 3 of The Best Inventory Valuation Methods

# 3 Methods to Calculate Inventory Valuation

Inventory, also called ‘stock, refers to the complete list of goods and materials that a business holds for future resale or production purposes. Businesses regularly take account of leftover inventory after an accounting period to assign a monetary value to a company’s stock on and determine the profitability of a business.

## What is inventory valuation?

Inventory valuation is the process of calculating the value of unsold inventory items at the end of an accounting period. The purpose of the valuation is to determine the amount that went into purchasing the inventory and to prepare the items for sale. The three methods of calculating inventory value are first-in-first-out (FIFO), last-in-first-out (LIFO), and weighted average cost method (WAC).

## First-in, first-out (FIFO)

The first-in-first-out (FIFO) inventory valuation method assumes that the first inventory items you purchase are the first items you sell. Under this method, you assume that you sell your products in the same order that you bought or produced them. In an inflationary environment, the value of your ending inventory will be higher under the FIFO method because newer items will be more expensive.

FIFO can provide more accurate estimates for the value of ending inventory (EI) because it reflects the current market prices of purchased inventory. Since most companies often use up older inventory before the new ones, it is often the most logical choice out of all the inventory valuation methods.

### How to calculate inventory using the FIFO method

Let’s assume you own a small business that sells paper towels, and you bought;

• 100 packs at \$10 each in January
• 250 packs at \$11 each in February
• 50 packs at \$12 in March.

Assuming you sold a total of 200 paper towels at the end of March, the ending inventory (EI) value using the FIFO method can be calculated as follows:

Since FIFO assumes that the oldest inventory was the first to go, the goods that were sold will be a combination of the first 100 packs you bought in January and the first 100 packs from the inventory you purchased in February.

Ending Inventory (EI)= Cost of the remaining items purchased in February + cost of the items purchased in March

Cost of remaining items purchased in February= (250-100) × \$11= \$1650

Cost of items purchased in March= 50 × \$12= \$600

Ending Inventory (EI)= \$1650 + \$600= \$2250

This, the ending inventory value under the FIFO method is \$2,250.

## Last-in, first-out (LIFO)

The last-in-first-out (LIFO) inventory valuation method is the opposite of the FIFO method, which assumes that the last items your buy are the first items you sell. Under LIFO, you calculate your ending inventory based on the assumption that the most recently purchased or produced inventory items are the first to leave the store.

In an inflationary environment, LIFO leaves a lower inventory value on your balance sheet since older inventory will be cheaper than newer ones. If the LIFO may

### How to calculate inventory using the LIFO method

Using the same example we used in the FIFO method, here’s how you calculate your ending inventory value using the LIFO method:

With LIFO, you assume you sold your newest first. Hence, the 200 paper towels that were sold will be a combination of the 50 packs you bought in March and the last 150 packs you bought in February.

Ending Inventory (EI)= Cost of the remaining items purchased in February + cost of the items purchased in January

Cost of remaining items purchased in February= (250-150) × \$11= \$1100

Cost of items purchased in January= 100 × \$10= \$1000

Ending Inventory (EI)= \$1100 + \$1000= \$2100

Thus, the ending inventory value under the FIFO method is \$2,100.

## Weighted average cost (WAC)

The weighted average cost  (WAC) method uses an item’s average cost per unit throughout a period to calculate inventory value. This method doesn’t take into account the first or last items that were bought. Instead, it assumes that all the inventory items were bought for the same average price. The WAC method is the most preferable option for businesses that don’t have major variations in their inventory.

### How to calculate inventory using the WAC method

Using the example we used in the FIFO example, here’s how to calculate your EI value using the WAC method:

The first step is to calculate the amount you spent on each inventory purchase and add them together.

January: 100 packs × \$10= \$1000

February: 250 packs × \$11= \$2750

March: 50 packs × \$12= \$600

Total cost of inventory purchased: \$1000 + \$2750 + 600= \$4350

Next, you calculate the total number of inventory items you purchased from January till March.

Total number of inventory items purchased: 100 + 250 + 50= 400

So, the weighted average cost of a pack of paper towels will be \$4350 divided by 400, which is \$10.875

Ending Inventory (EI) value= Number of remaining inventory items × average cost of an inventory item

EI= (400-200) × \$10.875

EI= \$2175

Thus, the ending inventory value under the WAC method is \$2,175.

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