LEARNING OUTCOME III: Learning hours: 30

APPLY INVENTORY MANAGEMENT AND VALUATION PRINCIPLES

Inventory or stock is the resourceful but idle assets lying with the company at the end of the
accounting period. It is one of the most significant assets of a company on its balance sheet. So,
inventory valuation is a very important factor in the accounting of a company. Construction
inventory management is a means by which construction companies and suppliers can keep track
of materials, workforce, equipment and plant. This is particularly important when a construction
company has multiple projects to manage, as efficient scheduling can become very complicated.
Construction inventory management is a process or method that allows construction business
owners, managers, contractors, and suppliers to record and track inventory at a construction site.

What are examples of inventory in construction? Some common examples include supplies,
tools, equipment, workforce, and factories. Construction inventory management also involves
preventative maintenance scheduling for tools and equipment, preventing needless downtime for
repairs. This process helps with efficient project scheduling and management which is especially
important for businesses that handle multiple complex projects at the same time. It also prevents
under-ordering, delays, as well as lost and misplaced items while boosting profitability.

GAAP requires that inventory is stated at replacement cost if there is a difference between the
market value and the replacement value, but upper and lower boundaries apply. This is known as
the lower of the cost and market value methods of inventory valuation. There are no absolute rules
about which inventory valuation method is best for a given organization.

What is inventory value?

Inventory value is the total monetary worth of a business’s goods and materials held in stock
and available for sale or use. Calculating inventory value is essential for financial reporting, tax
purposes, and managing various aspects of the business, including cash flow, profitability, and
overall financial health. Inventory valuation is a crucial aspect of financial management in the
construction industry. It refers to the process of determining the monetary value of materials,
supplies, and equipment held in stock by a construction company. This valuation not only impacts
the company's financial statements but also plays a significant role in decision-making, tax
calculations, and overall business strategies.

Significance of Inventory Valuation

When we talk about inventory, we usually refer to the stock-in-trade with a company of raw
materials, semi-finished goods, finished goods, and spare parts. So, at the end of the year
inventory must be counted to get to the closing stock.
However, only counting inventory is not enough, it also must be valued. The process of inventory
valuation helps determine the value at which we will record the inventories in the final accounting
statements of the company. The correct inventory valuation is essential to have a fair
representation of the company’s finances. The reasons inventory valuation is so important for a
company are the following:

1] Helps Determine Income

To calculate the gross profit or loss for the year we match the cost of goods sold to the direct
revenue of an accounting period. The formula for calculating the cost of goods sold is as follows,

COGS = Opening Inventory + Purchases + Direct Expenses – Closing Inventory

Inventory valuation will have a major impact on income determination if valuations are over or
understated, this can be explained as:

a. When closing inventory is overstated, net income for the accounting period will be
overstated.

b. When opening inventory is overstated, net income for the accounting period will be
understated.

c. When closing inventory is understated, net income for the accounting period will be
understated.

d. When opening inventory is understated, net income for the accounting period will be
overstated.

So, as you can see inventory valuation (closing inventory) has a direct impact on income
determination of a firm. The misstatement or miscalculation of inventory can overstate or
understate the profits of the firm.

2] Helps Determine Financial Position

Inventory is not only a part of the Profit and Loss statement but also of the Balance Sheet,
Inventories are considered as Current Assets of a firm. So, it is very important to have precise and
correct inventory valuation. If the calculated value of the inventory is wrong, it will represent a
wrong financial position on the date of the balance sheet.

3] Liquidity Analysis

Inventory is a current asset because the firm is not expected to hold it for a long period of time.
There is a lot of turnovers when it comes to stock. So, inventory actually is a significant portion
of the working capital (current assets – current liabilities) of a company. It is important to value
it correctly so the current ratio and liquid ratios can be calculated accurately. These ratios are
important to check for the liquidity of a company.

4] Statutory Compliance

All firms now must disclose the valuation of each class of inventory. The disclosure must include:

• Accounting policies adopted for the inventory valuation

• The total amount of the inventories along with the classifications (raw materials, WIP,
finished goods etc.)

Basic Principle of Inventory Valuation

There is one basic principle for inventory valuation. Generally, the inventory of a firm should be
valued at the lower of cost or net realizable value. This principle comes from the conservative
system of accounting. So, the principle basically states that we must value the inventory either at
the cost of the inventory or at its net realizable value. Let us understand the terms cost and net
realizable value.

• Cost: Cost of the inventory includes the cost of purchase of the materials. To this, we will
add the cost of conversion. These will be the direct expenses of the manufacturing process
like direct material and direct labor etc. Any other costs to bring the inventory to its current
condition will form a part of this cost. Abnormal losses, storage, distribution and selling
costs will be avoided.

• Net Realizable Value: This is the estimated price of a finished good after deducting the
costs to make the sale. In the case of raw materials, it will be the replacement cost of the
raw materials, i.e. their market price. And for WIP it will be the selling price minus the
cost of conversion.

Methods of Inventory Valuation

In the construction industry, various methods are used to value inventory, each with its own
implications. A business will select a specific inventory valuation method that aligns with their
accounting practices and accurately reflects its financial position. Typically, there are three basic
methods of calculating inventory value.

1. First In, First Out

2. Last In, Last Out

3. Weighted Average Cost
 • First-In, First-Out (FIFO): This method assumes that the first items purchased are the
first to be used or sold. It can be beneficial during times of rising prices, as older, lower-
cost inventory is used first, resulting in a lower cost of goods sold and higher reported
profits. It operates on the principle that the oldest inventory items are sold or used first.
This method is like a queue, where the first items in are the first ones out. It’s commonly
used for perishable goods to reduce the risk of expiration. When costs are stable or
increasing, FIFO often leads to a lower cost of goods sold (COGS), leading to higher
reported profits. Businesses will use this method when there’s a clear connection between
the physical flow of goods and their order of sale or use.
• Last-In, First-Out (LIFO): In contrast, LIFO assumes that the most recent items
purchased are the first to be used or sold. This can be advantageous during times of
inflation, as it matches the higher current prices with revenue, potentially lowering taxable
income. It assumes that the newest inventory items are sold or used first. It’s like a reverse
queue, where the last items in are the first ones out. LIFO is advantageous when costs
decrease, allowing businesses to report higher profits by assigning the most recent, lower
costs to the COGS. This method may be preferred when specific identification of inventory
items is crucial, as seen in industries with unique serial numbers or identifications.

• Weighted Average Cost: calculates the average cost of all units in inventory, regardless
of when they were bought. The average cost is applied to both the COGS and ending
inventory. Each unit contributes proportionately to the average cost, offering a more
blended and smoothed approach than FIFO and LIFO. The weighted average method
simplifies cost calculations by assuming a uniform cost per unit, making it a practical
choice for managing inventory and cost considerations. For example, you’d use this
method if you’re a manufacturing company producing standardized bolts or nuts where
each unit is identical in material and production cost.

Choosing the right method can significantly impact a construction company's financial statements
and tax liabilities. It's important to carefully consider the pros and cons of each method based on
the company's specific circumstances and the prevailing market conditions.

Examples of inventory value in forecasting

Inventory value directly impacts financial statements, cash flow, and overall business planning.
Here are a few examples of how inventory value is used in forecasting:

Financial forecasting: By accurately estimating inventory value, businesses can project their cost
of goods sold (COGS) and gross profit. This information is vital for creating income statements
and balance sheets.
Cash flow forecasting: Knowing the value of inventory on hand enables businesses to plan for
necessary working capital, covering operational expenses like salaries, utilities, and debt payments
alongside specific inventory holding costs.

Production planning: Businesses can forecast when to order new materials or produce additional
goods based on inventory levels and expected demand. This helps in optimizing production
schedules and avoiding excess stock or stock-outs.

Seasonal demand forecasting: Forecasting inventory value becomes critical for businesses with
seasonal fluctuations in demand. By analyzing historical data and considering seasonal trends,
companies can adjust their inventory levels to meet anticipated demand during peak seasons and
avoid excess inventory during slower periods.

Budgeting: Businesses can use historical data and market trends to forecast inventory costs,
allowing for accurate budgeting and resource allocation.

Strategic Planning: It helps businesses make informed decisions about pricing, promotions, and
product launches, ensuring they align with financial goals and market conditions.

