and manage business finances more efficiently.

Price Fluctuation Fixer: Proper inventory valuation ensures price changes don't negatively impact your business.

Valuation Vitality: Understanding different inventory valuation methods is essential for any retail business.

Tailor-Made Methods: Selecting the best inventory valuation method for your business is crucial for optimal financial health.

Defining Inventory Valuation: It's the process of assigning a monetary value to your existing inventory, essential for financial clarity.

Inventory valuation is an essential part of running a retail business. It helps you stay on top of your business financials, choose the right process to help you save on taxes, and ensure price fluctuations don’t have a negative impact on your business.

To get started, you need to have a clear understanding of the different inventory valuation methods. Then, you gotta figure out which one is the best option for your business.

In this guide, I'll help you get a better idea of what inventory valuation is, why it’s important, plus how to choose between the four most common methods.

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Let’s dig in.

What is Inventory Valuation?

Inventory valuation is the process of assigning a monetary value to your existing inventory. 

Your inventory is your company’s largest asset. So, a clear inventory value for each reporting period is essential to valuing your company as a whole.

Not only that, but it helps make sure you’re setting your product pricing accordingly, ensuring you have a healthy profit margin for your business.

Let’s look at a table to help visualize this process. 

Inventory valuation will often be done annually at the end of an accounting period to ensure you know exactly what your remaining inventory balance is.

So let’s say you run an ecommerce store that sells pillows. We’ll call your new pillow business Cloud Nine.

You source them from a manufacturer, then store them in a warehouse so they’re ready to ship once someone buys.

Your monthly purchases from the manufacturer, along with their cost per unit, could look like this table below:

	Number of Units Purchased	Purchase Price	Total Cost
January	100	$20	$2,000
February	100	$20	$2,000
March	125	$23	$2,875
April	125	$24	$3,000
May	100	$24	$2,400
June	150	$27	$4,050
July	150	$27	$4,050
August	100	$29	$2,900
September	100	$29	$2,900
October	125	$30	$3,750
November	125	$31	$3,875
December	100	$31	$3,100

Notice how the cost per unit increases each month as the cost for materials and other factors force those prices upwards.

(Note: This is a dramatized example of how this would occur. Also, keep Cloud Nine in mind. We’ll be referring back to this amazing new pillow business of yours throughout the article.)

Throughout the year, you’ll sell a large percentage of your inventory. 

However, with the actual cost fluctuating throughout the year, it can be difficult to know the exact initial cost of each remaining product.

This is where your different inventory valuation methods come into play. They’ll provide you with a way to calculate an accurate value of the inventory left at the end of the accounting period.

Why Does Inventory Valuation Matter?

Inventory valuation is an extremely important task for your ecommerce business to complete every year or so. 

This process ensures that your financial statements are accurate and can help to maximize profitability for your business.

More than that, your inventory value can impact your cost of goods sold (COGS), your business’s income, and your ending inventory.

Other reasons inventory valuation is so important include:

• Knowing the value of your inventory, or your unsold golds, helps you get a clear idea of your potential profitability. This will guide many upcoming business decisions.
• Your inventory is an asset. So, its assigned value helps your business get any loans or capital it needs to keep running.
• Having an accurate inventory value provides a clear view of your company’s financial situation. Something that any business owner needs to have an understanding of.
• The numbers that your inventory valuation provides can help you appease shareholders and bring in investors if you choose to go down that path.
• Because you’re unable to expense the cost of your inventory on your taxes, choosing the right inventory valuation method is essential for tax purposes.

And that’s just scratching the surface. 

Inventory valuation isn’t an optional process. Each accounting period, you need to go through your inventory so you can have a clear-cut monetary value for everything leftover.

Common Challenges With Inventory Valuation

Before we dive into some common methods used to value inventory items, let’s introduce you to a few challenges you might face throughout the process.

Here are some common challenges and potential solutions to keep in mind:

• Price fluctuations. This is the biggest challenge you’ll face. Cost of inventory items can fluctuate throughout the year based on seasonal changes, increase in inventory price, and more, making it difficult to accurately value your inventory. Choosing the right inventory valuation method can help you deal with these changes.
• Limited resources. Smaller businesses lack the resources for tracking and valuing inventory that larger companies have. This makes for a more complex and overwhelming process. Using inventory management software can help make this more manageable for businesses with smaller teams.
• Multiple inventory locations. If you store your company’s inventory in multiple locations, this can also pose a potential challenge. While this is a great way to ship products out faster, it becomes more difficult to accurately access your total inventory. Proper ecommerce inventory management systems can help combat this issue.

