Inventory valuation
Inventory valuation, in accounting, refers to a methodology whereby inventory on hand is valued after a portion of it is sold or is otherwise removed.
There are various methods which are commonly used to value inventory: the most common are specific identification, FIFO (First In, First Out), LIFO (Last In, First Out), and average cost (which may be either simple average or weighted average).
Specific Identification
Under this method, each inventory item is given a specific identification number, and when that item is sold it is removed from inventory.
This method is used only on large-ticket items which can be separately identified, such as houses and cars.
Example
The developer of Eagles Landing, a subdivision, has completed three houses but has not yet sold them:
| Address | Cost |
|---|---|
| 101 Bald Eagle Boulevard | $150,000 |
| 102 Golden Eagle Way | $155,000 |
| 103 Spotted Eagle Street | $159,000 |
The developer's inventory would show $464,000 in housing inventory.
Then, the developer sells the house at 103 Spotted Eagle Street. The inventory would be reduced by $159,000 (the cost to build that house) for remaining inventory of $305,000. If the developer then completes a house at 104 Bald Eagle Boulevard for $150,000, the inventory is increased to $455,000.
FIFO
Under FIFO, items are removed from inventory based on the oldest purchase cost shown in the accounting records. This method generally tracks how inventory is actually sold or removed, especially for items with short shelf lives (such as produce).
Example
The owners of God's World Garden Center sell SuperPlant, a premium plant food. The current SuperPlant inventory as of the end of March is as follows:
| Purchase Date | Number | Cost |
|---|---|---|
| January | 10 | $10 |
| February | 10 | $12 |
| March | 15 | $14 |
The inventory value as of the end of March is $540.
On April 1 the Eagles Landing Garden Club purchases five units of SuperPlant. Under FIFO, the five items sold are removed at $10 each (the oldest cost); the remaining inventory is valued as follows: (5 units x $10) + (10 units x $12) + (15 units x $14) = $380.
LIFO
Under LIFO, items are removed from inventory based on the oldest purchase cost shown in the accounting records.
This method was very popular since, due to inflation, it tends to reduce income for tax purposes. LIFO is still allowable for reporting purposes under United States Generally Accepted Accounting Principles and for tax purposes, but under international accounting rules it is no longer allowable.
Example
Using the garden center example above, under LIFO the five items sold are removed at $14 each (the newest cost); the remaining inventory is valued as follows: (15 units x $10) + (15 units x $12) + (10 units x $14) = $470.