Factors Influencing Inventory Valuation

Several factors affect how inventory is valued in the construction industry:

• Market Fluctuations: The volatile nature of construction markets can lead to rapid
changes in material prices. This volatility impacts the choice of inventory valuation method
and affects the reported financial results.
• Project Timelines: The duration of construction projects and the expected timing of
material usage can influence the choice of inventory valuation method. Long-term projects
might experience significant changes in material prices, affecting the overall cost structure.
• Accounting Standards: Construction companies need to comply with accounting
standards, such as Generally Accepted Accounting Principles (GAAP) or International
Financial Reporting Standards (IFRS), which provide guidelines for inventory valuation
methods and reporting.

Considering these factors is crucial for accurate financial reporting and informed decision-making
within the construction sector.

How inventory value can reduce risk

• Optimized cash flow: Maintaining an appropriate inventory level helps prevent excess
stock or stock-outs, ensuring that capital is efficiently utilized. This optimization
 minimizes the risk of tying up excess funds in unsold products or losing sales opportunities
due to insufficient stock.

• Reduce obsolescence: Regularly monitoring and managing inventory values can reduce
the risk of holding obsolete or outdated stock. By identifying slow-moving items promptly,
businesses can take proactive measures such as promotions or liquidation to minimize
losses associated with obsolete inventory.

• Reduce operational risk: Understanding the value of inventory aids in building a more
resilient supply chain. By having accurate insights into the financial investment tied up in
inventory, businesses can adapt quickly to changes in demand, supply chain disruptions,
or market fluctuations and reduce overall operational risk.

• Better decision-making: With accurate inventory valuation, businesses can make

strategic decisions on pricing, promotions, and procurement based on the real-time value
of their inventory. This proactive approach reduces the risk of reactive, uninformed
decisions that can negatively impact profitability.
• Improve profit margins: By aligning inventory levels with demand and market trends,
businesses can optimize pricing strategies and reduce the risk of markdowns or discounts
to move excess stock. This, in turn, contributes to higher overall profitability.

Impact on Financial Statements

Inventory valuation directly impacts the financial statements of construction companies:

• Balance Sheet: The value of inventory is reported on the balance sheet as a current asset.
The chosen valuation method affects the total asset value, which in turn affects metrics like
working capital and the company's overall financial health.

• Income Statement: The valuation method affects the cost of goods sold (COGS), which
impacts gross profit and net income. The choice between FIFO and LIFO can lead to
variations in reported profitability.

• Cash Flow: Fluctuations in inventory valuation impact cash flow through changes in
reported net income and changes in working capital. This can affect a construction
company's ability to invest, expand, and meet financial obligations.

Transparent and accurate inventory valuation is essential for providing stakeholders with a clear
picture of a construction company's financial position and performance.

Regulatory and Tax Implications

Inventory valuation also has regulatory and tax implications for construction companies:
 • Taxation: The valuation method chosen can impact taxable income and, consequently, the
taxes a construction company owes. Companies need to consider the tax laws and
regulations of their jurisdiction when selecting a method.

• Financial Reporting: Regulatory bodies and accounting standards require accurate and
consistent reporting of inventory valuation. Failure to adhere to these guidelines can result
in penalties and damage to the company's reputation.

It's crucial for construction businesses to work closely with financial and legal experts to ensure
compliance with applicable regulations and to optimize tax strategies. Inventory valuation is a
complex yet essential aspect of financial management within the construction industry. The
methods chosen, influenced by factors like market fluctuations and project timelines, impact
financial statements, taxes, and decision-making. Transparent and accurate valuation is necessary
for regulatory compliance, informed business strategies, and maintaining the financial health of
construction companies.

What Are the 4 Types of Inventory Management Systems?

The four types of inventory management systems include:

• Just-in-time (JIT) management: Under this model, vendors send supplies based on current
production needs.

• Materials requirement planning (MRP): It factors in the existing demand and bill of
materials (BOM) to determine the number of materials, parts, and prefabricated products
required for production.

• Economic order quantity (EOQ): This system relies on the exact quantities of materials
that a business must order to keep inventory costs low.

• Days sales of inventory (DSI): DSI helps companies calculate the average number of days
it takes to sell their inventory which indicates stock liquidity.

Businesses can use any of these inventory management systems to suit their specific needs.

How to calculate inventory value

Calculating inventory value considers the changes in inventory during a specific accounting period
to determine the value of the ending inventory. The basic idea is to start with the value of the
inventory at the beginning of the period (the beginning inventory), then add the cost of new
inventory acquired during the period (purchases or net purchases) and subtract the cost of the
inventory that was sold during the period (cost of goods sold or goods sold). The result is the
inventory value at the end of the accounting period, referred to as the ending inventory.
So, the formula for inventory value looks like this:

Inventory value= Beginning Inventory + Net Purchases − Cost of Goods Sold (COGS)

The components of the formula:

Beginning Inventory: The value of the inventory at the beginning of the accounting period.

Net Purchases or Purchases: The total cost of inventory acquired during the accounting period.
It includes the cost of goods purchased and additional costs like shipping or handling.

Cost of Goods Sold (COGS) or Goods Sold: The total cost of inventory sold during the
accounting period.

The result is ending inventory: the value of the inventory at the end of the accounting period.
This amount is crucial for accurate financial reporting and various financial analyses. Remember
that the specific details of calculating these components may vary based on the method used, such
as FIFO, LIFO, and Weighted Average Cost.

Why is an accurate inventory value so important? It’s essential for a business’s financial
integrity and decision-making processes. Reliable inventory valuation is crucial for building trust
with investors, creditors, and other stakeholders, as it demonstrates transparency and adherence to
accounting standards. Inaccuracies in inventory reporting can lead to financial mismanagement,
potentially impacting a business’s reputation and regulatory compliance.

Challenges of Inventory Valuation

Two basic challenges exist when valuing inventory: The company must determine the total cost of
its inventory, and to do so, it must figure out how much inventory it has, which can be complicated.

Costing your inventory. The basic equation for the value of your remaining inventory at the end
of an accounting period flows directly from the equation for COGS:

COGS = Beginning inventory + Purchases – Ending inventory

So, it follows that:

Ending Inventory = Beginning inventory + Purchases – COGS

However, the value of beginning and ending inventory may not be as simple as it seems. Anything
you cannot sell at full price because of damage, obsolescence or even changes in consumer
preferences must be marked down and valued accordingly.

Determining the amount of inventory.

This can also be more difficult than it may seem. For example, a company may have goods in
transit and needs to decide whether to include those items in inventory. In addition, it may need to
conduct physical inventory counts. Many companies tally inventory using a periodic inventory
system. Under this system, companies assess inventory at the end of an accounting period. The
alternative is a perpetual inventory system, which tracks every purchase order and sale and
continuously updates inventory to reflect those transactions.

III.1. Identification of WAC (weighted Average Cost) principle

Under the WAC method, a retailer estimates a weighted average by dividing the COGS by the
number of items available. So, the retailer can then have the actual picture of inventory available
on hand, an average between the newest and oldest products.

III.1.1 Description of WAC (weighted Average Cost) principles

▪ Weighted average cost (WAC). As the name suggests, WAC uses an average of all
inventory costs. WAC is generally used when inventory items are identical. It can simplify
inventory costing because it avoids the need to track the cost of separate inventory
purchases when calculating profit and tax liability. The other advantage of WAC is that it
reduces fluctuations in profit due to the timing of purchases and sales. Its most obvious
disadvantage is that a WAC system is not sophisticated enough to track FIFO or LIFO
inventories.

The chickpea retailer wants to simplify its accounting and obtains IRS permission to switch to
WAC inventory valuation. COGS is now calculated based on the weighted average cost of the
three chickpea purchases. Since the total purchase costs are $221.50 for 210 pounds of chickpeas,
the WAC per pound is just under $1.055 ($221.50 / 210). The COGS of 170 pounds is $179.31
and sold $255.00. So, the gross profit is $255.00 – $179.31 = $75.69. Note that the gross profit is
between that yielded by FIFO and LIFO, as you would expect.
 ▪ Specific identification. This method tracks each individual item from purchase to sale. It
generally makes no sense to use specific identification for identical products sold in the
thousands. But a dealer in high-value, one-of-a-kind items like classic cars would use
specific ID. Specific ID provides the most accurate record of the real inventory cost and
profit, and it allows the company to measure the profitability of each item.
If a company buys four cars for a total of $85,000 and sells them for $140,000, its COGS is $85,000
and gross profit would be $55,000 ($140,000 – $85,000). If it buys one additional car for $20,000
and sells it for $35,000 during the period, its COGS increases to $105,000 ($85,000 + $20,000),
and revenue increases to $175,000 ($140,000 + $35,000), for a gross profit of $70,000 ($175,000
– $105,000). The big jump in profit from one additional item makes it clear why the business
would want to know the value of each item.

