What Is Inventory Valuation? Definition, Importance and Methods (2024)

Inventory valuation is how businesses assign monetary value to inventory for their records. Find out why it’s important, different methods, and how to calculate in 2023.

Inventory valuation is essential for successful small retail businesses. It helps you determine revenue goals, save on taxes, and obtain financing. By finding the best inventory tracking method, you can better manage stock and forecast profits. 

So many variables impact the value of your inventory—from manufacturing costs, to cost of goods sold (COGS), to demand— that determining your inventory value can feel next to impossible.

Luckily, there are various inventory valuation methods you can use to streamline the process. This guide compares the common valuation methods, and will help you choose the best fit for your business.

What is inventory valuation? 

Inventory valuation is the cost associated with unsold inventory at the end of a reporting period. Since inventory is often the largest asset a company owns, it’s important to consistently measure its value. Understanding your inventory valuation helps maximize profitability and keep your company's financial statements accurate and updated. 

How you value inventory impacts your cost of goods sold, net income, and ending inventory—all factors that directly affect profitability. There are also tax implications associated with your inventory valuation method. 

The IRS requires you to stick to one method, such as First-In, First-Out (FIFO), or Weighted Average Cost (WAC), during your first year of filing tax returns. If you want to change your method in later years, you’ll need to get permission from the IRS. The goal of inventory valuation is to help you create a clear picture of your business’s financial position and profitability.

Importance of valuing inventory

As noted, inventory valuation is an important part of running a successful and efficient retail business. Below are some of the different ways that inventory valuation impacts your store.

Profitability

Inventory valuation helps you calculate the cost of goods sold and the costs of unsold inventory in your business. Retailers use inventory value to determine gross profit. Meanwhile, managing inventory isn’t getting cheaper. Estimates show that by 2024, retailers will face a 140 million square foot storage shortage, which will drive up the cost of warehousing.

Once you know how much your inventory is worth, you can decide:

• To stay with a manufacturer or supplier. 
• To reduce or increase warehouse space. 
• How much you’re willing to spend to produce a product.
• How much to sell products for.

Inventory is more than just products that a business sells, it’s one of the biggest investments a retailer makes. Having an understanding of your inventory value gives the insights needed to better evaluate profitability. It’s the difference between making or breaking your business.

Jay Gittens, Product Marketing Manager - Inventory, Shopify

Taxes

Taxes are an administrative challenge for most businesses. According to the IRS, you cannot deduct the cost of inventory when you purchase it. You must deduct the cost of inventory when it is sold, and are allowed to choose among four different methods when calculating costs during an accounting period.

Your inventory valuation method directly relates to how you file your taxes. For example, the First In, First Out (FIFO) method will yield different taxable income versus Last In, First Out (LIFO). The right valuation method can ensure that you pay the correct amount in taxes and avoid an audit from the IRS.

Loans 

Your company’s balance sheet lists inventory as an asset. You spend money on it and then it converts into revenue. 

If you want to apply for a loan, lenders will look at the value of the closing inventory on your balance sheet before approving it. Higher valuations give more assurance to the lender that you’ll pay the loan back.

Lenders may also put a restriction on the allowable proportion of current assets to current liabilities, known as loan ratios. If you cannot meet the target ratio, the lender may demand early repayment. Because inventory is often the largest component of loan ratios, keeping track of your inventory value can help ensure you’re meeting the target ratio.

Not all lenders operate this way. There are some options, like Shopify Capital, which base funding amounts on your sales instead of the value of your current inventory. It’s best to research and determine what works best for the needs of your business.

Accurate inventory valuation, stockroom counts, and sales records are key. Proper inventory management eases financial obstacles and gives lenders insight into your profitability and demand volume.

Jara Moser, Digital Marketing Manager at Shopventory

Inventory valuation methods for your business

As a small business owner, you want to fully understand the different inventory valuation methods and find the one that works best for your business. 

Your method of inventory valuation must:

• Meet generally accepted accounting principles (GAAP).
• Be consistent from year to year.
• Accurately reflect income. 

Let’s look at the four inventory costing methods you can apply:

• FIFO
• LIFO
• WAC
• Specific identification

FIFO

First In First Out (FIFO) is the most common inventory valuation method for retailers. It assumes that your oldest units in inventory are sold first. Accountants use FIFO for cost flow assumption purposes, which refers to the cost of moving products from inventory to cost of goods sold.

The FIFO method is typically the most common method, since it’s easy to use and provides the most accurate picture of costs and profitability.

Jay Gittens, Product Marketing Manager - Inventory, Shopify

Best for: Businesses that sell in an industry where product price remains steady. 

