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A company’s inventory is arguably its biggest and most important asset as it includes all materials, items, goods and merchandise that a company has in stock while waiting for sales completion and order fulfilment. Because the inventory is part of a company’s asset, it is usually valuated and included into the balance sheet and partly reflects a company’s financial position. To accurately present a company’s financial standing, the best inventory valuation methods must be applied to suit the company’s nature of business. In this article, we will explore various inventory valuation examples to give you an idea of which valuation method will suit your business.
What is inventory valuation?
Inventory valuation is how you give value to or calculate the dollar amount of your company’s inventory in hand, or unsold goods.
Types of Inventory
Before you can perform a valuation on your inventory, you must identify what items can be included into your inventory as different businesses have different types of inventory. There are 3 types of inventory in general i.e. raw materials, semi-finished goods, and finished goods.
| Raw Materials | Basic parts bought by a business to be remade into a new product to be sold. For example, A smartphone manufacturer buys raw materials such as aluminium, glass, and processors to produce a smartphone as a finished product. A restaurant buys raw materials such a s fish fillets, lemon and potatoes to produce fish & chips to be sold to customers. |
| Work in Progress | These refer to goods in production and will eventually be put up for sale. An example may be a smartphone waiting for its casing as a finishing touch, or a smartphone that is waiting for its box and packaging. |
| Finished Goods | These are completed products that are ready to be sold to customers such as a smartphone that is completely packaged and ready for sale, or a clothing item that is displayed online and ready to be delivered. |
If your company is a manufacturing company, you will most likely have all three types of inventory above, but if your company buys and resells clothing online, your inventory will consist of finished goods you purchased from your wholesaler or supplier. If your company sells items via a drop shipping model, you will not have any inventory as your customers’ orders are redirected to your wholesaler or supplier.
Cost of Inventory
Once you have identified the type of inventory your company has, you will usually keep track of your inventory by creating a product code to differentiate between your SKUs (stock keeping units). By creating specific product codes for each of your inventory items, tracking of your inventory items is made easy as you are able to trace the supplier you are ordering from, its cost price, and its selling price. Biztory has made this process much easier as users can easily create, track and trace their inventory via our cloud accounting app. Changes to inventory are automated with each purchase order and invoice issued and these changes can be viewed via an inventory change report, or the inventory log.
Through the inventory change report, inventory details and updates over a selected period can be viewed for easy high-level auditing. In addition to that, the inventory log brings users to a dashboard which allows an in-depth view of their inventory i.e. number of products sold, number of products bought, stock available for sale, stock available in the warehouse, stock adjustments and invoice details.
Effective inventory valuation requires you to know the cost of acquiring your inventory item. This cost may be different based on inventory type.
| Raw Materials | Cost of raw materials is straightforward; it is the cost of purchase. |
| Semi-Finished Goods | Since semi-finished goods are works-in-progress with several raw materials put together to create a product, cost of inventory may include cost of raw materials, labour cost, and other miscellaneous cost incurred during production. |
| Finished Goods | Cost of inventory for finished goods is given the same treatment as semi-finished goods if the finished goods are manufactured by your company. If your company buys finished goods from a supplier and resells them, cost of inventory is the cost of purchase. |
Once cost of inventory is identified, different inventory valuation methods can then be applied to determine cost of goods sold (COGS).
Types of inventory valuation methods
There are four types of inventory valuation methods i.e. Specific Identification, First In First Out (FIFO), Weighted Average Cost (WAC) and Last In First Out (LIFO).
1. Specific Identification Method
This method is the most accurate valuation method as it tracks every single inventory item individually from its point of purchase and arrival, to the day it is sold. Each inventory item will have its own product code and is tagged with its own cost of purchase and additional costs incurred post-purchase (e.g. warehouse storage) until the day it is sold. Due to the individual tracking, this method is more applicable to businesses selling high value items in small volume such as art dealers, or car dealers.
How cost of goods sold (COGS) is calculated using this method:
| Pros | Cons |
| 1. Highly accurate inventory tracking 2.Precise account of cost price and selling price | a. Requires massive information tracking b. Expensive system c. Not suitable for businesses selling high volume of same product e.g. clothing |
2. First In First Out (FIFO) Method
The FIFO method is one of two benchmark treatments accepted by the Malaysian Accounting Standards Board (MASB). It is also one of the most popular cost valuation method because even though it does not track inventory as specifically as the specific identification method, it still gives a close match of your inventory’s actual movement. By applying this method, you assume that your earliest stock purchased is the first to be sold. This is the preferred method for most businesses especially in businesses dealing with perishable items such as food.
How cost of goods sold (COGS) is calculated using FIFO method:
| Pros | Cons |
| Projects high profit as lower cost price is used (assuming earlier purchase has lower cost price) | Higher profit reported, higher the income, higher tax to pay |
3. Weighted Average Cost (WAC) Method
Weighted Average Cost (WAC) method is the second benchmark treatment accepted by MASB. It takes the average of your existing and new inventory cost to get the cost of goods sold (COGS). This method is beneficial if applied in businesses dealing with high volume of the same product e.g. petrol as average item cost is calculated.