How to calculate inventory value using the WAC method?

Let’s illustrate using the same example. All in all, grocery store bought 300 bottles of milk
(100pc+200pc) and paid 500$ (100$ + 400$).
Here comes the weighted average cost.
WAC = 500 / 300 = 1.66$ per bottle.
At the end of the month, we have sold 50 bottles, so the COGC = 50pc x 1.66$ = 83$

Inventory value = 250 x 1.66 = 415$

Regardless of the inventory valuation method chosen, real-time data records and accurate
calculations is a must-have. Keeping detailed spreadsheets for each SKU can be ineffective and
time-consuming, especially for large retailers that own dozens, hundreds and thousands of SKUs
across several locations and sales outlets. We recommend using more sophisticated automated
software which can accommodate any valuation method you choose, keep your calculations up-
to-date, and take care of all your business needs.

III.1.2 Procedures of applying WAC (weighted Average Cost) principle

WAC inventory valuation method is basic and simple and is sometimes referred to as a starting
point for retail business. WAC deals with simple similar items, that are easy to track. The
calculations are easy, and you do not have to invest time and money into sophisticated accounting
and record tracking systems or hire a lot of people.

On the contrary, if you use the WAC valuation and your products belong to different price
categories, you can lose money by taking the average price as a reference point and blurring the
difference between expensive and cheap goods.
The WAC inventory valuation method stands for Weighted Average Cost. Under the WAC
method, a retailer estimates a weighted average by dividing the COGS by the number of items
available. So, the retailer can then have the actual picture of inventory available on hand, an
average between the newest and oldest products.

WAC inventory valuation method is basic and simple and is sometimes referred to as a starting
point for retail business. WAC deals with simple similar items, that are easy to track. The
calculations are easy, and you do not have to invest time and money into sophisticated accounting
and record tracking systems or hire a lot of people.

On the contrary, if you use the WAC valuation and your products belong to different price
categories, you can lose money by taking the average price as a reference point and blurring the
difference between expensive and cheap goods.

III.2. Application of FIFO (First-In-First-Out) principle

First-In-First-Out (FIFO) method of inventory valuation is easy, accurate and quite logical: it is
based on the assumption that the products which are purchased from the supplier (or produced)
earlier are sold first. So, FIFO method takes the cost of the oldest inventory as a basis of COGS
(Cost of Goods Sold) formula.

If a company uses FIFO as a primary inventory valuation method, it has to understand that the
goods that arrived earlier from the supplier (or manufacturer) may sometimes be cheaper than the
newer ones. It depends on the supplier’s pricing strategy, but usually, the prices tend to rise rather
than fall. So, in this case, COGS will be lower and profit figures will be higher. That will result in
a higher base for taxation.

In addition to being easy to manage and understandable, the FIFO method helps retailers to cut
waste and spoiled goods quantities, as you always sell the older inventory first. That is why the
FIFO method is so popular among businesses dealing with fast-spoiling goods, such as fresh milk,
vegetables, meat, eggs, fruits, etc.

One of the biggest and most considerable disadvantages of the FIFO inventory valuation method
is a high level of dependence on prices. In the case of inflation, the base of taxable income may
rise dramatically and distort financial performance.

How to calculate inventory value using FIFO method?

In January a village grocery purchased fresh milk - at first, 100 bottles of full-fat milk, 1$ per bottle
and then, 200 bottles of same full-fat milk from another manufacturer, 2$ per bottle.

By the end of January, 50 bottles of milk were sold.

So, using FIFO we calculate the cost of goods sold for the first batch of milk. We take the FIFO
product price and multiply it by the number of products sold.

Cost of Goods Sold = 1$ x 50pc = 50$

We have another 50 bottles of milk on the shelves and 200 bottles of full-fat milk from another
manufacturer. Let’s calculate the inventory value: Inventory value in January = (1$ x 50pc) + (2$
x 200pc) = 450$

III.2.1 Description of FIFO Principles

Companies generally have a choice of four different inventory valuation methods, each with its
pros and cons. It’s important they consider all the potential advantages and disadvantages of each
approach and choose carefully:

▪ First In, First Out (FIFO). This is the most intuitive and widely used method. It assumes
that the first product a business sells is from the first (or oldest) set of materials or goods it
bought and values the inventory accordingly. Generally speaking, this is the method that
most closely matches the actual inventory costs.

First-in goods are generally cheaper than those that follow because materials prices and other
inventory costs tend to rise over time due to inflation. FIFO therefore generally results in a lower
COGS and higher gross income than other valuation methods. FIFO does have two significant
disadvantages. First, a higher gross income translates to a bigger tax bill. Second, during periods
of high inflation, FIFO can result in financial statements that can mislead investors.

Imagine you sell dry chickpeas by the pound. It’s a new business, so your beginning inventory is
zero. You initially buy 60 pounds and subsequently purchase an additional 70 pounds and then 80
pounds to stay ahead of future sales demand. The price rises between purchases, as shown in the
table. If you sell 170 pounds in the relevant accounting period at $1.50/pound, your revenue will
be $255, and your gross profit will be $255.00 – $177.50 = $77.50.

Beginning inventory value $0

Purchases

60 lbs. at a cost of $1.00/lb. $60.00

 70 lbs. at a cost of $1.05/lb. $73.50

80 lbs. at a cost of $1.10/lb. $88.00

Total purchases $221.50

Goods sold

60 lbs. at a cost of $1.00/lb. $60.00

70 lbs. at a cost of $1.05/lb. $73.50

40 lbs. at a cost of $1.10/lb. $44.00

Cost of goods sold $177.50

Ending inventory

40 lbs. at a cost of $1.10/lb.

Ending inventory value $44.00

Gross profit = Revenue – COGS = $255 – $177.50 $77.50

III.2.2 Procedures of applying FIFO principles

FIFO stands for first in, first out, an easy-to-understand inventory valuation method that assumes
that the first goods purchased or produced are sold first. In theory, this means the oldest inventory
gets shipped out to customers before newer inventory. To calculate the value of ending inventory,
the cost of goods sold (COGS) of the oldest inventory is used to determine the value of ending
inventory, despite any recent changes in costs.
How the FIFO inventory valuation method works

Since ecommerce inventory is considered an asset, you are responsible for calculating COGS at
the end of the accounting period or fiscal year. Ending inventory value impacts your balance sheets
and inventory write-offs. Due to inflation, the more recent inventory typically costs more than
older inventory. With the FIFO method, since the lower value of goods are sold first, the ending
inventory tends to be worth a greater value.

Additionally, any inventory left over at the end of the financial year does not affect cost of goods
sold (COGS). It’s important to note that FIFO is designed for inventory accounting purposes and
provides a simple formula to calculate the value of ending inventory. But in many cases, what’s
received first isn’t always necessarily sold and fulfilled first.

However, if you sell items that have a short shelf-life, are perishable, or tend to go obsolete quickly,
the FIFO method provides a dual advantage of proper inventory management and an easy method
for calculating ending inventory value. Calculating inventory value that matches the natural flow
of inventory throughout your supply chain, you’re able to track and regulate quality and offset the
risk of high holding costs for storing inventory that is obsolete or no longer sellable (also known
as dead stock).

Though it’s the easiest and most common valuation method, the downside of using the FIFO
method is it can cause major discrepancies when COGS increases significantly. If product costs
triple but accountants use values from months or years back, profits will take a hit. It also does not
offer any tax advantages unless prices are falling.