Pros:

• Saves money and time in calculating the exact cost of inventory.
• Simple concept and easy to understand. 
• Widely used and accepted valuation method.
• Makes it hard to manipulate income reported in financial records. 
• Shows increased gross and net profits during times of increasing price of goods.
• Can be used for all kinds of goods.
• Offsets risk of high holding costs for storing dead stock.

Cons: 

• Not ideal if the price of goods fluctuates.
• Not useful during times of inflation, because it results in higher net income compared to LIFO. 

LIFO

Last In, First Out is another common valuation method for US businesses. LIFO assumes that recently bought inventory constitutes the first items sold. A company using LIFO could have a lower tax liability because they make less profit, which over time can be beneficial to the bottom line. LIFO is not ideal for brands expanding internationally, because it is only legal in the US.

Best for: US businesses that sell products which raise in price every year. 

Pros:

• Lowers income tax bill during periods of inflation.
• Fewer inventory write-downs.
• Helps match revenue with cost.
• Ideal for businesses with rising prices for raw materials and labor.

Cons: 

• Can be difficult to maintain.
• Requires complex record-keeping.
• Not accepted by International Financial Reporting Standards (IFRS).
• Understates the value of ending inventory.
• Not recommended for time-sensitive or perishable goods.

WAC

The weighted average cost method is the happy medium between LIFO and FIFO. It uses a weighted average to work out how much money goes into COGS and inventory. To calculate the weighted average cost, divide the total cost of goods purchased by the number of units available for sale.

“We recommend weighted average cost methodology for calculating a company’s inventory value because it accounts for any variance in inventory cost over time,” says Darren Noll, the Head of Pricing at OpenStore, a company that helps ecommerce entrepreneurs sell their businesses. In his role, Noll spends most of his time determining how much inventory is worth before OpenStore acquires a new business. 

Best for: Businesses with a variety of non-perishable items at different prices.

Pros: 

• Provides a good overall estimate of inventory value.
• Best for when it’s difficult to assign specific costs to individual items.
• Standardizes expenses across inventory batches. 
• Harder to manipulate inventory accounting figures.
• Can provide an accurate picture of financial health.

Cons: 

• Doesn’t match inventory flow.
• Actual expenses are not assigned to items sold.
• Reported net income falls between FIFO and LIFO.
• Future tax benefits and cash flow advantages can be minimized.

💡 PRO TIP: With Shopify POS, it’s easy to keep track of your inventory costs, quantities, and retail value. To get started, view the Month-end inventory snapshot report in Shopify admin.

Specific identification

The specific identification method is a perpetual inventory system that has the highest accuracy levels for tracking individual items from the time they enter inventory, until they leave. It’s different from FIFO and LIFO, which groups items together based on purchase date and cost. Each item is tagged with its cost and any extra costs sustained until sold. Specific identification is often used for more expensive products, like rare antiques and vehicles.

This valuation method is used to cost and track specific inventory items. It’s done with items a business identifies using RFID tags, serial numbers, or stamped receipt dates. 

Best for: Businesses that sell a variety of items with different costs and features, or expensive and unique inventory.

Pros:

• Makes it easy to calculate ending inventory.
• High level of accuracy for inventory cost on balance sheet.
• Actual costs are aligned with revenues.

Cons: 

• Net income can easily be manipulated. 
• Requires detailed physical count. 

How to calculate inventory value

Now that you're familiar with the different methods for calculating inventory value, let's look at the formulas and variables associated with each.

FIFO

To calculate inventory value using FIFO, determine the cost of your oldest inventory and multiply it by the amount of inventory sold.

Cost of oldest inventory X amount of inventory sold

Let’s put it into practice. Say you’re evaluating Q2 inventory for your outdoor gear store. You have a beginning inventory of travel mugs valued at $3,000. Between April and June you made the following purchases.

Month	Quantity	Cost per unit
April	200	$2.50
May	200	$5.00
June	200	$6.50

Overall, you bought 600 mugs at a total cost of $2,800. Your order management system shows 250 travel mugs sales at the end of the accounting period. 

Since you bought the $2.50 mugs first, your COGS calculation would look like this: $2.50 x 250 = $625.

Using FIFO, your ending inventory valuation would be: Beginning inventory ($3,000) + new purchases ($2,800) - COGS ($625) = $5,175. 

LIFO

To determine COGS using LIFO method, determine the cost of your most recent inventory, then multiply it by the amount of inventory sold. 

Cost of recent inventory X amount of inventory sold

Using the same example as above, let’s imagine you use LIFO to determine inventory value. The cost of buying mugs for your inventory went up over the summer season, as seen in the “Cost per unit” column. 

You’d calculate COGS with the $6.50 mug price point, because those mugs were sold most recently. Selling 250 travel mugs would result in a COGS equal to $1,625. 

Your inventory valuation calculation is the following:

Beginning inventory ($3,000) + new purchases ($2,800) - COGS ($1,625) = $4,175. 

