Every company that manages physical inventory requires precise inventory valuation to prevent financial misstatements, tax compliance issues, and potentially costly audit findings.
Whether you are in manufacturing, distribution, retail, or third-party logistics, inventory typically accounts for the bulk of your business’s assets. Both its dollar value and the method you use to get to that dollar value could not be more critical. These calculations and the decisions how to get to them determine reported profits, tax liability, and how investors perceive overall company value.
Companies can choose from different inventory valuation methods, but it is important to know which one is best for their business. This article can help you determine which valuation method best suits your business, and how to implement it in your warehouse management framework.
What Is Inventory Valuation?
Inventory valuation is the process of determining the value of a company’s inventory when preparing financial statements. Business inventories refer to all supplies a business uses to operate, whether they are raw materials or finished goods ready to be sold.
For example, a dress-production clothing company would consider fabrics, zippers, and beads as well as finished dresses as inventory.
Companies must also add in cost components beyond purchase price to get to inventory valuation, including direct labor, handling fees, factory overhead, and import duties.
Proper inventory valuation ensures all these costs are accurately reflected in your income statement and balance sheet, directly impacting your reported profitability. This is why selecting the right valuation method is crucial. It determines how all these inventory-related costs affect your company’s financial position.
While warehouse management systems track physical inventory with precision, that data must be translated into accurate financial values. How your WMS is configured directly influences your ability to implement different valuation methods correctly
6 Benefits of Inventory Valuation
Here are some of the benefits of inventory valuation for businesses.
Financial reporting
Proper inventory valuation ensures that your financial statements are up-to-date and accurately reflect the company’s financial position, including assets, liabilities, and equity.
Profitability
With the right inventory valuation method, warehouse managers, inventory controllers, and accountants can record more accurate COGS calculations. These calculations are critical in determining a business’s gross profits. Businesses can make more informed decisions about pricing, production, and purchasing, leading to better profit margins.
Inventory management and operations
With accurate inventory valuation, businesses can understand their inventory levels and turnover, which leads to better cash flow. It can also help identify areas where inventory is over or understocked, thereby reducing holding costs and losses due to spoilage. With inventory valuation, decision-makers in retail can identify slow-moving inventory and optimize their inventory turnover.
Tax management
Inventory valuation helps you file taxes accurately and ensures compliance with tax laws by determining the cost of goods sold (COGS), which directly impacts taxable income. Choosing the right method helps businesses optimize tax strategies as well.
For example, using the LIFO method (Last In, First Out) when prices are rising usually results in higher COGS and lower taxable income, reducing tax payments. On the other hand, FIFO (First In, First Out) leads to lower COGS and higher profits, which can increase tax liability but make financial statements look stronger for investors.
Smarter decision making
When businesses clearly understand inventory costs, they can make more informed decisions about purchasing, production, and sales strategies. For example, if inventory costs are rising, a company may decide to buy in bulk before prices increase further. On the other hand, if costs are dropping, they might delay purchases to save money. This helps optimize cash flow and inventory turnover, reducing waste and excess stock.
Compliance and Auditing
Auditors and investors rely on accurate inventory records to assess a company’s financial health. Proper inventory valuation ensures that a business meets financial reporting standards and tax regulations. This reduces the risk of legal or financial penalties. If inventory is undervalued or overvalued, it can distort financial statements, leading to potential compliance issues or mistrust from stakeholders.
Common Inventory Valuation Methods
Here are the commonly used inventory valuation methods. Choose the one that best suits your business’s needs.
First-In, First-Out (FIFO)
According to the FIFO method, inventory products are sold in the same order they were bought or made, with the oldest inventory products sold first.
For example, a business that bought 30 T-shirts at different times and prices. The first transaction was 20 T-shirts at $500 each, and the second transaction was 10 T-shirts at $550 each. At the end of the month, the store sold 15 T-shirts.
With the FIFO method, costing is calculated from the first transaction when the user bought 20 T-shirts at $500 each.
So after selling 15 T-shirts, the accounting balance will be = 25 T-shirts x $500 each = $7,500
5 T-shirts are still left from the first purchase at $500 each, including the 10 T-shirts from the second purchase at $550.
The accounting balance of the inventory account would be: 5 T-shirts x $500 + 10 T-shirts x $550 = $8,000.
Pros
- FIFO provides a straightforward valuation method for e-commerce companies, eliminating the ability to manipulate revenue by selectively choosing which items to sell.
- The cost flow in FIFO aligns naturally with both the cash flow and physical movement of goods in the warehouse (oldest items leave first).
- Recent purchase price fluctuations at the end of an accounting period don’t affect the COGS calculation.
