An inventory valuation allows a company to provide a

monetary value In economics, economic value is a measure of the benefit provided by a goods, good or service (economics), service to an Agent (economics), economic agent, and value for money represents an assessment of whether financial or other resources are ...

for items that make up their

inventory Inventory (British English) or stock (American English) is a quantity of the goods and materials that a business holds for the ultimate goal of resale, production or utilisation. Inventory management is a discipline primarily about specifying ...

. Inventories are usually the largest current

asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...

of a business, and proper measurement of them is necessary to assure accurate

financial statement Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...

s. If inventory is not properly measured,

expenses An expense is an item requiring an outflow of money, or any form of fortune in general, to another person or group as payment for an item, service, or other category of costs. For a tenant, rent is an expense. For students or parents, tuition i ...

and

revenue In accounting, revenue is the total amount of income generated by the sale of product (business), goods and services related to the primary operations of a business. Commercial revenue may also be referred to as sales or as turnover. Some compan ...

s cannot be properly matched and a company could make poor business decisions.

Inventory accounting system

The two most widely used inventory accounting systems are the periodic and the perpetual. * ''Perpetual:'' The

perpetual inventory In business and accounting/accountancy, perpetual inventory system or continuous inventory system describes systems of inventory where information on inventory quantity and availability is updated on a continuous/real-time basis as a function of ...

system requires accounting records to show the amount of inventory on hand at all times. It maintains a separate account in the subsidiary ledger for each good in stock, and the account is updated each time a quantity is added or taken out. * ''Periodic:'' In the periodic inventory system, sales are recorded as they occur but the inventory is not updated. A physical inventory must be taken at the end of the year to determine the cost of goods Regardless of what inventory accounting system is used, it is good practice to perform a physical inventory at least once a year.

Inventory methods - perpetual

The perpetual system records revenue each time a sale is made. Determining the cost of goods sold requires taking inventory. The most commonly used inventory valuation methods under a perpetual system are: # first-in first-out (FIFO) #last-in first-out (LIFO) #(highest in, first out) (HIFO) #

average cost In economics, average cost (AC) or unit cost is equal to total cost (TC) divided by the number of units of a good produced (the output Q): AC=\frac. Average cost is an important factor in determining how businesses will choose to price their pro ...

weighted average cost Average cost method is a method of accounting which assumes that the cost of inventory is based on the average cost of the goods available for sale during the period. The average cost is computed by dividing the total cost of goods available for ...

These methods produce different results because their flow of costs are based upon different assumptions. The FIFO method bases its cost flow on the chronological order in which purchases are made, while the LIFO method bases its cost flow on a reverse chronological order. The average cost method produces a cost flow based on a weighted average of goods.

Periodic versus perpetual systems

There are fundamental differences for accounting and reporting

merchandise Merchandising is any practice which contributes to the sale of Product (business), products ("merch" colloquially) to a retail consumer. At a retail in-store level, merchandising refers to displaying products that are for sale in a creative w ...

inventory transactions under the periodic and perpetual inventory systems. To record purchases, the periodic system debits the Purchases account while the perpetual system debits the Merchandise Inventory account. To record sales, the perpetual system requires an extra entry to debit the

Cost of goods sold Cost of goods sold (COGS) (also cost of products sold (COPS), or cost of sales) is the carrying value of goods sold during a particular period. Costs are associated with particular goods using one of the several formulas, including specific iden ...

and credit Merchandise Inventory. By recording the cost of goods sold for each sale, the perpetual inventory system alleviated the need for adjusting entries and calculation of the goods sold at the end of a financial period, both of which the periodic inventory system requires. In Perpetual Inventory System there must be actual figures and facts.

Using non-cost methods to value inventory

Under certain circumstances, valuation of inventory based on cost is impractical. If the

market price A price is the (usually not negative) quantity of payment or compensation expected, required, or given by one party to another in return for goods or services. In some situations, especially when the product is a service rather than a phy ...

of a good drops below the purchase price, the

lower of cost or market In accounting, lower of cost or market (LCM or LOCOM) is a conservative approach to valuing and reporting inventory. Normally, ending inventory is stated at historical cost. However, there are times when the original cost of the ending inventor ...

method of valuation is recommended. This method allows declines in inventory value to be offset against income of the period. When goods are damaged or obsolete, and can only be sold for below purchase prices, they should be recorded at net realizable value. The

net realizable value Net realizable value (NRV) is a measure of a fixed or current asset's worth when held in inventory, in the field of accounting. NRV is part of the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS ...

is the estimated selling price less any expense incurred to dispose of the good.

Methods used to estimate inventory cost

In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. Two very popular methods are 1)- retail inventory method, and 2)-

gross profit For households and individuals, gross income is the sum of all wages, salaries, profits, interest payments, rents, and other forms of earnings, before any deductions or taxes. It is opposed to net income, defined as the gross income minus taxes ...

(or gross margin) method. The retail inventory method uses a cost to retail price ratio. The physical inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory. The gross profit method uses the previous years average gross profit margin (i.e. sales minus cost of goods sold divided by sales). Current year gross profit is estimated by multiplying current year sales by that gross profit margin, the current year cost of goods sold is estimated by subtracting the gross profit from sales, and the ending inventory is estimated by adding cost of goods sold to goods available for sale.

References

External links

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Financial Accounting Course

Costs Management accounting Inventory