Examples of calculating inventory using FIFO

According to the FIFO cost flow assumption, you use the cost of the beginning inventory and
multiply the COGS by the amount of inventory sold. Let’s revisit Susan’s pet supply store.
Originally, Susan bought 80 boxes of vegan pumpkin dog treats at $3 each. Later on, she bought
150 more boxes at a cost of $4 each, since the supplier’s price went up.
• Susan now has 230 boxes of dog treats in stock.
• Of these, 100 boxes of dog treats have been sold.
Using the FIFO method of inventory valuation, Susan assumes that she sold all 80 of the original
boxes before dipping into the newer stock. Thus, in her balance sheet, the total cost of goods she
sold above (100 boxes) would be:
COGS = (The Number of Original Units x Their Value) + (Remaining Units from the Second
Purchase x Their Value).
COGS = (80 x $3) + (20 x $4) = $320
Notice that the cost of the oldest inventory items are used first in the COGS calculations (the initial
purchase of 80 boxes at $3/each) and the remaining 20 boxes use the second purchase cost of
$4/each. The value of the remaining or ending inventory (130 boxes) is then calculated:
Ending Inventory Value = Remaining Units x Their Value
Ending Inventory Value = 130 x $4 = $520

Consider another example of a manufacturer producing the dog treats. The company produced 2
batches of the pumpkin treats with the following specifications:

Batch Unit count Cost per unit Total cost

Batch 1 10 $30 $300

Batch 2 50 $40 $2,000

Under FIFO, the manufacturer would assume that if they were to sell 20 units of the 60 total units
in stock, 100% of Batch 1 (10 units from Batch 2 (the remaining 10 units at $40/each) were sold.
The COGS would be calculated accordingly: COGS = (The Number of Original Units x Their
Value) + (Remaining Units from the Second Purchase x Their Value)

COGS = (10 x $30) + (10 x $40) = $700

And the ending inventory value is calculated by adding the value of the 40 remaining units of
Batch 2.
Ending Inventory Value = Remaining Units x Their Value
Ending Inventory Value = (40 x $40) = $1,600

FIFO method: Pros vs. Cons

While there is no one “right” inventory valuation method, every method has its own advantages
and disadvantages. Here are some of the benefits of using the FIFO method, as well as some of the
drawbacks.

Pro: Higher valuation for ending inventory

As mentioned above, inflation usually raises the cost of inventory as time goes on. This means that
goods purchased at an earlier time are usually cheaper than those same goods purchased later.

Because FIFO assumes that the lower-valued goods are sold first, your ending inventory is
primarily made up of the higher-valued goods. As a result, your ending inventory value is higher.
A higher inventory valuation can improve a brand’s balance sheets and minimize its inventory
write-offs, so using FIFO can really benefit a business financially.

Pro: Higher net income

The FIFO valuation method generally enables brands to log higher profits – and subsequently
higher net income – because it uses a lower COGS.

Suppose a coffee mug brand buys 100 mugs from their supplier for $5 apiece. A few weeks later,
they buy a second batch of 100 mugs, this time for $8 apiece. They sell every mug for $15 and sell
100 units.

Under FIFO, the brand assumes the 100 mugs sold come from the original batch. On each sale, the
net profit is $10 ($15 sale price – $5 COGS). Because the brand is using the COGS of $5, rather
than $8, they are able to represent higher profits on their balance sheet.

Pro: Often reflects actual inventory movement

For many businesses, FIFO is a convenient inventory valuation method because it reflects the order
in which inventory units are actually sold. This is especially true for businesses that sell perishable
goods or goods with short shelf lives, as these brands usually try to sell older inventory first to
avoid inventory obsoletion and deadstock. While using FIFO doesn’t mean brands must sell the
oldest goods first in reality, it is extremely intuitive for brands that do and helps simplify inventory
accounting.

Con: Discrepancies if COGS spikes

FIFO works best when COGS increases slightly and gradually over time. If suppliers or
manufacturers suddenly raise the price of raw materials or goods, a business may find significant
discrepancies between their recorded vs. actual costs and profits. For instance, say a candle
company buys a batch of 1,000 candles from their supplier at $2 apiece. Several months later, the
company buys another batch of 1,000 candles – but this time, the supplier charges $10 for each
candle. This is a significant increase in COGS for the brand. When they use FIFO to calculate
ending inventory value, the brand will use the lower COGS – but because that number is outdated
and COGS has spiked since then, the company’s recorded profits on the balance sheet will not
necessarily match their actual profits (with actual profits being much lower than represented).

Con: Higher taxes

Because net income is usually higher for brands using FIFO, those brands’ income taxes are
usually higher as well. For certain businesses, this can cause cash flow issues and eat further into
their bottom lines.
III.3. Application of LIFO (Last-In-First-Out) principle

The Last-In-First-Out method is the opposite of FIFO. It assumes that the most recent products are
sold first. Under the LIFO method, the inventory that was acquired first remains on the company’s
balance sheet while the newer items are being sold. The LIFO method is used in the US, as it is
acceptable under the GAAP regulations. If a company uses LIFO as a reference inventory
valuation method, it eventually has higher COGS but lower profit and taxable income indicators.
When a company uses the Last-In-First-Out inventory valuation method, the earnings and financial
statements shown are lower, and the taxable income is less. This may be good when the time to
pay taxes comes, but, on the other side, it may present the company as a less reliable contractor
and lower the chances of getting investor or credit funding.

How to calculate inventory value using the LIFO method?

Let’s continue using a grocery store example, and let’s calculate the end of January’s inventory
value using LIFO. So, we take 200 bottles of full-fat milk we purchased later at the price of 2$ per
bottle. 50 bottles were sold, as we know. So, using LIFO we calculate the cost of goods sold for
the second batch of milk.
Cost of Goods Sold = 2$ x 50 = 100$
And the 100 bottles of milk purchased at the beginning of the months (1$ each) are still unsold.
150 bottles of milk (2$ each) are also unsold. So, let’s calculate the inventory value in January:
Inventory value = (1$ x 100) + (2$ x 150) = 400$

III.3.1. Description of LIFO Principles

▪ Last In, First Out (LIFO). This model assumes that the newest inventory is sold first. If
the chickpea retailer used LIFO accounting, COGS would increase to $181.50 (see chart
below) because the newest inventory was the most expensive. As a result, gross profit drops
to $73.50.
LIFO provides a more precise matching of expenses with revenue. It also raises COGS and lowers
the company’s tax bill. But it often presents an out-of-date number on the balance sheet and can
keep the cost of goods bought earlier in the inventory account for many years.

Because the value of the remaining inventory at the period is lower than with the FIFO method,
the total value of COGS plus ending inventory is the same — $221.50 — so anyone who reviews
the business’s financials will see that the underlying situation is the same. Only the current tax bill
has changed. Note that the company hasn’t magically achieved a permanent financial benefit: If it
sells the remaining inventory in the next period, its COGS will be lower and its profits higher, so
its tax bill may be higher, too.
 Beginning inventory value $0

Purchases

60 lbs. at a cost of $1.00/lb. $60.00

70 lbs. at a cost of $1.05/lb. $73.50

80 lbs. at a cost of $1.10/lb. $88.00

Total purchases $221.50

Goods sold

80 lbs. at a cost of $1.10/lb. $88.00

70 lbs. at a cost of $1.05/lb. $73.50

20 lbs. at a cost of $1.00/lb. $20.00

Cost of goods sold $181.50

Ending inventory

40 lbs. at a cost of $1.00/lb.

Ending inventory value $40.00

Gross profit = Revenue – COGS = $255 – $181.50 $73.50

Principles of FIFO

– Chronological Cost Recognition

Chronological Cost Recognition: Under FIFO, the costs of the earliest goods purchased are the
first to be recognized as the cost of goods sold. This means that when items are sold or used, the
costs associated with the oldest inventory are accounted for first, aligning with the fundamental
principle of cost recognition in accounting books. For instance, in a hotel’s Food & Beverage
operations using FIFO, if the earliest batch of ingredients is utilized, its associated cost is
acknowledged first in the overall cost of goods sold.
– Physical Flow Parallel
The FIFO method aligns with the physical flow of merchandise, mirroring the natural progression
of inventory in a business setting. This is akin to how goods move through the system from
procurement to sale or use. In the context of housekeeping operations in a hotel, if linens from the
earliest stock are used first, it not only prevents waste but also parallels the actual flow of linens
in the hotel’s inventory. This alignment simplifies the tracking of inventory and helps businesses
maintain a smooth and efficient operation.

Application of FIFO

– Example Scenario: Bakery Batches

In hotel Food & Beverage operations, using the FIFO method means utilizing ingredients based
on their arrival dates, ensuring that the oldest stock is used first to maintain freshness. Similarly,
in housekeeping operations, a hotel employing FIFO for managing linens would prioritize using
the earliest received linens to prevent items from expiring or becoming outdated.
Advantages of FIFO
The FIFO method offers several advantages:
• Reflecting Current Market Prices: FIFO provides a better reflection of current market
prices as it values the cost of goods sold based on the most recent purchases.
• Real-world Flow Alignment: Its alignment with the physical flow of merchandise in a
business makes FIFO a practical and intuitive method.
• Simplicity in Accounting: FIFO is relatively straightforward in terms of accounting,
facilitating ease of implementation and understanding.