Your LIFO reserve, or the difference between FIFO and LIFO cost of inventory, is $1,000. This is the amount of taxable income deferred by using the LIFO valuation method. 

WAC

To calculate WAC, divide the cost of products offered for sale by the number of units available for sale to find your WAC per unit. 

Cost of goods available for sale / total number of units in inventory

Determining WAC seems challenging at first, but it’s relatively simple once you understand it. Here’s an example.

June transactions	Quantity	Cost per unit	Total cost
Beginning inventory (June 1)	50	$2.00	$100
June 10	150	$2.50	$375
June 20	100	$3.00	$300
Ending inventory (June 30)	300	$2.58	$775

In the above example, the total cost of inventory purchased was $775. The total number of units in inventory is 300. To determine WAC, divide $775 by 300 to get the average weighted cost per unit, which is $2.58.

Specific identification

With specific identification, you track the exact individual cost for each item in your inventory. Say you buy antique jewelry and resell it after making repairs. You begin June with $18,000 worth of inventory and buy three units at $1,000 each during the month. 

At the end of June, you determine the specific costs associated with your inventory (shipping, purchase price, marketing, etc.), which equals $9,000. 

Using specific identification, use the following COGS calculation:

New purchases ($3,000) + beginning inventory ($18,000) - associated costs ($9,000) = COGS ($12,000). 

Subtract $12,000 from your revenue, and you have an ending inventory valuation, which becomes your beginning inventory for July. 

Which inventory valuation method is best for you?

“You’ll want to know if your inventory costs are increasing or decreasing, what you’re selling, and even where your business is located,” says Jay Gittens, product marketing manager at Shopify. “There isn’t really any one-size-fits-all solution, since each method has different pros and cons.”

Let’s look at four key factors in choosing an inventory valuation method.

Financial goals

Retailers want to look at any future money plans they have when choosing an inventory valuation method. For example, will you benefit from reporting a higher net income? Or do you need to report higher asset value for financing? 

If you want to apply for a loan to expand your business, you’ll need inventory as collateral. A higher stock value can assure lenders you’ll pay the loan back. If you’re trying to attract investors, however, a business with high profit margins will gain more attention. 

Market conditions

A business should also look at current market conditions when determining a valuation method. The cost of purchasing or producing inventory can change quickly, depending on different economic factors. For example, if prices increase throughout the year, FIFO will result in a higher value for closing inventory. If you need a loan, the FIFO valuation technique is the way to go. 

Choose a method that you’ll stick with; it’s not strategic to change your valuation technique throughout the year. If you do, you’ll need to recalculate the value of your remaining inventory, which can result in inaccurate counts and impact your balance sheet. 

Attracting investment

Businesses with large profit margins are attractive to potential investors and shareholders. Accurately valuing inventory directly impacts its gross profit and income statement, which gives investors an idea of its financial performance.

“Inventory often consumes a significant amount of a retailer’s working capital,” says Noll, of OpenStore.

He suggests that inventory valuation is also important if you plan to sell your business. “When it comes time to sell their business, a retailer may have a large amount of capital tied up in inventory, especially if they are trying to maximize business performance through the sale process.

“Knowing how the inventory will be valued in a sale helps a retailer manage the trade-off between deploying capital pre-sale and how it will be recovered in the sale price,” he explains.

FIFO provides the highest profit, as the first items in stock usually carry the least cost. That’s because materials prices and other inventory costs tend to rise over time due to inflation. 

Saving on taxes

For a lower tax bill, businesses should use the LIFO inventory valuation method. This method assumes the newest inventory is sold first. Since the newest inventory is sold first, the COGs would increase because the newest inventory is more expensive. 

Gross profit is therefore smaller and so shrinks the company’s tax bill. 

Choose the right inventory valuation method for your store

Your inventory valuation method is key to managing stock levels and helps make filing taxes and financial analysis easier. For many retailers, FIFO and WAC are great ways to determine inventory value and keep accurate records easily. Just remember that whichever method you choose should be one you’ll want to use for a long time.

Inventory valuation FAQ

What is inventory valuation and why is it important?

Inventory valuation is the cost associated with unsold inventory at the end of a reporting period. It’s important to value inventory accurately because it impacts profitability, taxes, and a business’s ability to apply for loans.

What are the 4 inventory valuation methods?

The four inventory valuation methods are:

• FIFO - First in first out
• LIFO - Last in first out
• WAC - Weighted average cost
• Specific identification

How is inventory valuation calculated?

Here are the key formulas calculating inventory valuation: 

• FIFO = Cost of oldest inventory X amount of inventory sold
• LIFO = Cost of most recent inventory X amount of inventory sold
• Weighted average cost = Cost of goods available for sale / total number of units in inventory
• Specific identification = New purchases + beginning inventory ($18,000) - associated costs = COGS