Inventory Valuation Methods

Inventory is goods stored for manufacturing or sale, and the storage process requires ensuring the accuracy of the stored products and preventing loss of market value due to long storage periods and economic changes. There is information that must be available about your inventory, including:
 

• Unit of measurement: The unit used to estimate the quantity of goods, such as tons or kilograms.
• Classification: The category to which the item belongs.
• Batch number/lot number: A set of products manufactured or imported together, and each batch is marked with a number for tracking and identifying manufacturing defects.
• Expiration date: Relevant for items with a shelf life, such as medicines and food packages.
• Serial number: A tracking number for each product.
• Item location: The location of the item in the warehouses, and in which warehouse, if there are multiple warehouses.

If we start our topic by defining inventory valuation in industrial and commercial companies and others as simply knowing product prices, we will find that inventory valuation is identical to inventory pricing. However, the matter is different.

Therefore, in this article, we will cover the following points: What is inventory valuation, and what is the difference between it and inventory pricing? What are the methods of inventory valuation? What is the importance and objectives of inventory valuation?

Why do we revalue inventory? What are the steps for revaluing inventory? What are the standards for inventory valuation? Finally, we conclude with a solved practical example of end-of-period inventory valuation methods.

Quick summary points

• Inventory valuation is a process carried out mainly at the end of the accounting period to determine the current cost of inventory and whether there are any profits or losses resulting from market or raw-material price changes.
   
• Inventory pricing is a periodic procedure that determines the value of remaining inventory in warehouses. Therefore, you will find that pricing is a basic step in the valuation process. After determining the price, selling, conversion, and other costs are added to determine the inventory cost.
   
• There are two basic steps in inventory valuation: first, determine the cost of inventory; second, determine the market value of inventory. To adhere to the principle of prudence, the LCM (Lower of Cost or Market) method is applied.
   
• Determining market value depends on the principle of averaging three values: net realizable value, market value, or current replacement cost.
   
• Inventory valuation is associated with the end of the accounting period, whereas pricing is not tied to a specific time.

What is inventory valuation?

Inventory valuation converts the value of tangible products in the warehouse into their monetary value by comparing the inventory cost determined by pricing with the net realizable value and selecting the lesser.

Net realizable value is the estimated value of the asset when sold, minus selling costs. While pricing is a preliminary matter that occurs at the beginning of product storage and is repeated throughout ongoing purchase operations, with its own specific methods.

Valuation is only associated with the stocktaking period, which is followed by the preparation of budgets and financial statements at the end of the accounting period, which are required to convert the company’s assets into their monetary value as one of the company-owned assets, and valuation has methods other than pricing methods.

What are inventory valuation methods?

 Inventory valuation methods are the accounting procedures, in accordance with international standards, that accountants follow to estimate the monetary value of inventory.

Since this value is a real one, similar to pricing, each method produces a different result if another method is applied. In the following points, learn how inventory is valued step by step:

1- Cost

 Inventory valuation in this case depends on the costs of purchasing inventory, conversion, transportation, and other costs related to storage in your company’s warehouses.

2- Net value (selling or market value)

 The current value of inventory provides revenue upon sale, after deducting all expenses related to selling, transportation, and other costs that make it ready for sale.

While cost is fixed because it is based on invoices and purchase orders, the net realizable (selling or market) value changes over time, depending on the general economic conditions of the market or those specific to the commodity.

In application of the prudence principle, the lower of cost, net selling, or market value is chosen, for the purpose of presenting the company’s financial position at the end of the accounting period.

Therefore, the accountant is not allowed to change the inventory valuation method used in the company on their own initiative, and care must be taken when choosing the inventory valuation method at the outset to select the one most appropriate to the nature of the company’s activity and economic conditions.

However, there is always confusion between inventory valuation methods and inventory pricing methods, to the extent that some accountants consider them practically the same and use valuation methods for pricing and vice versa. So, what is the difference between inventory valuation and inventory pricing?

Inventory pricing is the process of determining the selling price and book value of inventory, while inventory valuation is the process of determining the value of unsold inventory at the end of the accounting period.

