Definition of Inventory Valuation
In the U.S., inventory valuation is the dollar amount associated with the items remaining in a company’s inventory.
Generally speaking, the amount is the cost of the items. (Cost is defined as all of the costs necessary to get the inventory items in place and ready for sale.) The cost may vary somewhat since U.S. companies may choose between the periodic inventory system and the perpetual inventory system. In addition, these companies may select from several cost flow assumptions, including FIFO, LIFO, average, etc.
While reporting at cost is the general rule, inventories must be reported at less than cost in certain situations. For example, some inventories will have to be reported at their net realizable value when it is less than cost.
A manufacturer’s inventory valuation will include the costs of production, namely direct materials, direct labor, and manufacturing overhead. Manufacturers are also required to consistently follow their selected cost flow assumption.
Examples of Inventory Valuation
Assume that a new company purchased three truckloads of its only merchandise item during its first year of operations at the following costs:
- January: 500 units at $10 each
- May: 1,000 units at $11 each
- September: 1,000 units at $12 each
Assume that throughout the year the company sold 2,300 units. As a result, the company had 200 units in inventory at the end of the year.
If the company uses the periodic system and the FIFO cost flow assumption, its inventory will be reported at the cost of $2,400 (200 units X $12). On the other hand if the company uses the periodic system and the LIFO cost flow assumption, its inventory will be reported at the cost of $2,000 (200 units $10).
Inventory valuation is also important because of its effect on the following:
- Cost of goods sold for more than one accounting period
- The amount of a company’s current assets
- The company’s working capital
- The company’s current ratio