Inventory management and selecting the best inventory valuation method for your business are both great ways to combat some of these challenges. 

Let’s cover the best methods to assign value to your inventory next.

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4 Common Inventory Valuation Methods

There are four main ways you can value your leftover inventory:

• First-in, first-out method
• Last-in, first-out method
• Weighted average cost method
• Specific identification method

Each of these methods has their own advantages and disadvantages.

Let’s talk more about why you’d choose each method of inventory valuation and how each one can be used to assign a monetary value to your remaining inventory.

First-in, first-out (FIFO)

The first-in, first-out or FIFO method assumes that the first goods purchased, or the oldest inventory, are the first goods sold. 

This is a great way to deal with price increases throughout the year, as it ensures that you always use the most recent cost of inventory to value the unsold inventory.

Think back to our pillow store. At the beginning of the year, Cloud Nine’s products cost $20 apiece, but had jumped to $31 apiece by the end of the year.

By assuming that the products bought at the beginning of the year were the first ones sold, you can attribute the later prices to your remaining inventory.

Let’s make this a little easier. 

Let’s say, in the month of September, you bought 100 pillows for the first half at $25 a pop. To keep up with sales, you then made another purchase of 150 pillows for the second half at $28 per unit. 

At the end of the month, you had 25 units remaining. 

By following the FIFO valuation method, you can assume that all the older inventory was sold first. So, to calculate the market value of your remaining inventory, you would simply multiply the 25 remaining units by the most recent cost per unit, or 25 x $28.

So your FIFO inventory valuation would be $700.

Pros:

• This method is simple and easy to understand.
• This method is essential for businesses selling perishable goods as it cuts down on the amount of inventory that cannot be sold, minimizing obsolescence.
• This method makes it impossible to manipulate your income statement, ensuring your business remains trustworthy.

Cons:

• This method can be difficult to use if the prices of your goods fluctuate considerably and often.
• This method can make your income tax higher, as it can inflate your financial statements.

Last-in, first-out (LIFO)

The last-in, first-out or LIFO method is the opposite of the previous method, as this assumes that the most recent inventory added is the first to be sold. 

This would work essentially in the opposite way of the FIFO method, so let’s use that same example here.

In the month of September, you bought 100 pillows at $25 per unit, then 150 at $28 per unit. At the end of the month, you had 25 units remaining in your inventory. 

Here, you’re assuming that the last ones in, so the units bought at $28 apiece, were sold first. So you multiply the 25 remaining units by the initial cost per unit, or 25 x $25, giving you an inventory value of $625.

While still being a common process—and one that is accepted in the United States under the GAAP, or Generally Accepted Accounting Principles—the LIFO inventory valuation method really can only be used by companies that sell stock that won’t go bad.

Think about it like this. 

Companies that sell products like food, cosmetics, and even technology don’t want their oldest stock to go obsolete. So the LIFO method simply won’t work for them, or they could lose out on their beginning inventory.

But there are some benefits to the LIFO inventory valuation method that could make this make sense for certain companies.

Pros:

• COGS, or cost of goods sold, is higher than with the previous method.
• This method comes with tax benefits, unlike the previous method, due to the COGS being a higher value than the inventory balance sheet. Less taxes will have to be paid, as well.
• This method matches expenses and revenue much more precisely.
• This method can be used as a hedge during times of inflation.

Cons:

• It can keep initial inventory on hand for years—even indefinitely—which can lead to obsolescence.
• Few businesses actually prefer to sell fresh inventory before their older inventory, making this an unlikely method.
• While accepted by the US’s GAAP, it’s still disproved by many other regulatory bodies, like the International Financial Reporting Standards (IFRS).

Weighted average cost (WAC)

The weighted average cost or WAC method assigns an average value to all remaining inventory based on how much it cost to purchase it.

With our pillow example again, we have 100 units purchased at $25 each and 150 units purchased at $28 each. That’s a total of 250 pillows and a total cost of $6,700. 

To calculate the average, divide the 250 pillows by the $6,700 total cost to get $26.80 per pillow.

This means, no matter which product is pulled from your inventory, you value all remaining products at $26.80 each. So if you end the month with 25 pillows again, your inventory value is $670.

This method is often used by businesses that don’t have much variation to account for within their inventory, but it can also be a great way to combat consistent price changes. 