Use the Daftra accounting system to easily value inventory at the end of the period, as it helps you set up the inventory system to suit your business activity through settings, enables quantity and price tracking, and determines the most appropriate valuation method.

How is inventory revaluation performed?

 Inventory revaluation is the method followed when an economic event occurs that affects the value of inventory specifically or affects goods in general, including the inventory موجود in your company’s warehouses. There are two cases in which you need to perform revaluation, as follows:

1- A change in the condition or prices of materials obtained from suppliers. When these materials become scarce or unavailable and represent essential components in the products you manufacture, the result is an automatic increase in the value of the products you offer.

2- Market changes and the emergence of strong demand or rejection by the public for the goods inventory you have, which leads to a direct impact on inventory value—either an increase in the first case or a decrease in the second.

You can also know the quantities of goods received, sold, and issued during the day by downloading a ready-to-use warehouse daily log template from Daftra.

What are the steps for inventory revaluation?

 When revaluing inventory, the principle of choosing the lower of cost and market value is applied:

LCM (Lower of Cost or Market). Cost is determined and known. When determining market value, what steps ensure the correct value is determined?

Here are the steps supported by illustrative values to make the idea easier to understand, as follows:

1- Determine the cost of inventory. For example, the cost of one unit of a smartphone accessory was 1 USD.

2- To determine the market value of the unit, there are three values that should be relied upon, as follows:

• Net Realizable Value (NRV): A value that represents the upper market value (ceiling). It is the current selling price minus the cost of completion to make the goods ready for sale, plus the cost of disposal, including commissions and expenses.
•  NRV = Selling price − Cost of completion − Cost of sales

 Suppose the selling price is 5 USD, the cost of completion is 1 USD, and the selling cost is 1 USD.

•  Net realizable value = 3 USD
• Lower market value (floor): the lowest value an asset can have. It is the result of subtracting the NPM (net profit margin) from the NRV. Suppose the acceptable profit margin per unit is 1 USD.
•  Lower market value = 2 USD
• CRC (Current Replacement Cost): The price your company would pay to replace the existing inventory at current market prices with similar goods.
•  Current replacement cost = 2.5 USD

3- In this case, the middle number of the three figures is taken, which is 2.5 USD, and it is compared with the cost, which is 1 USD.

4-1 USD is adopted as the current value of inventory by applying the prudence principle.

You may also be interested in: How to code inventory items.

What are the inventory valuation standards?

According to the International Financial Reporting Standards (IFRS), inventory should be measured at the lower of cost or net realizable value. Cost includes:

1- Purchase cost: Includes the purchase price, import duties, and other taxes.

2- Conversion cost: These are expenses that change materials from one form to another. They include direct labor and fixed and variable manufacturing overheads.

With regard to net realizable value standards, the following items should be known:

• In cases where inventory is damaged, its cost cannot be recovered, or it has become partially or fully obsolete, or its selling price has declined.
• Inventory value is reduced to net realizable value on an item-by-item basis.

Inventory should be recognized as an expense in the following cases:

• In the period in which its revenue is recognized.
• When inventory is written down to net realizable value to recognize the loss.

Read also:Warehouse and inventory management, its importance, and requirements

What is the difference between inventory valuation methods and inventory pricing methods?

Both lead to a result of estimating inventory in monetary terms, to know how much your stored goods are worth. However, the methods differ depending on the objective and timing. Nevertheless, some use pricing methods for valuation and vice versa. So, let us get to know both.

It is well known that inventory pricing is a basic step in inventory valuation, as valuation compares cost with market price. Determining inventory cost begins with pricing and determining the purchase price of the product, then adding the remaining costs. Therefore, pricing can be considered a preliminary step for valuation that cannot be overlooked.
 

Importance and objectives of inventory valuation

At the stage when inventory is revalued at the end of the accounting period, when you still have a number of units of the same product with different prices, how do you know at which purchase price the remaining item was bought among the various supply prices at which the product was purchased throughout the year, as prices changed?

