Different inventory valuation methods were established to help a business offset the tax burden that’s associated with costing inventory. There can be different rules related to various types of businesses. For the purpose of this tutorial, the two methods discussed are generalities of the more common methods of inventory valuation.
Inventory Valuation’s Affect on Income and Cost of Goods Sold
Since many businesses are taxed on net income, choosing a particular valuation method can have an affect on the cost of goods sold. Cost of goods sold is determined by the value of inventory, the higher the cost in relationship to the revenue collected, the lower the gross profit.
- Gross profit = revenue – cost of goods sold
- Net profit before taxes = gross profit – expenses
- Net profit = net profit before taxes – taxes
Lowering gross profit will also lower the net profit before taxes. Considering these implications, let’s look at some common methods of valuating inventory.
Last In, First Out or LIFO Method of Inventory Valuation
The LIFO method assumes that the last goods purchased is the first to be sold. During times of inflation and rising prices, this method will increase the cost of goods sold and simultaneously maintain a lower total inventory value on the books. The following is a general example.
- 50 units @ $10 each beginning inventory = $500
- 40 units @ $12 each purchased April 1st = $480
- 60 units @ $14 each purchased August 1st = $840
Let’s assume a physical inventory was conducted at the end of August and there were 70 units on hand.
LIFO example
- 60 units @ $14 each = $840
- 10 units @ $12 each = $120
- Cost of goods sold = $960
First In, First Out or FIFO Method of Inventory Valuation
The FIFO method is just the opposite of LIFO. The FIFO method assumes the first goods purchased are the first to be sold or first-in, first-out. FIFO paints a much truer picture of actual inventory value. Using the same example for beginning inventory, purchases and ending inventory of 70 units, let's see the end results.
FIFO example
- 50 units @ $10 each = $500
- 20 units @ $12 each = $240
- Cost of goods sold = $740
In these examples FIFO lowered inventory value and gross profit (as well as net profit) by $220 compared to the LIFO method. There are regulations that must be adhered to when using certain valuation methods for accounting purposes. Once a method is used, ti may prohibitive to change. Before adopting an inventory valuation method, a certified public account (CPA) or other tax professional should be consulted.
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James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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