Comparison with Other Methods

While FIFO is widely adopted, it is often compared with other inventory valuation methods, such
as Last-in, First-out (LIFO).
• FIFO (First-in, First-out): Assumes that the earliest goods purchased are the first to be
sold, recognizing costs associated with the oldest inventory first. This reflects the actual
flow of goods, providing a more accurate representation of current market conditions.
• LIFO (Last-in, First-out): Assumes that the most recently acquired goods are the first to
be sold, recognizing costs associated with the newest inventory first. This may result in
 lower reported income and taxes during periods of rising prices, although it may not
precisely represent the physical flow of inventory.
In summary, while FIFO aligns with the physical flow of goods and tends to provide a more
accurate reflection of current market conditions, LIFO can have tax advantages in certain
situations, potentially leading to lower reported income. The choice between FIFO and LIFO
depends on factors like specific business operations, financial reporting objectives, and the
economic environment in which the business operates.
Real-world Applications
Many businesses, especially those dealing with perishable goods, have found success in
implementing FIFO for inventory management. This method ensures that the earliest acquired
goods are the first to be used or sold. In industries where product freshness is crucial, like the food
and beverage sector, FIFO helps maintain the quality of goods by prioritizing the use of the oldest
inventory.
As a result, businesses can reduce the risk of spoilage and waste, improving overall product quality
and customer satisfaction. Additionally, case studies show that FIFO enhances financial reporting
accuracy and provides better control over inventory levels, contributing to the efficiency and
profitability of businesses dealing with time-sensitive and perishable products.
Conclusion
In conclusion, the First-in, First-out (FIFO) method offers a practical and intuitive approach to
inventory management. By aligning with the physical flow of merchandise, recognizing costs
chronologically, and providing advantages such as simplicity and accuracy, FIFO stands as a
valuable tool for businesses seeking efficient inventory control.

III.3.2 Procedures of applying LIFO principle

Why Would You Use LIFO?

The LIFO method is used in the COGS (Cost of Goods Sold) calculation when the costs of
producing a product or acquiring inventory has been increasing. This may be due to inflation.
Since LIFO uses the most recent, and therefore usually the more costly goods, this results in a
greater expense recorded on a company’s balance sheet. This translates to a lower gross income
and therefore a lower tax liability. Should the cost increase last for some time, these savings could
be significant for a business.
LIFO Example
Here is an example of a business using the LIFO method in its accounting. Brad’s Books has placed
several new product orders over November and December. The following table shows his order
summary:
 Month Amount Price Paid

Nov 7 100 books $18.00 per

Nov 21 100 books $18.00 per

Nov 28 125 books $18.25 per

Dec 4 150 books $18.50 per

Dec 7 150 books $19.25 per

Dec 15 150 books $20.00 per

Brad’s Books has sold 450 books to date, each at a price of $25.00. This gives him a total revenue
of $11,250 for the last two months. Using the LIFO method, Brad would start with his most recent
unit cost of $20.00. However, he cannot apply that unit price to all 450 books sold this accounting
period, because he did not pay that price for all 450. What he can do is this:

Cost of Goods Sold Calculation

150 books x $20.00: $3,000.00 (using Dec 15 cost)

150 books x $19.25: $2,887.50 (using Dec 7 cost)

150 books x $18.50: $2,775.00 (using Dec 4 cost)

COGS Total: $8,662.50

COGS Total: $8,662.50

The 450 books are now no longer considered inventory, they are considered cost of goods sold.
The value of the remaining books will stay in inventory.

The LIFO method assumes that Brad is selling off his most recent inventory first. Since customers
expect new novels to be circulated onto Brad’s store shelves regularly, then it is likely that Brad
has been doing exactly that. In fact, the very oldest inventory of books may stay in inventory
forever and never be circulated. This is a common problem with the LIFO method once a business
starts using it, in that the older inventory never gets onto shelves and sold. Depending on the
business, the older products may eventually become outdated or obsolete.
Under LIFO accounting purposes, using the most recent (and more expensive) costs first will
reduce the company’s recorded profit but decrease Brad’s Books’ income taxes. Since gross
income is calculated as revenue – cost of goods sold, Brad’s gross income for this time using the
LIFO method is $11,250 – $8,662.50 = $2,587.50.

LIFO and FIFO: Advantages and Disadvantages

When a company selects its inventory method, there are downstream repercussions that impact its
net income, balance sheet, and ways it needs to track inventory. Here is a high-level summary of
the pros and cons of each inventory method. All pros and cons listed below assume the company
is operating in an inflationary period of rising prices.
LIFO
• Pro: LIFO results in lower tax liability compared to other methods.
• Pro: LIFO may be easiest to implement if inventory is easily accessible because it has been
recently purchased.
• Con: LIFO often does not represent the actual movement of inventory (i.e. many companies
try to move older inventory).
• Con: LIFO results in lower net income compared to other methods.
FIFO
• Pro: FIFO results in higher net income compared to other methods.
• Pro: FIFO often results in higher inventory balances compared to other methods,
strengthening a company's balance sheet.
• Con: FIFO results in a higher tax liability compared to other methods.
• Con: FIFO may not accurately communicate the true cost of materials if inventory has been
stagnant while prices have risen.
Example of LIFO vs. FIFO
In the tables below, we use the inventory of a fictitious beverage producer called ABC Bottling
Company to see how the valuation methods can affect the outcome of a company’s financial
analysis.
The company made inventory purchases each month for Q1 for a total of 3,000 units. However,
the company already had 1,000 units of older inventory that was purchased at $8 each for an $8,000
valuation. In other words, the beginning inventory was 4,000 units for the period.
The company sold 3,000 units in Q1, which left an ending inventory balance of 1,000 units or
(4,000 units - 3,000 units sold = 1,000 units).
ABC CO. — MONTHLY INVENTORY PURCHASES

Month Units Purchased Cost / Each Value

Jan 1,000 $10 $10,000

Feb 1,000 $12 $12,000

Mar 1,000 $15 $15,000

3,000 = Total Purchased

ABC CO. — INCOME STATEMENT (SIMPLIFIED), JANUARY—MARCH

Item LIFO FIFO Average Cost

Sales = 3,000 units @ $20 each $60,000 $60,000 $60,000

Beginning Inventory 8,000 8,000 8,000

Purchases 37,000 37,000 37,000

Ending Inventory 8,000 15,000 11,250

COGS $37,000 $30,000 $33,750

Expenses 10,000 10,000 10,000

Net Income $13,000 $20,000 $16,250

COGS Valuation

• Under LIFO, COGS was valued at $37,000 because the 3,000 units that were purchased
most recently were used in the calculation or the January, February, and March purchases
($10,000 + $12,000 + $15,000).
• Under FIFO, COGS was valued at $30,000 because FIFO uses the oldest inventory first
and then the January and February inventory purchases. In other words, the 3,000 units
comprised of (1,000 units for $8,000) + (1,000 units for $10,000 or Jan.) + (1,000 units for
$12,000 or Feb.)
 • The average cost method resulted in a valuation of $11,250 or (($8,000 + $10,000 +
$12,000 + $15,000) / 4).

Below are the Ending Inventory Valuations:

• Ending Inventory per LIFO: 1,000 units x $8 = $8,000. Remember that the last units in
(the newest ones) are sold first; therefore, we leave the oldest units for ending inventory.
• Ending Inventory per FIFO: 1,000 units x $15 each = $15,000. Remember that the first
units in (the oldest ones) are sold first; therefore, we leave the newest units for ending
inventory.
• Ending Inventory per Average Cost: (1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000
x 15)] / 4000 units = $11.25 per unit; 1,000 units X $11.25 each = $11,250. Remember that
we take a weighted average of all the units in inventory.

LIFO or FIFO: It Really Does Matter

The difference between $8,000, $15,000 and $11,250 is considerable. In a complete fundamental
analysis of ABC Company, we could use these inventory figures to calculate other metrics—
factors that expose a company's current financial health, and which enable us to make projections
about its future, for example. So, which inventory figure a company starts with when valuing its
inventory really does matter. And companies are required by law to state which accounting method
they used in their published financials.
Although the ABC Company example above is fairly straightforward, the subject of inventory and
whether to use LIFO, FIFO, or average cost can be complex. Knowing how to manage inventory
is a critical tool for companies, small or large; as well as a major success factor for any business
that holds inventory. Managing inventory can help a company control and forecast its earnings.
Conversely, not knowing how to use inventory to its advantage, can prevent a company from
operating efficiently. For investors, inventory can be one of the most important items to analyze
because it can provide insight into what's happening with a company's core business.