How COGS is calculated using WAC method:
| Pros | Cons |
| a. More distributed cost price b. Lesser tax to pay as income may be lower due to a more distributed cost price | a. Average needs to be recalculated whenever there is new stock added b. May sell products at a loss due to averaged cost price |
Even though this method generates a fairer cost treatment compared to FIFO, it is not as popular because of the additional work that goes into recalculating the WAC with every new stock added into the inventory (refer to ‘cons’ in table above).
To address this pain point, Biztory has developed a new inventory feature that automates WAC calculation for each inventory item whenever new stocks are added. Biztory users are only required to input details of stock purchase invoice, and the WAC will be automatically calculated, and channeled into closing inventory and balance sheet, it’s that easy!
4. Last In First Out (LIFO) Method
The LIFO method assumes the latest inventory item is the first to be sold, cost price is assumed to be cost price of latest inventory item.
How cost of goods sold (COGS) is calculated using FIFO method:
| Pros | Cons |
| Higher cost pricePay the least tax as latest cost price is used (assuming latest cost price to be higher than earliest cost price) | Not approved by the Inland Revenue Board of Malaysia (IRBM) for income tax purposes |
Which inventory valuation method is the best for your e-commerce business?
A summary of the 4 inventory valuation methods is provided below:
| Method | Specific ID | FIFO | WAC | LIFO |
| Pros | a. Accurate record of cost price and profit b.0% inventory loss | a. Easy to understand b. Reports higher profit due to higher selling price and low cost price used, more attractive to stakeholders c. MASB’s benchmark treatment | a. Simplest to calculate b. Cost price between prices calculated via FIFO and LIFO methods c. MASB’s benchmark treatment | a. Pay less taxes as profit is less when higher cost price is used b. Counter inflation |
| Cons | a. Expensive system b. Large amount of tracking required for big business | a. Profit may be inaccurate if old cost price is used but new cost price has increased tremendously b. Pay higher taxes if profit is higher due to low cost price used | a. May sell products at a loss as cost price is averaged b. Average cost needs to be refreshed whenever new inventory comes in | a. Unrealistic inventory system as business will always have old stock that’s never sold b. Not approved by IRBM for income tax purposes |
| Suitable for | a. Small businesses b. Start-ups c. Art dealers d. Car dealers | a. Restaurants b. Food manufacturers c. Clothing stores d. Products with short lifespan | a. Oil & gas companies b. SMEs c. Stable economy | a. Technology companies b. High inflation economy |
With LIFO method out of the picture for income tax purposes, Malaysian businesses are left with the options to select Specific ID, FIFO or WAC methods for their inventory valuation.
Why is inventory valuation important in e-commerce?
Inventory valuation is important because it shows a company’s financial health. Companies are required to provide a financial statement of their company’s performance at the end of each fiscal year. Inventory, being a large part of the company’s asset, is required to be declared in the balance sheet.
By performing a periodic inventory valuation, you will be able to make better financial decisions based on your company’s sales trend i.e. fast-selling products, slow-selling products. With the knowledge of sales trend, you can apply the right sales strategy for you to maximise profits e.g. reduce purchase of slow-moving products and increase purchase of fast-selling products, also ensuring you never run out of stocks to sell.
Once you have a sales strategy for your inventory items, you can make better budgeting decisions as you know your customers’ preferred products, and are able to determine the estimated volume and cost of purchase over the year. Inventory valuation can also help you decide whether to change suppliers or stick with your current suppliers.
Last but not least, identifying a suitable inventory valuation method will allow your accounting and taxation process to go smoothly over a fiscal year. It is advisable not to change the inventory valuation method too often as it may disrupt accounting processes. It is also advisable for inventory valuation to be done on a monthly or quarterly basis for better control.
Biztory One Stop Cloud Accounting Solution
Worried that inventory management has too much data to track? Or are you just starting your business and prefer to keep a low headcount? Fret not as Biztory has just the right solution for you!
Biztory, being a cloud accounting app, has a built-in inventory management system which allows clients to manage purchases and expenses, issue purchase orders, and track their inventory via an inventory log. All these processes are fully automated, and reports can be printed for easy reference and documentation. Not only do you have all the cloud accounting goodness in your fingertips, you get to track your inventory from the same app too! The best thing is, you can access this information anywhere you go, as long as you have the app installed and you are a registered Biztory user.
Or maybe… you are looking for more than an inventory management system? Maybe a holistic digital solution to seamlessly integrate with your e-commerce? No problem! Biztory has also recently launched pre-built e-commerce plugins as part of Biztory’s mission to become your one stop cloud accounting solution for all your e-commerce needs!
Through our integrated e-commerce plugins featuring SiteGiant, Easy Store, and Netshop, our clients’ sales, purchases, bookkeeping, and inventory management will be synced with Biztory. Upon synchronisation, sales, inventory, and accounting figures are automatically tracked and reflected into Biztory dashboards and financial reports. With the automated accounting and report generation, you will be able to gauge your sales performance, analyse best sellers, plan for stock orders, and do tax submissions in a timely and error-free manner.
Watch the short video below for a more detailed explanation.
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