Inventory Valuation is a critical part of running a successful retail business, but what does that actually mean? And more importantly, what methods should you be using to value your inventory?
In this post, we’ll walk you through everything you need to know about inventory valuation. We’ll start with the basics and move on to some more advanced concepts, so by the time you finish reading this post, you’ll be an expert on the topic. Let’s get started!
What Is Inventory Valuation?
You’ve probably heard the term “inventory valuation” before, but what does it actually mean? Inventory valuation is the process of estimating the value of a company’s inventory.
There are a few different ways to do this, but the most common is to use the cost method or the retail method. The cost method calculates the value of inventory based on how much it cost the company to purchase it, while the retail method takes into account how much money the company would make if it sold all of its inventory at retail prices.
There are pros and cons to each method, but ultimately, the right valuation method depends on your business and what you’re trying to achieve.
The Different Methods of Inventory Valuation
When it comes to inventory valuation, there are a few different methods that you can use. Let’s go over each one.
The first is the cost method. Under this approach, you simply assign a value to each item in your inventory based on what you paid for it. This is the most common method and is used by most small businesses.
The second is the current replacement cost method. This approach takes into account the current market value of each item in your inventory. So if you were to sell an item today, what would you get for it?
The third is the net realizable value method. This approach assigns a value to each item in your inventory based on its estimated sale price, minus any costs that would be incurred to actually sell it. This includes things like shipping and handling fees, advertising costs, and so on.
The fourth is the net realizable value less allowances method. This is similar to the net realizable value method, but it takes into account any potential discounts that may be offered on items in your inventory. For example, if you have a lot of slow-moving items in your inventory, you may want to factor that into your calculations and give them a lower value.
So which method is right for you? That depends on your business and what makes the most sense for your specific situation. But it’s important to understand all of your options so you can make the best decision for your business.
Last in First Out (LIFO)
When it comes to inventory valuation, there are a few different methods that retailers can use. The most common is Last in First Out or LIFO.
With LIFO, you value your inventory based on the most recent items that were purchased. So, the older items in your stock are considered to be worth less than the newer items. This method is commonly used because it helps businesses stay afloat during tough economic times.
But LIFO isn’t perfect. For one thing, it’s not always accurate, since it’s based on how recently something was purchased rather than its actual value. Additionally, this method can be difficult to manage, especially if you have a large inventory.
That’s why it’s important to weigh the pros and cons of each inventory valuation method before making a decision for your business.
First in First Out (FIFO)
You’ve probably heard of the First in First Out (FIFO) method of inventory valuation. It’s one of the most common methods, and it’s pretty simple to understand.
Basically, with the FIFO method, you assume that the oldest items in your inventory are the first ones to be sold. This way, you’re always accounting for what’s been sold and what’s left in your inventory.
It’s a good way to make sure your numbers are always accurate, and it gives you a good idea of how much merchandise you have on hand and how fast it’s selling. But it’s not perfect—for example, it doesn’t take into account seasonality or trends.
Weighted Average Cost Method (WAC)
When it comes to inventory valuation, the Weighted Average Cost Method is one of the most commonly used methods. Here’s how it works: you take the cost of all your inventory and divide it by the number of units you have on hand. This will give you your average cost per unit.
This method is useful for businesses that experience a lot of stock movement, as it gives a more accurate picture of the average cost of the inventory at any given time. It’s also helpful for businesses that sell a variety of products, as it takes into account the varying prices of different items.
Specific Identification Method
When it comes to inventory valuation, there are a few different methods that retailers can use. Today, we’re going to focus on the Specific Identification Method.
This is a popular choice among retailers because it’s so straightforward. With this method, you simply identify and track the specific units of inventory that are sold. So if you sell a shirt for $10, and that shirt was in your inventory at the beginning of the period, you would record that $10 as income in your books.
It’s a pretty simple approach, which is why it’s so popular. But it can also be time-consuming, especially if your inventory changes often.
Best Inventory Valuation Method for Retail Businesses
You’re probably wondering what the best inventory valuation method is for your retail business. And we get it—this is an important decision that can impact your bottom line.
There are a few different ways to value your inventory, and each has its own advantages and disadvantages. Here are the most common methods:
1. Cost-based valuation: This is the most basic way to value your inventory, and it’s based on the cost of the items you have in stock. This includes the purchase price, plus any shipping and handling costs, plus any taxes that have been paid.
2. Market-based valuation: This takes into account what similar items are selling for on the open market. So if you have a T-shirt that’s selling for $10 in your store, but you can find a similar T-shirt for $5 at Walmart, your inventory is actually worth $5.
3. Replacement cost valuation: This approach takes into account how much it would cost to replace the items in your stock. So if you have a T-shirt that’s selling for ₦10,000 in your store, but it would cost ₦15,000 to replace, your inventory is actually worth ₦5,000.
4. Forward pricing: This method uses future purchase orders to estimate inventory value. So if you expect to purchase 100 T-shirts at a cost of $8 each, your inventory is worth $800 (100 x $8).
5. Backward pricing: This approach uses past sales data to estimate inventory value. So if you’ve sold 1,000 T-shirts at a cost of ₦4,000 each, your inventory is worth ₦4,000,000 (1,000 x ₦4000).
BWBMart offers B2B eCommerce services to Nigerian CPG suppliers who want to sell to local buyers in bulk and export wholesale to Western national retailers. Our inventory valuation methods can help your retail business choose the best inventory valuation strategy for your specific needs.