There may not be a precise answer, but the inventory valuation method is closer to the principle of prudence and gives us the most appropriate price for accounting purposes. So, what is the importance and benefit of inventory valuation if we resort to it in this careful manner?

• To determine the company’s financial position, assets must be matched with liabilities, and inventory is among the largest, most easily liquidated assets the company owns. Accurate inventory valuation leads to an accurate determination of the financial position.
   
• If a company wants a loan or investor financing, its assets—especially inventory—must be valued as a guarantee of the company’s ability to meet its obligations and to estimate future profits.
• Company profits are among the matters that may be subject to manipulation. Changing inventory valuation and pricing methods, or choosing an inappropriate method, can affect profits and losses. Accuracy and adherence to accounting standards are essential to know the true profits.
   
• One objective of inventory valuation is to estimate the liquidity available to the company and the assets that can be converted into cash in a short period, as inventories are among the easiest products to sell and liquidate, unlike those involved in manufacturing and production processes or raw materials.
   
• Reducing taxes, especially during times of economic crises, by choosing the most tax-efficient method according to circumstances.
   
• Valuing the company as a whole is one of the most important objectives of inventory valuation, in cases of selling the company or listing its shares on the stock exchange.

A solved practical example of inventory valuation methods

To better visualize and apply the concept practically, here is an example of the First In, First Out (FIFO) method, which is considered one of the best inventory pricing methods. On 5/8/2019, a car company purchased 10 units of a new car at a purchase price of 2 million USD per unit.

The company then purchased 5 units of the same item from another supplier at 2.5 million USD per unit and sold 12 units. The total units sold amount to 12.

Method of price calculation:
10 units are issued at a cost of 2 million USD per unit, for a total of 20 million USD; then 2 units are issued at a cost of 2.5 million USD per unit, for a total of 5 million USD.

• The cost of goods sold becomes:
  20 million USD + 5 million USD = 25 million USD.
• The total cost of ending inventory is 7.5 million USD, assuming a unit cost of 2.5 million USD.

As for determining the market cost, it can be applied using the following equations:

• NRV = Selling price − Cost of completion − Cost of selling

Assume the selling price is 3.1 million USD, and there are no completion or selling costs.

• Net realizable value = 3.1 million USD

• Lower market value (floor): It is the result of subtracting the NPM (net profit margin) from the NRV. Assume the acceptable profit margin per unit is 0.5 million USD.
• Lower market value = 2.6 million USD
• CRC (Current Replacement Cost): The price your company would pay to replace the existing inventory at current market prices with similar goods.
• Current replacement cost = 3 million USD

3- In this case, the middle number of the three figures is taken, which is 2.6 million USD, and it is compared with the cost, which is 2.5 million USD. After adopting the lower figure, in this case the inventory cost after revaluation also becomes 7.5 million USD.

Frequently Asked Questions

What are the best methods for valuing inventory?

The First In, First Out method is the best for valuing inventory, as it is one of the simplest and most practical methods and aligns with the actual flow of inventory.

What are the entries that should be considered when valuing inventory?

Here are the entries that should be considered when valuing inventory:

1. Inventory purchase entry
2. Inventory issue entry
3. End-of-period adjustment or inventory count entry
4. Inventory depreciation or damage entry
5. Excess inventory count entry

What is the moving average method for inventory valuation?

The moving average method for inventory valuation is a method of calculating inventory cost for the purpose of valuing the remaining inventory at the end of the accounting period, using the following equation:

Inventory cost = Total cost of goods available for sale ÷ Total number of units available for sale

How are inventory valuation differences treated?

Inventory valuation differences are treated by comparing the actual inventory value with the inventory value recorded in the accounting books. If there is a difference, an adjustment entry is made to correct the value.

Your understanding of inventory valuation and its methods qualifies you to determine whether inventory has generated profits or caused losses. Knowing inventory cost and comparing it with market value makes closing the accounting period easier and more precise.

Through this article, we covered the most important valuation methods and learned the difference between pricing and valuation, as well as the importance of inventory valuation for your company.