10 Ways Inventory Management Can Make or Break You. — Part II
Last week we introduced our 10 part series “10 Ways Inventory Management Can Make or Break You.” Part I asked the question whether you knew what the value of your inventory was, right now, so that you can effectively plan and assess your financial position. If you didn’t see it, here it is again — Part I.
Part II further illustrates the importance of having a good Inventory Management System that has the costing method options of — FIFO, LIFO, weighted average and standard cost – and the impact it plays on your balance sheet, income statement and cash flow.
Part II: What Valuation Method are You Using?
It is important to understand your valuation method because it can impact profit margins and your income statement based on which method you are using. The valuation methods available, for example, are First in First Out (FIFO), Last in First Out (LIFO), Weighted Average and Standard Cost.
FIFO is an approach in which the tracking of inventory and costs assumes the first items purchased are the first items sold. This matches inventory flow similar to what you would expect in a retail establishment in which new items would be placed behind the existing items on a shelf so, in theory, the oldest items would be the next sold. Of course even if the actual flow of inventory does not match this, the cost and valuation will follow this pattern and, as a result, costs recorded on sales will be based on the oldest and most likely lowest items, and the current valuation will always be based on the value of the most recent costs. In this case the result is that the costs of the items will be lower and the result is higher recorded profit and taxes.
LIFO is an approach in which the tracking of inventory and costs assumes that the last items purchased are the first items sold. This flow would be less common in practice because it would be as if a business always purchased the newest items on the front of a shelf and the items on the back of the shelf could be much older. Regardless, costs of items sold will be based on the most recent items purchased and the value of inventory will be based on the oldest items. In this case the outcome is that the cost of items will be higher and result in lower recorded profit and lower taxes.
Average cost creates an average based on the cost of all inventory items and takes the approach that the current cost most accurately reflects the cost of all items by using an average cost. This method is most effective with a computer system that can track and update costs as soon as items are received. This method will impact the resulting profitability and inventory valuation, but the results will vary depending on whether items increased in cost over time, by how much, how frequent the items were purchased and so forth.
Standard cost uses a static cost entered manually for an item and any variation with the actual cost is recorded in a variance account. The advantage to this method is that the user has more control over the costing being used and can prevent valuation changes that are not wanted or don’t match the business environment. However, in many businesses the inability to effectively update the cost for items could easily make this method useless.
Overall any business may have good reason to use any of the valuation methods described above to meet the needs and objectives or requirements of their business. The main point to remember is that the method used can impact what your profits and inventory value may look like. Having a good management system can be central to effectively understanding how these methods impact your accounting so that you can make intelligent business decisions based on reality, not based on variance resulting from valuation methods.
Read the full article in its entirety – “10 Ways Inventory Management Can Make or Break You.”
Leave a Comment