Inventory valuation

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Raj Mehan

Tax Question:

What is inventory valuation?

Facts:

Inventory valuation is the method used to calculate the cost of goods sold and the ending value of inventory. Following are the most widely used inventory valuation methods: First-in, First-out (FIFO), Last-in, First-out (LIFO), and Weighted Average.

Discussion:

Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income.

Under LIFO, inventory valuation is exactly opposite to first-in-first-out method. Here it is assumed that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost of goods sold in LIFO method is relatively higher and ending inventory balance is relatively lower. This is because the cost of goods sold mostly consists of newer higher priced goods and ending inventory cost consists of older low priced items.

Under the Weighted Average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. Weighted average cost per unit is calculated as follows:

Weighted Average Cost Per Unit = Total Cost Of Goods in Inventory / Total Units in Inventory

The weighted average cost as calculated above is multiplied by number of units sold to get cost of goods sold and with number of units in ending inventory to obtain cost of ending inventory.

Raj Mehan, B.Com, M.Com, Junior Associate

Email: faqs@gilmour.ca
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