A correct estimation of the inventory helps the company to maximize its profitability and have correct and clear financial statements. Learn more!
Inventory valuation relates to the costs associated with a company at the end of each financial year. Specifically, it refers to the accounting practice of calculating the value of a company’s inventory, i.e., the physical items which are sold or products which are produced in order for the company to track its value.
A correct estimation of the inventory helps the company to maximize its profitability and have correct and clear financial statements at the end of each accounting period. There is a number of popular methods for a business to value its inventory, each one addressing the different needs and demands of each company. The method of valuing a company’s inventory is strictly an accounting decision, hence, does not directly affect how a company actually utilizes its inventory. However, by choosing the most suitable inventory valuation method, the gross profit of an accounting period is largely affected.
The method each company uses for its inventory valuation is directly associated with the cost of the goods that the company has sold, its gross income and, finally, the monetary value of unsold goods and products by the end of each financial year. Therefore, inventory valuation affects the profitability of a company and tracks its potential value, as it is shown in its financial statements.
While inventory valuation may sound simple, it can prove to be complicated, particularly for larger or growing businesses. This is because a company may buy a large number of products that need to be resold or need to buy numerous components to build its products after the end of the financial year. The cost of these needs to be determined after considering profit and tax liability of each product. The required spreadsheets for these calculations can prove to be a very complex and time-consuming process while mistakes can occur easily. For this reason, it is important for a company to invest in the appropriate financial management software in order to automate the tracking and calculation of inventory costs instead of manually creating financial statements. As a result, the company will eliminate any potential errors and have access at any given time to accurate and up-to-date information on their financial situation. At the same time, the company’s personnel will be able to focus on other tasks, possibly more important for the company and which cannot be executed in another manner.
Selecting the right inventory valuation method is a decision that should not be taken lightly while each method has its advantages and disadvantages. The First In, First Out (FIFO) method is a popular option among companies, and it sets the inventory cost close to its sale price. However, it can result in higher profits and taxes if used during inflation. The Last in, First out (LIFO) method seems to offer a more precise estimation of current earnings since it matches recent costs to most recent revenues. However, many countries do not permit its use due to different accounting standards. The Weighted Average Cost (WAC) method can certainly simplify accounting processes when it is used for identical products sold in large numbers. Finally, the Specific Identification method may be more complicated, but it is the most effective method for accurately measuring the profitability of individual, high value items.
The inventory valuation method of any business is of vital importance since it represents a significant percentage of the company’s total asset value. Each company has its unique needs, hence it should choose a method that best serves these.
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