By calculating the average of the total cost, you can assign a near-accurate price point to each remaining item.

Pros: 

• This method works well for retailers with large amounts of similar inventory, like different style or color sweatshirts that would be similar in cost.
• The date of purchase doesn’t matter with this method—you simply average all inventory costs together, and it can be sold at any time without impacting your inventory accounting.
• This method is easy to adopt and maintain.
• This method is similar to FIFO in that it is difficult to manipulate, creating a trustworthy accounting method.

Cons:

• If the cost of inventory suddenly increases dramatically, your weighted average may not accurately reflect that, leading to you selling the product at a loss.
• If you have products from vastly different price points, taking the average can also lead to you selling them at a loss.

Specific identification method

Finally, we have the specific identification method. 

This method is used when each specific price of each specific product really matters, and you can’t use any other method to value your inventory.

For this to be properly incorporated into your business’s processes, you either need a small amount of inventory or a solid inventory management system to ensure nothing gets lost.

Again, Cloud Nine bought 100 pillows for $25 each, then 150 pillows for $28 each. The specific identification method will track the cost of each specific item. 

So, if you have 20 remaining pillows that were purchased for $25 apiece and 10 pillows that were purchased for $28 apiece, your inventory valuation sits exactly at $780.

Pros:

• This is the most accurate way to access your inventory’s value.
• When you have the right systems in place for this method, you’re less likely to lose inventory or lose money on inventory.

Cons: 

• You must be able to identify every single item in your inventory and how much it cost.
• This method requires that you invest in inventory management software.
• Larger companies that are moving more inventory in and out can more easily lose track of inventory than smaller companies, making this method more difficult for enterprise organizations.

The Pros and Cons of Inventory Valuation Methods

Let’s see those pros and cons in one handy table:

Method	Pros	Cons
First-In, First-Out (FIFO)	- Simple and easy to understand  - Essential for perishable goods - Reduces risk of obsolescence - Difficult to manipulate income statements	- Difficult to use with fluctuating prices - Can lead to higher taxable income, resulting in higher taxes
Last-In, First-Out (LIFO)	- Higher COGS reduces taxable income - Tax benefits due to higher COGS - Matches expenses and revenue accurately - Hedge against inflation	- Can keep initial inventory on hand for years, leading to obsolescence - Uncommon preference - Not accepted by IFRS
Weighted Average Cost (WAC)	- Works well for similar inventory- Simplifies accounting - Date of purchase doesn’t matter - Difficult to manipulate, creating trust	- May not reflect sudden cost increases accurately - Averages can lead to selling at a loss for high-cost items
Specific Identification	- Most accurate valuation - Reduces risk of loss or theft	- Requires detailed tracking of each item - Needs investment in inventory management software - Complex for large inventories

How to Choose the Right Inventory Valuation Method

Now that we’ve covered the four main inventory valuation methods and how they work, let’s talk about how to choose the right one. 

The main thing you need to know is this: once you select an inventory valuation method, you cannot change it.

So there’s no hopping from FIFO to LIFO when inflation hits, or starting out with the specific identification method then moving to weighted average as your business grows. 

You choose a method and you stick with it.

With that in mind, let’s talk about how to make sure you’re picking the right method.

1. Consider certain factors going in

Different factors will impact your decision. Things like:

• Your business model—i.e., how many products you sell, your warehousing needs, and other factors that relate back to how your business runs
• Your product type—i.e., products with a shorter versus longer shelf life
• The market conditions—i.e., how expensive it is to stock your product
• Inflation—i.e., price increases, market volatility

We’ve walked you through what some of these factors look like with each valuation method. 

Now, you simply need to look at the big picture to decide which method is going to make the most sense and be the most profitable for your business.

Here are a few helpful tips:

• If you need a method to help you calculate COGS (cost of goods sold), the FIFO and WAC methods will be your best options.
• If you sell perishable products, you’re going to want to use the FIFO method.
• If you’re wanting to calculate the overall value of your entire inventory, the WAC method is the way to go.
• If your business only sells a single product, the WAC method gives you the best outcome.
• If you’re looking for a way to save on taxes, the LIFO method is often the best fit.
• If you sell high value products, the specific identification method is probably the best option.

2. Assess financial reporting needs

As we mentioned, a retail brand’s inventory can often be considered its largest asset. 

This means you need to keep financial reporting in mind, considering how each method could impact things like gross profit, net income, and cash flow.

