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What is the role of inventory analysis in selecting an inventory valuation model?

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Inventory analysis is the process of examining the quantity, quality, and cost of the goods that a business holds in stock. It helps to optimize the inventory levels, avoid stockouts or overstocking, and improve cash flow and profitability. But how does inventory analysis affect the choice of an inventory valuation model? An inventory valuation model is a method of assigning a monetary value to the inventory items based on certain assumptions and rules. Different inventory valuation models can have a significant impact on the financial statements and tax liabilities of a business. In this article, we will explore the role of inventory analysis in selecting an inventory valuation model that suits the business goals and needs.

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Vignesh S

Linkedin Top Inventory Management & Warehouse Operations Voice | LSSYB | Strategic Supply Chain Professional | Supply…
Eappen Ninan

Sr. Manager - Inventory | Supply Chain | Fixed Assets

1 Types of inventory valuation models

Businesses can use several inventory valuation models, depending on the nature and movement of their inventory. The most common are First-in, first-out (FIFO), Last-in, first-out (LIFO), and Weighted average cost (WAC). FIFO assumes that the oldest inventory items are sold first, reflecting the actual flow of goods in most businesses and resulting in higher inventory value and lower cost of goods sold (COGS). LIFO assumes that the newest inventory items are sold first, not reflecting the actual flow of goods but reducing the taxable income and tax burden. WAC calculates the average cost of all inventory items, providing a middle-ground inventory value and COGS that smooth out price fluctuations.

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Vignesh S

Linkedin Top Inventory Management & Warehouse Operations Voice | LSSYB | Strategic Supply Chain Professional | Supply Chain Manager | Operations Manager | Expertise in Warehouse | Logistics | Supplier Management
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These inventory valuation models are common in the industry. But your WMS should support product-based valuation methods like FEFO (First Expiry First Out), LEFO (Last Expiry First Out), HIFO (Highest In First Out), LIFO (Lowest In First Out), and FEMAL (First Expiry Minimum Available Lifetime). WMS should be capable of providing these additional techniques based on the product types and the organization's preference. By default, the system should prioritize the picking and packing based on the order and product types.

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JATRA INVENTORIES

JATRA INVENTORIES_STOCK TAKING COMPANY
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Inventory analysis plays a crucial role in selecting an inventory valuation model by providing insights into how inventory is managed and valued within a business. It helps assess the specific characteristics of a company's inventory, such as its turnover rate, obsolescence risk, and cost structure. This data informs the choice of an appropriate valuation method, such as FIFO (First-In-First-Out), LIFO (Last-In-First-Out), or weighted average cost, as it aligns the valuation model with the economic reality of the inventory. A more accurate and suitable valuation method can lead to better financial reporting, cost control, and decision-making, ensuring that a company's financial statements reflect the true economic value of its inventory.

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MD ALAMIN AL MAMUN

Officer (SCM) at Akij Resources Limited
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"Inventory analysis guides the choice of valuation model by assessing factors like demand patterns, cost fluctuations, profit margins, tax implications, and compliance requirements. It ensures that the selected model aligns with financial goals, regulatory standards, and operational strategies."

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Catherine Muthami

Procurement Professional/Supply chain management/Inventory management/ERP-SAP
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Perishable goods may benefit from a FIFO (First-In-First-Out) method to prevent obsolescence, while unique or custom items might be better valued using specific identification. Different valuation models, such as FIFO, LIFO (Last-In-First-Out), and average cost, make different assumptions about how costs flow through the inventory, affecting the reported cost of goods sold and, consequently, net income. Compliance with industry standards or regulatory requirements may influence the choice of a particular valuation model. Also, Consistency in the use of an inventory valuation method enhances comparability between financial periods, making it easier for investors and analysts to evaluate a company's performance over time.

