Inventory valuation
Also known as: inventory costing, valuation of inventories
Inventory valuation is the process of assigning a monetary cost to the goods a business holds. The chosen method determines both the inventory figure reported on the balance sheet and the cost of goods sold reported on the income statement.
Inventory valuation answers two linked questions: what is the unsold inventory worth, and what cost should be released to cost of goods sold when items are sold? Because every dollar assigned to ending inventory is a dollar kept out of cost of goods sold, the method chosen moves reported gross profit as well as the balance sheet total.
Inventory is normally carried at the lower of cost and net realizable value. Cost includes the purchase price plus import duties, non-recoverable taxes, freight-in, and — for manufactured goods — direct materials, direct labor, and an allocation of production overhead. Costs excluded from inventory include abnormal waste, most storage costs, administrative overhead, and selling costs. Net realizable value is the estimated selling price less the costs to complete and sell, so obsolete or damaged goods must be written down.
When identical units are bought at different prices, a cost flow assumption is needed. FIFO assigns the oldest costs to cost of goods sold and the newest to ending inventory. Weighted average blends all costs into a single unit cost. LIFO does the opposite of FIFO and is permitted under U.S. GAAP but prohibited under IFRS. In a period of rising prices, FIFO produces lower cost of goods sold and higher reported profit than LIFO. In a job order costing system, the same principles determine the cost carried in work-in-process and finished goods before it flows to cost of goods sold.
Inventory valuation is core material on the CMA Part 1 exam, where it appears in both external financial reporting and costing systems, and on the ACCA Financial Accounting exam, which tests the IAS 2 rules on cost, net realizable value, and the required disclosures.
Key takeaways
- Inventory valuation sets both the balance sheet inventory figure and the cost of goods sold expense.
- Inventory is measured at the lower of cost and net realizable value, so damaged or obsolete goods are written down.
- Cost includes purchase price, duties, freight-in, and production conversion costs, but excludes abnormal waste and selling costs.
- FIFO, weighted average, and LIFO are the main cost flow assumptions; LIFO is allowed under U.S. GAAP but not under IFRS.
- With rising prices, FIFO reports lower cost of goods sold and higher profit than LIFO.