Major Differences - LIFO and FIFO (During Inflationary Periods)

LIFO
• The newest inventory item is the first item to be sold.
• Net income is often lower.
• Cost of goods sold is often higher.
• Ending inventory on the balance sheet is often lower.
• LIFO often does not represent the actual movement of inventory (as companies try to sell
the items at the most risk of obsolescence).
FIFO
• The oldest inventory item is the first to be sold.
• Net income is often higher.
• Cost of goods sold is often lower.
• Ending inventory on the balance sheet is often higher.
• FIFO more closely represents the actual movement of inventory (as companies try to sell
the items at the most risk of obsolescence).

III.4. Checking the status of stock

Stock control, otherwise known as inventory control, is used to show how much stock you have
at any one time, and how you keep track of it. It applies to every item you use to produce a product
or service, from raw materials to finished goods. It covers stock at every stage of the production
process, from purchase and delivery to using and re-ordering the stock. Efficient stock control
allows you to have the right amount of stock in the right place at the right time. It ensures that
capital is not tied up unnecessarily, and protects production if problems arise with the supply chain.
This guide explains different stock control methods, shows you how to set one up and tells you
where to find more information.

Types of stock

Everything you use to make your products, provide your services and to run your business is part
of your stock. There are four main types of stock:

• raw materials and components - ready to use in production

• work in progress - stocks of unfinished goods in production
• finished goods ready for sale
• consumables - for example, fuel and stationery
The type of stock can influence how much you should keep - see the page in this guide on how
much stock you should keep.

Stock value

You can categorize stock further, according to its value. For example, you could put items into
low, medium and high value categories. If your stock levels are limited by capital, this will help
you to plan expenditure on new and replacement stock. You may choose to concentrate resources
on the areas of greatest value. However, low-cost items can be crucial to your production process
and should not be overlooked.
How much stock should you keep?

Deciding how much stock to keep depends on the size and nature of your business, and the type
of stock involved. If you are short of space, you may be able to buy stock in bulk and then pay a
fee to your supplier to store it, calling it off as and when needed. Keeping little or no stock and
negotiating with suppliers to deliver stock as you need it.

Advantages Disadvantages

Efficient and flexible - you only have what Meeting stock needs can become complicated
you need, when you need it and expensive

You might run out of stock if there's a hitch in the

Lower storage costs
system

You can keep up to date and develop new You are dependent on the efficiency of your
products without wasting stock suppliers

This might suit your business if it's in a fast-moving environment where products develop rapidly,
the stock is expensive to buy and store, the items are perishable or replenishing stock is quick and
easy. Keeping lots of stock

Advantages Disadvantages

Easy to manage Higher storage and insurance costs

Low management costs Certain goods might perish

You never run out Stock may become obsolete before it is used

Buying in bulk may be cheaper Your capital is tied up

This might suit your business if sales are difficult to predict (and it is hard to pin down how much
stock you need and when), you can store plenty of stock cheaply, the components or materials you
buy are unlikely to go through rapid developments or they take a long time to re-order. Stock levels
depending on type of stock

There are four main types of stock:

✓ Raw materials and components

Ask yourself some key questions to help decide how much stock you should keep:
• How reliable is the supply and are alternative sources available?
• Are the components produced or delivered in batches?
 • Can you predict demand?
• Is the price steady?
• Are there discounts if you buy in bulk?

✓ Work in progress - stocks of unfinished goods

Keeping stocks of unfinished goods can be a useful way to protect production if there are problems
down the line with other supplies.

✓ Finished goods ready for sale

You might keep stocks of finished goods when:

• demand is certain
• goods are produced in batches
• you are completing a large order

✓ Consumables

For example, fuel and stationery. How much stock you keep will depend on factors such as:
• reliability of supply
• expectations of price rises
• how steady demand is
• discounts for buying in bulk

Stock control methods

There are several methods for controlling stock, all designed to provide an efficient system for
deciding what, when and how much to order. You may opt for one method or a mixture of two or
more if you have various types of stock. For further information, see the page in this guide on
types of stock.
• Minimum stock level - you identify a minimum stock level, and re-order when stock
reaches that level. This is known as the Re-order Level.
• Stock review - you have regular reviews of stock. At every review you place an order to
return stocks to a predetermined level.
Just In Time (JIT) - this aims to reduce costs by cutting stock to a minimum. Items are delivered
when they are needed and used immediately. There is a risk of running out of stock, so you need
to be confident that your suppliers can deliver on demand. These methods can be used alongside
other processes to refine the stock control system. For example:
Re-order lead time - allows for the time between placing an order and receiving it.
Economic Order Quantity (EOQ) - a standard formula used to arrive at a balance between
holding too much or too little stock. It's quite a complex calculation, so you may find it easier to
use stock control software.
Batch control - managing the production of goods in batches. You need to make sure that you
have the right number of components to cover your needs until the next batch.
If your needs are predictable, you may order a fixed quantity of stock every time you place an
order, or order at a fixed interval - say every week or month. In effect, you're placing a standing
order, so you need to keep the quantities and prices under review.
First in, first out - a system to ensure that perishable stock is used efficiently so that it doesn't
deteriorate. Stock is identified by date received and moves on through each stage of production in
strict order.
Stock control systems - keeping track manually
Stocktaking involves making an inventory, or list, of stock, and noting its location and value. It's
often an annual exercise - a kind of audit to work out the value of the stock as part of the accounting
process.
Codes, including barcodes, can make the whole process much easier but it can still be quite time-
consuming. Checking stock more frequently - a rolling inventory - avoids a massive annual
exercise but demands constant attention throughout the year. Radio Frequency Identification
(RFID) tagging using handheld readers can offer a simple and efficient way to maintain a
continuous check on inventory. See the page in this guide on using RFID for inventory control,
stock security and quality management.
Any stock control system must enable you to:
• track stock levels
• make orders
• issue stock
The simplest manual system is the stock book, which suits small businesses with few stock items.
It enables you to keep a log of stock received and stock issued. It can be used alongside a simple re-
order system. For example, the two-bin system works by having two containers of stock items.
When one is empty, it's time to start using the second bin and order more stock to fill up the empty
one. Stock cards are used for more complex systems. Each type of stock has an associated card,
with information such as:
• description
• value
• location
• re-order levels, quantities and lead times (if this method is used)
 • supplier details
• information about past stock history
More sophisticated manual systems incorporate coding to classify items. Codes might indicate the
value of the stock, its location and which batch it is from, which is useful for quality control.
Stock control systems - keeping track using computer software
Computerized stock control systems run on similar principles to manual ones but are more flexible
and information is easier to retrieve. You can quickly get a stock valuation or find out how well a
particular item of stock is moving. A computerized system is a good option for businesses dealing
with many different types of stock. Other useful features include:
• Stock and pricing data integrating with accounting and invoicing systems. All the systems
draw on the same set of data, so you only have to input the data once. Sales Order
Processing and Purchase Order Processing can be integrated in the system so that stock
balances and statistics are automatically updated as orders are processed.
• Automatic stock monitoring, triggering orders when the re-order level is reached.
• Automatic batch control if you produce goods in batches.
• Identifying the cheapest and fastest suppliers.
• Bar coding systems which speed up processing and recording. The software will print and
read bar codes from your computer.
• Radio Frequency Identification (RFID) which enables individual products or components
to be tracked throughout the supply chain. See the page in this guide on using RFID for
inventory control, stock security and quality management.
The system will only be as good as the data put into it. Run a thorough inventory before it goes
"live" to ensure accurate figures. It's a good idea to run the previous system alongside the new one
for a while, giving you a back-up and enabling you to check the new system and sort out any
problems.
Choose a system
There are many software systems available. Talk to others in your line of business about the
software they use or contact your trade association for advice. Make a checklist of your
requirements. For example, your needs might include:
• multiple prices for items
• prices in different currencies
• automatic updating, selecting groups of items to update, single item updating
• using more than one warehouse
• ability to adapt to your changing needs
 • quality control and batch tracking
• integration with other packages
• multiple users at the same time
Avoid choosing software that's too complicated for your needs as it will be a waste of time and
money.

