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What is the appropriate inventory valuation method for your business?

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Inventory valuation is the process of assigning a monetary value to the goods that a business holds in stock. This value affects the calculation of cost of goods sold, gross profit, and net income on the income statement, as well as the value of current assets on the balance sheet. Choosing the appropriate inventory valuation method for your business depends on several factors, such as the nature of your inventory, the industry standards, the accounting principles, and the tax implications. In this article, we will discuss the pros and cons of four common inventory valuation methods: first-in, first-out (FIFO), last-in, first-out (LIFO), weighted average cost (WAC), and specific identification (SI).

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1 FIFO Method

FIFO stands for first-in, first-out, which means that the inventory items that are purchased or produced first are sold first. This method assumes that the oldest inventory has the lowest cost, and the newest inventory has the highest cost. FIFO is suitable for businesses that sell perishable goods, such as food or medicine, or goods that have a high turnover rate, such as fashion or electronics. FIFO has the advantage of reflecting the current market value of the inventory, and minimizing the obsolescence risk. However, FIFO also has some disadvantages, such as increasing the tax liability, inflating the net income, and distorting the cost of goods sold.

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2 LIFO Method

LIFO stands for last-in, first-out, which means that the inventory items that are purchased or produced last are sold first. This method assumes that the newest inventory has the lowest cost, and the oldest inventory has the highest cost. LIFO is suitable for businesses that sell non-perishable goods, such as metals or chemicals, or goods that have a low turnover rate, such as machinery or furniture. LIFO has the advantage of matching the current cost of goods sold with the current revenue, and reducing the tax liability. However, LIFO also has some disadvantages, such as understating the inventory value, deflating the net income, and violating the matching principle.

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3 WAC Method

WAC stands for weighted average cost, which means that the inventory items are valued at the average cost of all the units available for sale during the period. This method assumes that the inventory items are homogeneous and interchangeable, and that the cost of inventory does not fluctuate significantly. WAC is suitable for businesses that sell bulk goods, such as grains or oil, or goods that are difficult to track individually, such as books or toys. WAC has the advantage of smoothing out the price fluctuations, and simplifying the record-keeping. However, WAC also has some disadvantages, such as ignoring the inventory flow pattern, and being less accurate than FIFO or LIFO.

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Ali Eshetu

Internal Audit manager
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weighted average method: A mathematical technique for calculating an average that considers the relative importance or frequency of different values in a dataset. It assigns weights (numerical values) to each data point, reflecting their significance or contribution to the overall average. it's used: More accurate representation: In many situations, a simple average might not accurately reflect the true picture, especially when some data points carry more weight than others. Common applications: Inventory valuation Academic grading Financial analysis Survey analysis Economic indicators

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4 SI Method

SI stands for specific identification, which means that each inventory item is identified and valued individually based on its actual cost. This method assumes that the inventory items are unique and distinguishable, and that their cost can be easily traced. SI is suitable for businesses that sell high-value goods, such as jewelry or art, or goods that have a serial number or a barcode, such as cars or computers. SI has the advantage of reflecting the true cost of goods sold, and avoiding the inventory valuation errors. However, SI also has some disadvantages, such as being costly and time-consuming, and allowing the manipulation of net income.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Kenosi Seema

BAP (SA) & Tax Practitioner
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The best method depends on the type of business (industry) one operates within. The food industry for one can do weighted average methods where an electronics company should rather stick SI. We are living in a developing world and it's always wise to check in with the industry and industry regulations before picking the best method of evaluation.

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What is the appropriate inventory valuation method for your business?

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1 FIFO Method

2 LIFO Method

3 WAC Method

4 SI Method

5 Here’s what else to consider

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