What's the story, inventory

In January, each year, post-Christmas sales focus the mind of the retail sector on the value of their inventory.

For the rest of the year, many other businesses have to think about the value of inventory in acquisition situations. It becomes important from an ongoing profitability point of view, and from the perspective of the company’s tax exposures to establish the proper basis of valuation for this inventory.

Because of this importance, it is vital to have a consistent approach to this valuation issue.

IVS 230 – Valuation of Inventory

Luckily, the International Valuation Standards board has published a standard on the valuation of inventory, IVS 230.

This provides for two methods of valuation, the top-down and the bottom-up. ??

Based on both the increasing frequency of inventory valuation in these acquisition scenarios and the widely varying approaches that we see in the market, it seemed helpful to outline how the standards methods work in this article.

To give a bit of a flavour as to how these methods work, I have provided a simple example with a business which sells widgets with a sales price of $100. The table below shows a pro forma P&L for that business.

The bottom up method

The next table features a table of calculations for the value of inventory on a bottom up basis, going from the accounting value of purchase costs plus freight inwards to in the warehouse value, which takes that and adds the procurement costs and the associated profits to the in-store value, which adds the value of the intrinsic value added of moving the inventory around the internal network.

The top down method

Conversely, the top-down method, works from sales price and deducts the costs (and associated profits) of moving from the point in the value chain where the inventory sits to the customer.

We've worked back to the same numbers and as you can see the top-down, bottom-up methods in this simple scenario, equate the numbers very nicely.

This calculation really conveys that in order to value inventory, one needs to understand at a great level of detail the value chain of the company that utilizes that inventory.

Complications

There are of course, some complications.

The first of which is the holding costs vary across the life of the product. To some industries this is a major concern. For example, in high-end wine makers, the holding costs of keeping wine of long ago vintages can be hugely significant. These holding costs are often explains the differential in price between a recent vintage and one of more elderly years.

Another complicating factor is intellectual property. When the intellectual property (IP) of the relevant business is added to the products the value can change greatly.?

For example, consider an iPhone, a collection of parts, where the component parts are probably worth very little, but according to my most recent phone contract, the iPhone 13 Pro is worth at retail level, almost $2,000.?It is only when the IP of Apples design, brand and ecosystem are added the value really adds up.

These complications play out in very different ways, which are too elaborate to explore in this article, but it's probably enough to just be aware of some of these complications.

Common errors

There are of course common errors of valuation in relation to inventory.

?The first is that the selling price at the retail level does not equate to the market value. No business could acquire the entire inventory of a business added selling price to a customer and hope to make any sort of profit when selling that inventory on.

Accordingly, the costs and profitability associated with those costs needs to be deducted even from the value of stock in stores.

The second major problem is that the P&L and the associated value chain are not understood by the value or insufficient detail. If you don't reconcile to the P&L you can have very large increases in value without real basis.

The third issue is that people do not cross-check with both the top down and bottom of methods to ensure that they're making appropriate assumptions with respect to various costs.

Takeaways

Inventory is one of the most valuable assets in many businesses.

Because of the particular tax consequences and accounting consequences of the treatment of inventory, it's the most contested area in many purchase price allocations.

Helpfully, the international valuation standard 230 provides significant amounts of guidance about how to deal with the most common issues with an approach, which is both top down and bottom up, which helps valuers through the journey of providing these important valuations.

Of course, there are particular areas to watch out for in the areas of holding cost and intellectual property.

And we've pointed out three key errors that need to be addressed to avoid valuation mistakes.

With these in mind, the inventory challenges of the post-Christmas sales need bother a valuer no more.

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Richard Stewart OAM is a Corporate Value Advisory partner with PwC. He has been with them for 35 years in Australia, Europe and the USA, doing his first valuation in 1992. He has helped his clients achieve great outcomes using his value skills in the context of major decisions, M&A, disputes and regulatory matters. His clients span both the globe and the industry spectrum. He holds a BEc, MBA, FCA, FCPA, SFFin, FAICD and is an accredited Business Valuation Specialist with CAANZ. He has written two books, Strategic Value, and Hitting Pay Dirt, and is an Adjunct Professor at UTS. The opinions in this article are his own and not necessarily PwC's. He apologises to Oasis for any similarity to their song in the headline of this article.