4 Inventory Valuation Methods + the Impact on Ecommerce Profit Margins
For most eCommerce businesses, inventory is the largest current asset, which makes precise inventory valuation critical to success. Inventory valuation enables you to calculate your Cost of Goods Sold (COGS) and, ultimately, your profitability. So, you want to be sure you’re keeping a close eye on it!
In this blog, we’ll look deeper into inventory valuation, exploring its importance, different inventory valuation methods, how to choose the method that’s right for your business, and more.
What is Inventory Valuation?
Inventory valuation is an accounting practice that involves calculating how much your inventory is worth at the end of an accounting period or fiscal year. The valuation is based on the expenses involved in acquiring or producing inventory and prepping it for sale.
Inventory stock is only considered an asset on your balance sheet if it has financial value. Overvaluation or undervaluation can paint a misleading picture of the working capital position and the overall financial position of your business.
Why is Inventory Valuation Important?
Understanding and keeping track of inventory value is crucial because an excess or shortage of inventory can impact the production and profitability of a business.
Think of it this way: Let’s say you run a cell phone case company and you’re left with 100 cases at the end of the year. To put this inventory on your balance sheet, you’ll first need to calculate their financial value.
Of course, identifying the unsold cases is just the first step in inventory valuation. You also need to determine a price to multiply by 100 to arrive at a final value. This can be easier said than done, as you may have paid different prices for the items throughout the year. So, to accommodate for these price fluctuations, you need to calculate a common rate.
In the next section, we’ll explore four different inventory costing methods and then we’ll highlight some tips to help you choose which technique is right for your business.
4 Most Common Methods of Inventory Valuation
Which valuation method is best for your eCommerce business? Here are the four most frequently used valuation methods, along with some advantages and disadvantages of each.
The FIFO (First In, First Out) method means that the oldest (or first) manufactured or purchased goods will also be the first sold. Many business owners like the FIFO method because it’s easy to understand; income can’t be manipulated by choosing which item to ship because the cost of a single item sold is always the old cost.
A major benefit of FIFO is that since prices tend to rise over time and the least expensive product always goes first, COGS is lowered – which increases net income over time.
On the other hand, FIFO valuations can be inaccurate if the cost to make or purchase a product suddenly jumps. Let’s say the cost of those phone cases doubles, but your accountant is still using values from six months ago; profits will definitely take a hit. FIFO also does not offer any tax advantages.
The LIFO (Last In, First Out) method means that the most recent (or last) manufactured or purchased goods will be the first sold. With the LIFO method, the lower cost of older products will be reported as inventory. LIFO is rarely used by businesses because older inventories, especially those with a short shelf life, often go unsold and lose their value over time, resulting in significant profit loss.
The only reason to use LIFO is for tax benefits. During times of inflation, LIFO increases COGS and lowers the balance in the remaining inventory. When COGS is greater than profits, businesses pay less in taxes.
The WAC (Weighted Average Cost) method uses a weighted average to determine the amount that goes into COGS and inventory. Business owners simply average the price of all goods in stock, regardless of purchase or manufacture date, to determine value (for this reason, it’s also commonly called the “Average Cost Method”).
The calculation is simple: Cost of Goods in Inventory / Total Units in Inventory = WAC
Businesses with a high volume of inventory with items that are the same or very similar prefer this method because it evens out inventory costs, which reduces the likelihood of COGS being impacted. That cell phone case company would probably use WAC, for example. Even though they might have several SKUs (for different phone models, case colors, etc), the value of the items is basically the same.
One negative to WAC is that you could wind up selling goods at a loss if costs increase and you’re still calculating prices based on a standard COGS markup.
4. Specific Identification Method
Last but not least, the specific identification method monitors every single item in stock from the time it arrives to the time it’s sold (often, RFID tags are used to keep track of items). Businesses that sell very different products with very different values will use this; often, it’s reserved for large items that can easily be identified. The cell phone case company probably would not use the specific identification method!
While this method has a high degree of accuracy, it’s typically only feasible for small businesses or startups. Even with RFID tags, large businesses that move high volumes of inventory every day can’t realistically do this.
How to Pick Your Best Inventory Valuation Method
Your inventory costing method impacts your budgeting, taxes, inventory reorder quantities, and ultimately, your profitability. So, it’s important to carefully consider which is best for your business.
