Inventory Valuation

Inventory Valuation

Retailers define inventory as intended sellable assets consisting of goods that are available for resale to customers. Manufacturers also maintain three components of inventory. These include “finished goods” which are goods that have been completed and are awaiting sales. Manufacturers may also have “work in process inventory” made up of goods being manufactured but not yet completed. The third category of inventory is “raw materials,” consisting of goods that are to be used in producing products. Overall, inventory should include all costs that are both ordinary and necessary to put the goods in place and in condition for their resale. For many companies, what they have in inventory represents a major portion of assets and therefore makes up an important part of the balance sheet. It is therefore crucial for investors to understand how inventory is valued.

Inventories are kept track of by periodic and perpetual inventory systems. Both terms, periodic and perpetual, imply a time frame for determining the amount of ending inventory. Under the periodic system the amount of inventory on hand is determined through physical count once at the end of an accounting period or periodically. A more robust system is the perpetual system. With a perpetual system, a running count of goods on hand is maintained at all times. The perpetual inventory method is not a physical check of inventory but rather a recording of changes in inventory when sales transactions occur. The FIFO method, which is explained later, will produce the same financial statement results no matter whether it is applied on a periodic or perpetual basis. This occurs because the beginning inventory and early purchases are taken away and charged to the cost of goods sold whether the associated calculations are done as you go (perpetual) or at the end of the period (periodic).

There are advantages to both inventory systems. Through perpetual systems, inventory quantities are maintained on a consistent basis and internal control is enhanced by allowing spot checks of inventory quantities on a random basis at any time. The timely manner knowledge of inventory is relayed to managers allow for them to react to changing trends to avoid running out of a fast moving item or from restocking unwanted slow moving items. A few advantages to the periodic inventory system include it requiring no computer systems due to its relatively simple record keeping method. This is beneficial to small start up businesses not able to afford the higher priced inventory systems. The periodic system allows firms to determine inventory and cost of goods sold at the end of the year without having to record the effect of every sale and purchase made throughout the year.

Whether a company uses a periodic or a perpetual inventory system, a physical count of goods on hand should occur from time to time. When physical counts are not possible or not cost effective one of two estimation methods must be employed. The first estimation method is the gross profit method. This method applies the company’s historical gross profit percentage to current period information about net sales and the costs of goods available for sale. The other method is the retail inventory method. The cost to retail percentage is multiplied by the ending inventory at retail.

Companies value their inventory at cost or otherwise whatever price they pay for it. The value of a company’s inventory shows up in two different places. One is on the balance sheet, usually under the heading “ending inventory”, the company’s inventory is reflected in the assets section. The number is a calculation of whatever the value of the physical inventory a company has on hand at the end of a given time. Inventory is also shown on income statements as the cost of goods sold. This is the value of the inventory items that were sold during a certain period of time.

The value of a company’s inventory is a major factor in figuring out its taxable income. Two general methods used for valuing inventory include the cost method and the lower of cost or market method. To properly use the cost method in valuing your property, all direct and indirect costs associated with it must be applied. Some general rules apply to the cost method including that for merchandise on hand at the beginning of the tax year, cost means the inventory price of the goods. Also, for any merchandise purchased during the year, cost means the invoice price less discounts plus freight and other charges occurred in acquiring the goods. For any merchandised produced during the year, cost means all direct and indirect costs that have to be capitalized under the uniform capitalization rules (UNICAP). Under UNICAP, you must capitalize the direct costs and partial