How can you use inventory valuation to make informed purchasing decisions?

1 Inventory valuation methods

There are three main methods of inventory valuation: first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted average cost (WAC). Each has its own advantages and disadvantages depending on the nature of your business and the market conditions. FIFO results in a higher inventory value and a lower cost of goods sold, as it assumes the first items purchased are the first ones sold. This is suitable for perishable or seasonal goods, or businesses operating in a stable or rising price environment. LIFO assumes the last items purchased are the first ones sold, resulting in a lower inventory value and a higher cost of goods sold. This is suitable for non-perishable or durable goods, or businesses operating in a falling price environment. WAC calculates an average cost of all items in your inventory with neither an increase nor decrease in inventory value or cost of goods sold. This is suitable for homogeneous or similar goods, or businesses operating in a fluctuating price environment.

2 Inventory valuation and financial statements

The method of inventory valuation you choose can have a significant impact on your financial statements, particularly your income statement and balance sheet. For instance, FIFO will result in a higher inventory value and a lower cost of goods sold, consequently increasing gross profit and net income. This can make your business appear more profitable and attractive to investors, lenders, and tax authorities. However, it also means that you will be paying more taxes on your income, and that your inventory may not accurately reflect the current market value of your goods. On the other hand, LIFO will lead to a lower inventory value and a higher cost of goods sold, resulting in a lower gross profit and net income. This can make your business look less profitable and less attractive to investors, lenders, and tax authorities. Additionally, you will be paying less taxes on your income, but the inventory may not reflect the current market value of your goods. Finally, WAC will generate a moderate inventory value and cost of goods sold, leading to a moderate gross profit and net income. This can make your business look more realistic and consistent as it smooths out the fluctuations in the prices of your goods. However, it also means that you are not taking advantage of the tax benefits or the market signals that the other methods offer.