III.4.1 Use of software system

Inventory valuation can become very complex, especially as businesses grow. A company may
buy hundreds or thousands of different items for resale or components to build its products, and it
must assign costs to each product to accurately calculate profit and tax liability. Attempting to
manage and monitor inventory finances with spreadsheets can become extremely cumbersome,
time-consuming and error prone.
Leading financial management software supports the most popular inventory valuation methods
to automate the tracking and calculation of inventory costs. That helps give leaders a clear, accurate
and up-to-date financial picture of their business at any time and reduces the burden of creating
financial statements. Using software to manage inventory valuation can increase accuracy and
allow staff to focus on more valuable tasks.
The choice of inventory valuation method is an important decision for any company. For many
businesses, inventory represents a significant percentage of their total asset value. The way a
company values that inventory can directly affect its COGS, profit and tax liability, and once it
chooses a method, it generally has to use it for an extended period.

III.4.2 Periodic physical inventory count

Physical inventory is the actual count of a company's retail goods and products. Businesses across
various industries implemented structured approaches to accurately document their inventories at
the end of reporting periods. They may use various methods to improve accuracy, such as
collecting estimates from third parties or automating measuring and weighing processes. While
physical inventory counts may be necessary to comply with tax regulations or accounting
standards, many businesses count their inventories to plan restocking schedules.

Types of physical inventory counts

Electronic counting

This method involves employees using computers and tablets to scan items into an inventory
management system. These digital records make it easy to track inventory levels and find available
products for customers. Electronic counting requires the company to invest in specialized
technology, but the resulting improved accuracy and efficiency are often worth the cost.
Cycle counting

Cycle counting is counting inventory at different points throughout the day or week. This method
can help stores save time and resources by allowing them to complete the total count in manageable
sections. It also allows stores to stay open, so they don't have to shut down operations like they
might for a complete inventory count.

Manual completion

Manual completion of the count involves using one or more employees to walk around the store,
both on the floor and in the storeroom, and count the inventory and record results with pen and
paper. Once the employees finish counting, they compile the numbers and review them for
accuracy. This method may result in inaccuracies, but proper training can help organizations
benefit from the affordability of manual inventory counts.

Full inventory

For full inventory counts, stores can rely on current employees or hire temporary staff. Supervisors
provide individuals with helpful counting documents and instructions to accurately record the
number of goods and products. If a third party conducts the count, it can be helpful for the store to
organize and condense its inventory to make the job easier and more efficient. Full inventory
counting can result in high labor costs and temporarily require the store to cease normal operations,
but it's one of the most accurate methods.

The Four Types of Physical Inventory Counts

There are four types of inventory counts: manual, electronic, cycle counting and full inventory
counting. The methods vary but choosing the right technique can be the difference between good
and bad data for your company.

Pros and Cons of the Types of Inventory Counts

Physical
Inventory Description Pros Cons
Method

This count uses paper

Manual count cards or sheets
Low cost for materials High rate of errors
Completion and pencils to record
inventory.
 Physical
Inventory Description Pros Cons
Method

This count can use

Cuts down This method still takes
Electronic scanners, RFID,
significantly on extra time and
Counting barcodes or mobile
counting errors. resources to complete.
devices.

It cuts down on extra Depending on the

Staff count random
time or resources cycle counting
portions or rotating
Cycle necessary to count, and method, some
sections of the
Counting companies may not companies count
inventory at any given
need to stop operations inventory less than the
time.
during counts. ideal number of times.

This method provides

Companies repurpose This method may
accurate inventory
Full staff or bring in temp require an operational
records for creating the
Inventory staff to count all the shutdown and is labor-
annual financial
stock at one time. and time-intensive.
document.

How to count physical inventory

1. Schedule the count

Depending on which type of count you're planning to conduct, it can be important to schedule it
ahead of time to ensure consistent store operations. For example, you might schedule a complete
inventory account after a store closes. Scheduling enough employees for this shift can help them
complete the count before the store opens, allowing them to work without customers interfering.
If a stock conducts a manual completion count, you might ask an employee to start the count at
the beginning of their shift so they can finish before they leave for the day.

2. Restock the floor

Before conducting the count, it's important to restock as much inventory on the floor as possible
to help create an easier counting experience. Moving and sorting inventory from the backroom to
the selling floor can help employees organize the products to find them more easily while counting.
It can also help diminish the amount of inventory employees need to count in the back and help
make room for incoming products.

3. Explain the process

Consider explaining the process of conducting a physical inventory account to anyone involved in
the process. Emphasize the importance of adhering to company standards to ensure accuracy and
efficiency. You might also provide training on procedures or special technology and only allow
employees to count inventory once they've demonstrated proficiency in this skill.

4. Assign locations

Stores with vast amounts of inventory might benefit from assigned locations. For instance, a shift
supervisor might delegate an aisle to every employee and have them double-check the aisle to their
left to ensure accuracy. Some stores require each department to conduct inventory for relevant
goods, as the team's familiarity with specialized goods can streamline the process. Note that this
method is also beneficial if you want to close off certain aisles at a time instead of shutting down
the entire store.

5. Compile and review the count

Because companies rely on inventories to reorder products and make financial decisions, it's
important to ensure the accuracy of every count. If two employees conduct counts of the same
inventory, consider comparing their documents to ensure they align. Recounts, assessments of
inventory management software or additional employee training may be necessary if you discover
significant discrepancies.

Benefits of a physical inventory count

Benefits of physical inventory counts include:

• Increasing customer satisfaction: Accurate inventories help customers better understand

what's available for sale, meaning they're more likely to trust the company and have
positive shopping experiences.
• Planning restocks: When a company starts to run low on a product, its inventory
management system can alert them to place a reorder or even perform this task
automatically.
• Identifying promotion opportunities: If a count reveals products that aren't selling
because of damage or irrelevance, the company can sell them at a discount to generate
profit and create more room in their warehouses.
• Maintaining finances: Accurate inventory records ensure a business can develop a
reliable budget, document earnings and create financial reports for stakeholders.
 • Monitoring theft and damage: Tracking instances of theft and damage can help
companies understand their causes and prevent future instances to save time and money.

III.4.3 Continuous physical inventory count

The continuous physical inventory procedures supported by Extended Warehouse Management

(EWM) are described in more detail. For all these physical inventory procedures, you must archive
the warehouse tasks (WTs) in accordance with legal provisions. This is necessary to be able to
provide proof of all individual movements involving storage bins or products over the entire fiscal
year.

Ad Hoc Physical Inventory (Storage-Bin-Specific and Product-Specific)

For the storage-bin-specific ad hoc physical inventory, you carry out the inventory-taking for
certain storage bins at any time during the fiscal year. This physical inventory procedure is
manually controlled. An ad hoc physical inventory may become necessary because a product has
been damaged, for example. The product-specific ad hoc physical inventory corresponds to the
storage-bin-specific ad hoc inventory except that you perform it for products. For example, you
may have to make a targeted check of the stock of a certain product after receiving a complaint
about the product from a customer.

Low Stock Check (Storage-Bin-Specific)

The low stock check is a physical inventory procedure that you perform when confirming WTs.
Here you assume that a storage bin should only contain a small quantity of a product after a stock
removal in accordance with the storage bin data in EWM. You define this quantity in the form of
a limit value that is based on the operative unit of measure for the product per storage type. During
the physical removal of stock from storage, you check whether the storage bin data reflects the
actual stock situation. Since the stock comprises only a small quantity of the product (approx. 3-5
pieces), the picker can establish the stock level at a glance, without having to carry out an explicit
count. You confirm on the printed WT that you have performed the physical inventory. When you
confirm the WT in the system, the system automatically creates the physical inventory document
in the background on the basis of the WT. You can use the WT number to determine the physical
inventory document number.

Note

A variant of the low stock check is the zero stock check. Here the limit value is zero. You have the
following options:
 • Low stock check with physical inventory (low-stock physical inventory): The first time
that the stock falls below the limit value, you carry out the low-stock physical inventory.
The system creates a physical inventory document.
• Low stock check without physical inventory: We recommend this setting if you want to
carry out the low stock check multiple times to improve stock security. In this case, no
physical inventory document is created. You must therefore carry out a physical inventory
for the bin at the end of the fiscal year to create a physical inventory document.
• You can also combine the two options. The first time that the stock falls below the limit
value, the system proceeds in the same way as for the low stock check with physical
inventory (low-stock physical inventory). In subsequent cases, it proceeds as for the low
stock check without physical inventory, in other words, it no longer creates physical
inventory documents.

