Your inventory is extremely valuable to you. As an eCommerce business, it is essentially your entire reason for being (no pressure). Choosing how you value that inventory impacts everything from your profit/loss statements, your cost of goods sold, and your overall state of finances.
Inventory valuation can be a part of your business you’d rather leave up to your accountant. However, it’s important to understand this aspect of inventory management- if you don’t use the ideal valuation method for your product, industry and country, your expenses and revenue at the end of any given period may not reflect the reality of the situation.
First, tracking your inventory
There are two major ways of tracking your inventory for accounting purposes: periodic and perpetual. Especially with an eCommerce business, you need to keep careful track of your stock - these are two options:
With a periodic inventory system, you keep track of sales as they happen, but don’t update inventory levels until you do a periodic stock-take. With this method, you hypothetically know how much inventory you have left, based off of sales orders. While this method can be manageable for small quantities, overall, it leaves lots of room for inaccuracies and errors.
With a perpetual inventory system, you keep routine, updated record of the inventory on hand at any point in time. In the fast-paced world of selling online, we highly recommend this method. If you don’t have time to do perpetual inventory updates manually, try using a cloud-based software (like TradeGecko!) to do it for you.
The perpetual system leaves less room for errors, oversights and other supply chain issues that can come from not keeping track of real-time stock movements.
Once you’ve chosen the perpetual valuation method (hint, hint), it’s time to calculate the actual value of your inventory in one of three ways.
First-in, First out, FIFO
With the First-in, First-out method, the oldest inventory is recorded as the first sold, regardless of whether or not the actual product itself was the first stock bought. Because FIFO values the inventory based on current sale value, it also more accurately reflects what the cost of replacing that item will be based on current market prices.
Basically, FIFO assigns the cost you paid for a case of beer you bought 2 weeks ago to the sale and profit you made today, even if the actual item you sold was bought 2 days ago (at a different price).
FIFO is generally considered more systematic, as it creates a more linear flow of goods through the supply chain.
Last-in, First-out LIFO
In this method, the newest inventory is recorded as being sold first, and the costs are assigned likewise. So, the costs recorded definitely don’t match the actual flow of items and when the oldest goods are eventually sold, their actual cost could vary greatly from the price they were sold for.
This method is mostly only used in the USA, but is pretty popular there. With high levels of inflation, it pairs up current costs of inventory with more current prices and increases tax breaks.
However, this method is more of an assumed cost of inventory and doesn’t accurately reflect prices paid, especially for the oldest items in your line-up. Because of this discrepancy and International Financial Reporting Standards (IFRS), LIFO isn’t practiced outside of America.
Weighted Average Cost or WAC
Using Weighted Average Cost, you value your inventory using the average cost of goods sold of all the inventory to determine the inventory value of one item. The costs of all the inventory in one period are averaged to determine the cost of each piece.
What it all means for your bottom line
The difference between all these methods is the changing cost of goods sold and fluctuating inflation. If these inventory costs stayed the same, then all three methods would produce pretty much the same results. However, because costs of buying inventory can change a lot over time, a company has to choose which method works best for their purposes.
If you’re accounting in a period of high inflation, FIFO would produce the highest net income, LIFO methods would show the lowest net income and WAC will be something in the middle, averaging the highs and lows of any given time period.
All cleared up
These are the basics of these inventory valuation accounting methods. With your inventory making up a significant part of both your assets and business costs, it’s important to choose a method that gives you an accurate picture of inventory cost.
Whatever way you (or your accountant) chooses to do it, will have an impact on your overall supply chain costs.
And if you’re still looking to automate your perpetual inventory management system, why not give TradeGecko a try?