To make this determination, you need to pay close attention to changes in the inventory costs. For example:
- If inventory costs are increasing or expected to increase, LIFO may be your best option since higher cost items are counted as sold, resulting in a higher COGS and lower profits, which can have tax benefits.
- If inventory costs are dropping, FIFO may be your best option since lower cost items are already out the door. This lowers your COGS and increases your profit margin.
- If you sell a lot of similar products with similar price points, and your products’ raw material costs are not usually impacted by macro or microeconomic changes, you may want to consider WAC. This method simplifies the process by averaging out the cost amongst all inventory.
- Do you sell a smaller number of products that are unique and easily identifiable? If you have the time to track them all, the specific identification method is an ideal way to achieve high levels of accuracy.
It’s important to seriously consider the best method for your business as switching from one method of inventory valuation to another is a time-consuming process. First off, you’ll need to file an IRS Form 970. Then, you’ll have to spend a lot of time recalculating the value of your inventory. This can lead to inaccurate value amounts, affecting your balance sheet.
How Inventory Valuation Supports Business Growth
So which inventory valuation method is right for you? Here are a few more considerations that can directly impact the growth of your eCommerce business.
Acquiring a Loan
Your inventory acts as collateral when you’re applying for a business expansion loan. Ideally, you want the valuation to be high to give the lender more assurance. So, if prices tend to increase over time, FIFO will provide you with the higher closing inventory.
On the other hand, if prices are decreasing, LIFO will provide the higher value. If you plan to apply for a loan, always choose the technique that provides the highest inventory value.
To attract investors, you need to have a sustainable business model. That means having a high profit margin. Once again, this may mean choosing FIFO during times of inflation and LIFO during times of deflation. Whatever you do, just be sure your portrayal is accurate or you could face legal battles down the road.
It’s important to keep shareholders happy, and the best way to do this is to give them a great return on their money investment by choosing the best inventory valuation method. Happy investors send a positive signal to potential future investors, and are more likely to recommend your company to them.
Saving on Taxes
Want to cut down on tax liability? As mentioned previously, when your COGS is greater than your profits, you’ll receive tax benefits. So, consider choosing LIFO during times of inflation (this is the only time most businesses choose this model) may be beneficial.
You may also want to check out this IRS article on COGS before completing your taxes, and of course, consider consulting with a tax professional to keep your nose clean.
The Challenges of Valuing Inventory
Large companies invest millions into inventory tracking to accurately calculate the value of their inventory. This isn’t an option for most small and medium-sized businesses, which can pose a problem when it comes to inventory valuation.
Thankfully, there are other options, such as using a third-party order fulfillment company. So how does a company like The Fulfillment Lab help?
It’s difficult for growing eCommerce businesses to calculate the current value of their inventory if there are thousands of units in stock. Often, they wind up overpaying when it comes to carrying costs (warehousing, labor, insurance, and rent, plus the value of damaged, expired, or antiquated products).
The Fulfillment Lab allows you to easily keep track of your inventory and make decisions about reordering and more through our proprietary fulfillment software.
Managing inventory becomes even more complicated when you have inventory stored in multiple locations. However, this may be necessary in order to reduce shipping costs in regions where you most frequently sell products.
The Fulfillment Lab understands this, and operates out of 14 domestic and international locations. So, you get the benefit of storing your inventory in the best location to optimize your supply chain, along with full tracking and visibility into all units, regardless of location, using our fulfillment software.
Inventory audits are a necessary evil if you want to maintain your financial statements and stock levels. Small and medium-sized businesses doing this manually waste a lot of time that could be better spent growing the business, and are prone to accounting errors resulting in inventory shrinkage (recording a higher inventory than there actually is, impacting profits).
Using The Fulfillment Lab’s inventory management software, businesses can easily keep track of their inventory, maintaining an accurate count even as products sell, expire, etc.
Manage Your Inventory with The Fulfillment Lab
Inventory management can be a complicated and time-consuming process. With The Fulfillment Lab, you can avoid errors and keep your inventory (and profits) on track with GFS™, our Global Fulfillment Software.
It allows you to quickly integrate your eCommerce platform and set up your fulfillment logistics. You can start easily managing inventory, tracking orders, and more in no time! Contact us today to learn more.