What Is Inventory Valuation? Methods, Worked Through

Inventory valuation is putting a dollar value on the stock you hold at a point in time, usually the end of a month or year. It matters because the same number decides your cost of goods sold, and so your profit and your tax: whatever value stays on the shelf didn't go into this year's cost. The value is quantity times cost, and the method is how you decide which cost, when you bought the same thing at different prices: FIFO (the oldest cost is used first), average cost, or LIFO (the newest cost first). On top of the method, stock that's worth less than it cost, because it's expiring or damaged, is written down. Below are the methods worked through on one month of butter, and a write-down example.

The short version

• Inventory value = quantity on hand × cost per unit, item by item.
• FIFO: the oldest prices go into cost of goods sold first; the newest stay on the shelf.
• Weighted average: one average price for the period.
• Moving average: a new average every time a delivery arrives.
• LIFO: the newest prices go out first. Allowed for US taxes, not under international rules.
• Stock worth less than it cost is written down to what you can get for it.
• Pick a method, use it every year, and change only with your accountant.
• TaroStack values stock in FIFO layers or moving average, every day. More below.

One month of butter, four ways

Windward Roots, the made-up taro business I use in these examples, buys butter for its taro sweet bread. October:

So 100 kg were available at a total of $870.00, 75 kg were used, and 25 kg are left. The question is what those 25 kg are worth, and the answer depends on the method.

Every row adds up to the same $870.00. The method only decides how it's split between this month's cost and the shelf.

How each one works

FIFO, first in first out. Usage takes the oldest layers first: all 20 kg at $8.00, all 40 kg at $8.50, then 15 kg at $9.25, which is $638.75. The 25 kg left are from the newest delivery, at $9.25: $231.25. When prices are rising, FIFO gives the lowest cost of goods and the highest inventory value, and the shelf is valued close to what it would cost to replace. This accountant's FIFO isn't the same thing as using the oldest stock first on the shelf, which is covered in FIFO and FEFO in the food industry.

Moving average. A new average after each delivery. After Oct 3: 60 kg for $500.00, $8.33 a kilo; 30 kg used cost $250.00, leaving 30 kg at $250.00. After Oct 17: 70 kg for $620.00, $8.86 a kilo; 45 kg used cost $398.57. Total used $648.57, and 25 kg left at $221.43.

Weighted average. One average for the whole period: $870.00 ÷ 100 kg = $8.70 a kilo. Used 75 kg × $8.70 = $652.50; left 25 kg × $8.70 = $217.50. Simple, but you only know the cost at the end of the period.

LIFO, last in first out. Usage takes the newest layers first: 40 kg at $9.25 and 35 kg at $8.50, $667.50. The 25 kg left are the oldest: 20 kg at $8.00 and 5 kg at $8.50, $202.50. When prices rise, LIFO gives the highest cost of goods and so the lowest taxable profit, which is why some US businesses use it. It's permitted for US taxes, with conditions, and not under international accounting standards.

There's also specific identification, where each unit carries its own actual cost, used for things like art or vehicles. For butter and flour, it isn't practical.

Writing down stock that's worth less

Whatever the method, stock shouldn't sit on the books above what it'll bring in. Under US accounting rules, stock valued by FIFO or average cost is carried at the lower of its cost and its net realizable value: what you can sell it for, less what it costs to sell.

Suppose Windward Roots has 60 jars of guava jam that cost $5.22 each, three weeks from their best-by date. They'll only sell at a discount, $4.00 a jar, with $0.50 a jar to sell them:

Net realizable value   $4.00 − $0.50 = $3.50 a jar
Write-down             ($5.22 − $3.50) × 60 = $103.20

The jars go on the books at $210.00 instead of $313.20, and the $103.20 is a cost this period. If they expire unsold, what's left is written off, which is covered in expired inventory tax write-off.

Which method should a small maker use?

My suggestion: FIFO or moving average, whichever your accountant prefers, and then don't change it. Both keep the shelf valued near today's prices, both are accepted for US taxes, and both are what inventory software usually supports. Whatever you choose, use it every year: switching later usually needs your accountant and, for taxes, IRS approval. This is general information, not tax advice.

The valuation is only as good as the count under it. How to do the count at year end is in year-end inventory count, and how the value flows into cost of goods sold is in how to calculate COGS for a bakery.

Where this stops working

FIFO on paper means keeping every layer: which delivery, how many kilos, at what price, and how many of them are left. For one item over one month, that's the table above. For 150 items over a year, with freight to spread, deliveries that arrive short, batches that use butter from two deliveries at once and finished goods carrying the cost of what went into them, nobody does it by hand. So the spreadsheet uses "last price paid" for everything, which is none of the methods, and the year-end value is a guess with decimals.

How TaroStack does it

TaroStack keeps the layers for you, item by item and delivery by delivery, so your inventory value is right on any day, not only on the night of the count.

The method is a setting, and it runs itself. Stock is costed in FIFO layers, or moving average if you prefer, chosen when you set up the business and locked once stock has moved, which is the consistency your accountant wants. Every delivery comes in at the price you paid, with freight and other landed costs spread across what arrived, so each layer carries its real cost. Every batch takes its ingredients from the layers it used, and the finished goods go on at what they actually cost, so the jar of jam is valued at the guava and sugar that went into it.

The value is a screen. Stock value is shown at what it really cost, per site and per item, split by type (raw materials, packaging, finished goods), with a month-by-month history and a chart. Your accountant's year-end number is there without anyone doing the layers, and the month-end figures for cost of goods sold come from the same records.

And the write-downs show up early. TaroStack forecasts which lots will expire before they're used and what that stock cost, while there's time to sell it. Stock that isn't moving shows how long since it last went out. Every write-off carries its reason (expired, damaged, spoiled, sample), so the losses report shows what was lost, where and what it cost.

Stock value, FIFO or moving average, landed costs and the losses report are on every plan, from $49 a month; batches that carry their actual cost into finished goods are on Standard at $99. The first 30 days are free, with no credit card. If you'd like a hand setting up, ask, and we'll do it with you.

Questions people also ask

What are the main inventory valuation methods?

FIFO (first in, first out), average cost (weighted or moving) and LIFO (last in, first out), plus specific identification for items tracked one by one. On top of any method, stock worth less than it cost is written down.

What is the best inventory valuation method for a small business?

FIFO or moving average suits a small maker well: both keep the shelf near today's prices and are accepted for US taxes. Pick one with your accountant and keep it.

How do you calculate inventory value?

Multiply the quantity on hand of each item by its cost under your method, then add them up. In the example, 25 kg of butter is worth $231.25 by FIFO and $217.50 by weighted average.

Why does inventory valuation affect profit?

Cost of goods sold is opening inventory plus purchases minus closing inventory. A higher closing value means a lower cost of goods sold and a higher profit, so the method and any write-downs change the profit you report.