How do you choose an inventory valuation method?
The method used to assign cost to units held and units sold. You pick one method and use it consistently, so the same rule prices units on the shelf and units that sold.
Definition
Inventory valuation is the rule that assigns a dollar cost to each unit you still hold and each unit you sell. On the books, this is a method, not an account you can point to.
The same cans on a shelf can carry different book values depending on which method you pick. The physical goods do not change; the cost assigned to them does.
Once you choose a method, you use it consistently from period to period. Switching later is allowed only with a good reason and a clear note on the statements.
Where it shows up
Balance Sheet: Related to the inventory line and the cost assigned to units still on hand.
P&L: Related to cost of goods sold for the units sold.
See also: FIFO · Cost Of Goods Sold · Inventory
When you look at your Balance Sheet, inventory sits with the other current assets. The method decides the dollar amount on that line, not whether the goods exist.
The Income Statement does not name the method. It shows cost of goods sold, which is the cost the method assigned to the units that left.
A higher remaining inventory cost usually means a lower cost of goods sold for the same sales. Every purchase dollar is either still on the shelf or already in cost of goods sold.
There is no cash-flow line for the method itself. Cash moved when you paid the vendor, not when you assigned a cost.
How it works
You start with the actual purchase costs. Invoices, freight, and other costs to get the goods ready to sell are the raw numbers the method will sort.
The method then answers one question: which of those costs still sit in inventory, and which have been used up by sales. A count tells you how many units remain; the method tells you what those units cost.
The common options are FIFO, LIFO, and weighted average cost. FIFO treats the oldest costs as sold first, LIFO treats the newest costs as sold first, and a weighted average blends them.
You pick one method and apply it to a class of goods. A grocery can use one method for canned goods and still need the same discipline: pick it, document it, and stay with it.
The method does not change what you paid the vendor. It only changes how those paid costs are split between the Balance Sheet and the P&L.
At period end, a physical count confirms the units. The method then prices those units so the books can close.
If later selling prices fall below the assigned cost, a separate rule may require a write-down. That write-down is not the valuation method itself.
Example
A neighborhood grocery buys canned tomatoes in two lots. Monday's 100 cans cost $1 each, and Friday's 100 cans cost $2 each.
The store sells 100 cans over the weekend. The method decides whether the remaining 100 cans are carried at $100, at $200, or at $150.
The grocery records the first lot when the delivery arrives:
Debit: Inventory $100
Credit: Accounts payable $100
Assets and accounts payable both go up by $100. Cash has not moved.
The second lot is recorded the same way at $200. After the weekend sale, the chosen method assigns $100, $150, or $200 to the remaining cans, and the rest becomes cost of goods sold.
The grocery has to pick one method and stick to it. Next month's books only make sense if the same rule is used again.
Common mix-ups
Inventory valuation is not the same as counting the stock. A count tells you how many units are there; the method tells you what those units cost on the books.
The method is not three different pages of math you run every week. FIFO, LIFO, and average cost are options under this one choice, not a menu you mix for the same goods.
Changing the method is not a way to tidy one month's profit. Consistency is the point, so a reader can compare one period to the next.
Related terms
- FIFO: An inventory method that assumes the oldest units are sold first.
- LIFO: An inventory method that assumes the newest units are sold first.
- Weighted Average Cost: An inventory method that spreads total cost evenly across all units on hand.
- Lower Of Cost Or Market: A rule requiring inventory to be carried at the lower of its cost or what it can actually be sold for.
- Cost Of Goods Sold: The direct cost of the products sold during the period.
- Inventory: Goods held for sale or used to produce goods for sale.
- Standard Cost: A pre-set expected cost per unit used for planning and comparison.
- Physical Inventory Count: A full hands-on count of stock used to correct the recorded balance.