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2 Factors to consider in inventory analysis

When choosing an inventory valuation model, a business should consider several factors that relate to its inventory analysis. These include the type and nature of the inventory, the inventory turnover ratio, and the applicable accounting standards and tax laws. For instance, perishable goods may require a FIFO model to avoid obsolescence or spoilage, while durable goods may benefit from a LIFO model to reduce taxes or match costs with revenues. The inventory turnover ratio is a measure of how quickly a business sells and replaces its inventory; a high ratio indicates efficient inventory management and high sales performance, while a low ratio suggests excess or slow-moving inventory and low sales performance. Different countries and regions may have different accounting standards and tax laws that regulate the use of inventory valuation models; for example, in the US, GAAP allows the use of FIFO, LIFO, or WAC, while IFRS only allow the use of FIFO or WAC. Therefore, it is important that businesses comply with the applicable regulations when selecting an inventory valuation model.

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Eappen Ninan

Sr. Manager - Inventory | Supply Chain | Fixed Assets
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Inventory valuation models varies according to the nature of each business. For retail businesses such as garments, sports, watches, toys, etc, WAC is ideal. But both aging analysis and inventory turnover analysis must be strictly observed to get the best results when adopting WAC model.

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3 Benefits of inventory analysis in selecting an inventory valuation model

By conducting inventory analysis and considering the factors mentioned above, a business can gain multiple advantages from selecting an inventory valuation model that meets its goals and needs. For instance, it can improve the accuracy and reliability of financial statements by choosing a model that reflects the actual flow and cost of the inventory. This can also optimize the inventory management and performance, as well as maximize cash flow and profitability by aligning with the inventory turnover ratio and tax laws. Additionally, it can enhance credibility and transparency to stakeholders and investors, avoid stockouts or overstocking, reduce inventory-related costs and risks, increase sales revenue, lower the tax burden, and boost efficiency and effectiveness of inventory operations.

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Kaye C.

Amazon Operations Manager | Media Buyer | Digital Creator
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Inventory analysis guides the choice of an inventory valuation model by assessing turnover rates, cost structures, and inventory characteristics. It ensures alignment between the selected model and the business's operational and financial goals, considering factors like product cost stability or fluctuations in market prices.

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4 Challenges of inventory analysis in selecting an inventory valuation model

Inventory analysis can be beneficial in selecting an inventory valuation model, however, businesses may face some challenges. Complexity and variability of the inventory data can be a problem, as the size, diversity, location, and accuracy of the inventory items must be taken into account. Advanced inventory systems and software may need to be invested in, as well as regular inventory audits and reconciliations. Trade-offs and limitations of the inventory valuation models must also be considered; for example, FIFO may result in higher taxes and lower cash flow in times of rising prices. WAC may not capture the costs and benefits of each item, making it difficult to apply to complex items. Ultimately, businesses must weigh the pros and cons of each model to determine which is best suited for their needs.

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5 Best practices for inventory analysis in selecting an inventory valuation model

To maximize the benefits of inventory analysis in selecting an inventory valuation model and overcome any challenges, a business should conduct a comprehensive and consistent inventory analysis. This should cover all aspects of its inventory, such as quantity, quality, cost, demand, supply, price, turnover, and performance. They should also choose an inventory valuation model that fits their business strategy and context. Additionally, they should communicate and document the inventory valuation model and the inventory analysis to internal and external stakeholders. This includes explaining the rationale and assumptions behind the analysis as well as disclosing any impacts or outcomes on financial statements and tax liabilities.

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6 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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What is the role of inventory analysis in selecting an inventory valuation model?

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1 Types of inventory valuation models

2 Factors to consider in inventory analysis

3 Benefits of inventory analysis in selecting an inventory valuation model

4 Challenges of inventory analysis in selecting an inventory valuation model

5 Best practices for inventory analysis in selecting an inventory valuation model

6 Here’s what else to consider

Inventory Management

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What is the role of inventory analysis in selecting an inventory valuation model?

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6

1 Types of inventory valuation models

2 Factors to consider in inventory analysis

3 Benefits of inventory analysis in selecting an inventory valuation model

4 Challenges of inventory analysis in selecting an inventory valuation model

5 Best practices for inventory analysis in selecting an inventory valuation model

6 Here’s what else to consider

Inventory Management

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