Each method ends up with different results to put on your financial statements. You need to decide what is most important—i.e., mitigating loss or increasing cost flow.

Now, while we’ve already discussed many of these points, let’s put it all together into a single place to make your decision easier.

Method	Gross Profit	Net Income	Cash Flow
FIFO	Higher, as older, cheaper inventory costs are used	Higher, as lower COGS increases taxable income	Potentially lower, as more taxes might be due
LIFO	Lower, as newer, more expensive inventory costs are used	Lower, as higher COGS reduces taxable income	Potentially higher, as less taxes might be due
WAC	Average, balancing out price fluctuations	Average, providing a middle ground for net income	Stable, as average costs smooth out cash flow
Specific Identification	Most accurate, based on actual item costs	Most accurate, reflecting true net income	Varies, based on the precise cost of each item sold

3. Consult with accounting professionals

Depending on where you do business, you need to understand compliance for accounting regulations like the GAAP and IFRS. 

Talking to an accountant can help you get advice on the best inventory valuation methods for your location and the type of business you’ll be running.

The GAAP is founded on 10 main principles that help guide businesses and accountants going by these rules. 

The GAAP, as mentioned previously, is only accepted within the United States. Whereas, the IFRS is accepted worldwide and was put into practice by the International Accounting Standards Board (IASB).

The biggest difference between the two is that the GAAP accepts the use of the LIFO method, while the IFRS prohibits it. 

The other methods we covered are accepted by both sets of guidelines.

4. Analyze tax liabilities and profitability

In addition, each method comes with its own tax implications. 

The LIFO method is known for being the best option for saving money on taxes. However, you still need to remain compliant with your local standards and regulations.

Make sure you have a good understanding of both tax liabilities and profitability optimization with each method to choose the best one for your needs.

To help you out, here are some of the implications to keep in mind:

• FIFO: This method generally means you have a higher taxable income during periods of inflation, leading to potentially higher taxes.
• LIFO: As this is the opposite of FIFO, it means you could end up with a lower taxable income during periods of inflation, cutting down on your taxes.
• WAC: This method, as would make sense for a value based on averages, likely falls somewhere between FIFO and LIFO, depending on the circumstances, creating a median of sorts when it comes tax time.
• Specific identification method: This method offers extremely limited tax flexibility due to being such a rigid valuation method.

5. Use inventory management software

Inventory management software has a number of features that can help make the valuation process much more efficient.

For example, they can:

• Keep track of your inventory
• Categorize products
• Automatically re-order stock
• Provide real-time data and analytics
• Integrate with accounting software

Find the right inventory management software for your needs (and your budget) to get started automating the valuation process.

1. 1. SkuVault — Best for its detailed restocking recommendations
2. 2. Cin7 Core — Best for manufacturers and product sellers
3. 3. Linnworks — Best for multichannel management automation
4. 4. MRPeasy — Best for manufacturers
5. 5. Helcim — Best for small business inventory + POS in one
6. 6. Zoho Inventory — Best for small businesses
7. 7. Acumatica — Best for modern UI
8. 8. Sage X3 — Best enterprise resource tracking (ERP) package
9. 9. Cin7 Omni — Best for advanced multichannel order management
10. 10. ShipBob — Best end-to-end inventory & fulfillment

Show More (5)

Final Thoughts

Inventory valuation is a key practice come tax time each year. You need to be able to accurately assign a value to your inventory so you can price your products and report your inventory’s value.

There are four main ways to do this, each with its own advantages and disadvantages. 

We’ve covered each method, how to calculate it, plus factors to keep in mind when choosing the right inventory valuation method.

One great tool that can help with this process is the right inventory management software. Check out our guide to discover some of the best options for your business.

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Inventory Valuation FAQs

What is the most accurate inventory valuation method?

The most accurate inventory valuation method is the specific identification method, as it uses the exact product cost for each and every product.

However, this can be difficult to use for large businesses with massive inventories. This is why many companies will use the weighted average cost (WAC) method to calculate the overall inventory average.

How does inventory valuation affect taxable income?

Your inventory valuation reflects how much you’re able to sell your products for.

This in turn impacts your taxable income. A higher COGS tends to relate to a lower taxable income, which is why the LIFO method can be so appealing to some businesses.

How often should I perform inventory valuation?

This depends on your business and the lifespan of its inventory.

For example, some businesses (i.e., those selling food and perishable goods) may need to take inventory monthly, while others just need to perform inventory valuation once per year, right before tax time.