The following situations can occur:

• You request the low stock check manually if you discover that a storage bin lies below the
defined limit value after stock removal, but no low stock check has been planned for this
storage bin.
• The system automatically activates the low stock check as soon as you create a WT for a
storage bin that should lie below the defined limit value after the stock removal.

When the WT is created, the system checks whether the following conditions have been met:

• No open WT exists for the storage bin.

• Negative quantities are not permitted for the relevant storage type.
• Mixed storage is not permitted for the relevant storage type, in other words, only one quant
exists.

Note
In the radio frequency environment, the check is performed when you confirm the WT.
If these conditions are met, the system requests that you enter the quantity counted when you
confirm the WT.

The following situations can occur:

• The storage bin should be empty and really is empty (zero stock check) or the quantity in
the storage bin lies below the permitted limit value (low stock check). In this case, you
enter zero or the remaining quantity as the quantity counted.
The system creates a physical inventory document.

• The storage bin should be empty but is not empty (zero stock check) or the quantity in the
storage bin does not lie below the permitted limit value (low stock check).

In this case, you have the following options:

o You enter the remaining quantity. The system creates a physical inventory
document and displays the differences in the Difference Analyzer.
o You reject the physical inventory, for example, because the remaining quantity is
too large, and you cannot enter the quantity based on a quick glance but would need
to count each piece. In this case, the system does not create a physical inventory
document and does not display the difference.

Recommendation
If some storage bins do not fall below the limit value as a result of stock removal within the fiscal
year, we recommend that you also define a periodic physical inventory for this physical inventory
area in addition to the low stock check. This allows you to carry out a periodic physical inventory
for the storage bins that have not been recorded at the end of the fiscal year.

Putaway Physical Inventory (Storage-Bin-Specific)

As with the low stock check, the putaway inventory is a procedure for simplifying the work
involved in carrying out a physical inventory. In this case, the physical inventory for a storage bin
is carried out at the time of the first putaway in this bin in the fiscal year. The warehouse employee
confirms during the first putaway that the stock in the warehouse matches the confirmed quantity
in the WT after the putaway.

During the current fiscal year, no further physical inventory is performed for this storage bin, even
if a completely different quant is stored there at the end of the year, or if the bin is empty. In the
case of the putaway physical inventory, the system checks when the WT is created whether the
following conditions have been met:
• The storage bin is empty.
• Mixed storage is not permitted for the relevant storage type, in other words, only one quant
exists.
• You are putting stock away for the first time in the physical inventory year.
 Note

In the radio frequency environment, the check is performed when you confirm the WT. If these
conditions are met, the system requests that you enter the quantity counted when you confirm the
WT.
The following situations can occur:
• The storage bin is really empty: This means that after the WT has been confirmed, the
storage bin quantity is the same as the WT quantity. The system creates a physical
inventory document for this WT quantity.
• The storage bin is not empty, in other words, there are still products in the storage bin. In
this case, you reject the putaway physical inventory. The system does not create a physical
inventory document.

Recommendation

If putaway does not take place for all storage bins within a fiscal year, we recommend that you
make additional provision for a periodic physical inventory (see Periodic Physical Inventory
Procedure) for the relevant storage type. This allows you to carry out a periodic physical inventory
for the storage bins whose data has not yet been recorded at the end of the fiscal year.

Storage Bin Check

The storage bin check is a procedure in which you check whether a product is actually stored in
the storage bin in which it is supposed to be located. The quantity of the product in the storage bin
is immaterial in this case. Thus, the storage bin check is not a physical inventory procedure in the
true sense.
Tips for CFOs to optimize inventory value

Optimizing inventory value impacts a company’s working capital, cash flow, and profitability.
Here are several strategies CFOs can ensure their business follows to maximize inventory value:
• Demand forecasting: accurate demand forecasting helps align inventory levels with
customer demand. CFOs should invest in advanced forecasting solutions to predict market
trends and customer preferences.
• ABC classification: automatically classify inventory based on sales and velocity. Class A
items are high-value items that may require closer monitoring and more frequent reorder
decisions, while Class C items are lower-value items with less stringent control.
• Safety stock optimization: determine the appropriate safety stock level to minimize the
risk of stock-outs without holding excess inventory. This involves understanding lead
times, demand variability, and supplier reliability.
• Supplier relationships: healthy supplier relationships can lead to better terms, discounts,
and improved reliability. Negotiate favorable payment terms, bulk purchase discounts and
explore vendor-managed inventory arrangements.
• Cycle counting and inventory audits: conduct cycle counting and periodic inventory
audits to identify and rectify discrepancies. This ensures that inventory records are
accurate, preventing excess stock or stock-outs due to inaccurate data.
• Economic Order Quantity (EOQ): calculate the EOQ to determine the optimal order
quantity that minimizes total inventory holding costs and ordering costs. This helps balance
holding too much inventory and ordering too frequently.
• Obsolete inventory management: identify and manage obsolete or slow-moving
inventory proactively. Implement markdowns, promotions, or liquidation policies to
prevent tying up capital in products that are no longer in demand.
• Collaboration across departments: foster collaboration between finance, sales, and
operations teams to ensure a holistic understanding of inventory needs and challenges,
leading to better decision-making.
• Financial metrics monitoring: monitor key financial metrics such as inventory turnover
ratio, days sales of inventory, and gross margin return on inventory investment. From these
metrics, you can identify areas for improvement.
• Technology: invest in inventory management software that provides accurate data,
analytics, and visibility of your inventory holding to make informed decisions and
streamline inventory processes.
Inventory management and valuation principles: take-home assignment
This assignment is designed to assess your understanding of inventory management and valuation
principles.
Scenario:
You are the inventory manager for a small retail clothing store called "Trendy Threads." The store
sells a variety of clothing items, including t-shirts, jeans, jackets, and accessories. Recently, Trendy
Threads has been experiencing stockouts (running out of popular items) and overstock (having too
much of unpopular items) issues. This has led to lost sales and inefficient use of storage space.
Your Tasks:
1. Analyze Inventory Management:
o Identify the key challenges Trendy Threads is facing with inventory management.
o Recommend two specific inventory management techniques that could help
address these challenges. Briefly explain how each technique would work in the
context of Trendy Threads.
2. Inventory Valuation:
o Imagine you are taking inventory at the end of the month. There are 10 pairs of
jeans on hand, with a cost price of $20 per pair. However, the current market value
of these jeans has dropped to $15 per pair.
o Explain the concept of "lower of cost or market" (LCM) principle in inventory
valuation.
o Using the LCM principle, calculate the total value of the jeans inventory at the end
of the month.
3. Impact on Financial Statements:
o Briefly explain how the chosen inventory management techniques and valuation
method (LCM) might impact the financial statements (Income Statement and
Balance Sheet) of Trendy Threads.
QUESTIONS AND ANSWERS

How is inventory valuation calculated?

There are several methods for calculating the value of inventory. The First In, First Out (FIFO)
method values inventory on the basis that the first inventory items purchased are the first to be old.
The Last In, First Out (LIFO) method assumes that the most recently obtained inventory is sold
first. Weighted average cost (WAC) takes the average inventory cost. Specific Identification tracks
the cost of each inventory item.

What is the best method of inventory valuation?

Each inventory valuation method has advantages. Many companies use the FIFO method, which
typically most closely matches the actual cost of inventory to its sale price; however, it can result
in a higher gross income and taxes. The LIFO method matches current revenue to recent expenses,
but it is not permitted under accounting rules in many countries. Weighted average cost can
simplify accounting. Specific identification can make inventory tracking more complicated but is
useful for companies that sell high-value or one-of-a-kind items.

What is included in valuing inventory?

A broad range of costs are included in inventory valuation. They include direct labor and materials,
factory overhead, freight-in, handling and import duties or other taxes paid on a company’s
inventory purchases.

Is inventory valued at cost or selling price?

Inventory is generally valued based on cost. Calculating cost can get complicated, depending on
the type of business and the inventory valuation method used. To determine the total cost of
inventory, the company first has to determine how much inventory it has at all stages of production.
It needs to calculate all the materials, labor and other expenses associated with that inventory. And
it also must pick an inventory valuation method.