Cons
- During periods of rising prices, FIFO can create a mismatch between current replacement costs and older inventory costs used in calculating profits. This can create cash flow challenges: The business must use current cash to replace inventory at higher prices until reported profits are not translating to equivalent cash availability.
- During inflation, FIFO typically produces higher reported profits than other methods, potentially resulting in higher tax liabilities.
Last-In, First-Out (LIFO)
This inventory valuation method Last-In, First-Out is the direct opposite of the FIFO method because the most recently bought products are shown as the first sold. Let’s take the same scenario: if a store bought 30 T-shirts via two transactions, the first for 20 T-shirts at $500 each, the second for 10 T-shirts at $550 each, after selling 10 shirts:
The accounting balance for the COGS is 10 T-shirts x $550 = $5500.
Ten T-shirts are still left from the first purchase at $500, and 10 T-shirts from the second one are at $550.
So the inventory account = 10 T-shirts x $550 + 10 T-shirts x $500 = $10,500. That’s higher than the $8,000 inventory value using the FIFO approach for the same scenario.
Pros
- The LIFO method has tax benefits. Companies pay less tax if the COGS is higher and the earnings are lower, as in the LIFO method.
- The LIFO mechanism is more focused on profitability as it takes into account the most recent cost.
- When compared to the FIFO method, it generated far more paper profits.
Cons
- Selling the most recent purchases can result in older inventory never being sold.
- Major accounting authorities discourage the LIFO technique, and as such, there might be risks associated with the country and its regulations.
Weighted Average Cost (WAC)
The weighted cost average valuation method and cost of goods sold (COGS) are calculated based on the average cost of all items bought in a period. If a business bought t-shirts at different times and prices, with the first transaction at 10 t-shirts at $500 each and the second, 5 t-shirts at $550. You have a total of 15 t-shirts for which you paid $7,750 in total.
Your weighted average cost would be $7,750 divided by 15 t-shirts, which is approximately 516.66 per t-shirt. After selling 13 t-shirts, the accounting balance for the COGS = 13 x 516.66 average cost = $6,716.58
Accounting balance of inventory account = 2 x 516.66 = $1033.32
Pros
- Ideal for companies managing high-volume inventory where individual item tracking is impractical
- Provides a systematic, consistent approach that reduces calculation complexity
- Particularly valuable for warehouses storing identical items from different purchase batches where physical identification is difficult (like liquids, grains, or components)
- Smooths out price fluctuations, creating more stable cost reporting across accounting periods
Cons
- During rapidly rising prices, weighted average can result in selling items below current replacement cost, potentially creating cash flow challenges
- Less precise than item-specific costing methods, potentially masking profitability issues with specific product lines
How to Choose the Right Inventory Valuation Method
The IRS requires businesses to choose one inventory valuation method and stick to it for the first year of filing tax returns. To change the method, you would need permission from the IRS.
Here are some of the ways you can choose the best inventory valuation method for your company:
Industry and Inventory type
When dealing with perishable goods, the FIFO method is the best choice, as you sell out the items according to which came first. Perishable goods are most profitable when they are fresh and sold immediately after they are bought. However, businesses that deal in non-perishable goods may find the LIFO method more advantageous, as may industries that experience significant price fluctuations.
Financial reporting requirements
If your business operates internationally and must comply with the IRS, you should avoid the LIFO method. FIFO or weighted average cost would be more appropriate. Make sure to evaluate the tax implications of each method. The LIFO method can reduce tax liabilities despite rising prices, but the FIFO method can incur higher tax responsibilities due to higher reported net income.
Price Trends
LIFO is useful when prices are rising as it results in higher COGS while reducing taxes. FIFO or weighted average cost may be more beneficial if prices are stable or reduced.
Business Objectives
It is important to consider the impact of valuation methods on profitability. FIFO tends to improve net income during inflation and can attract investors. If accurate inventory valuation is essential for your business, FIFO provides value that can reflect current market conditions.
Challenges of Valuing Your Inventory
Here are some challenges you may face with inventory valuation.
Physical inventory discrepancies
Physical inventory may not match the recorded inventory because of theft, damage, loss, or recording errors. Inaccurate records can lead to over or undervaluation of inventory, which can affect the price of goods sold, gross profit, and inventory turnover ratio. Carrying out regular physical inventory alongside inventory control procedures is critical to maintaining uniform inventory on all platforms.
Fluctuating market prices
The price of inventory products can change very quickly and frequently, making it difficult to accurately value them at any given time. This is especially true for industries whose prices are determined by demand and supply. The right inventory valuation method can help mitigate the effects of those fluctuations.
Limited resources
Smaller businesses often struggle to find the resources or expertise to track and value their inventory. This inadequacy can lead to reliance on estimates, which results in inaccurate valuations. Inventory management software that caters to low-budget businesses can make the process more manageable and help them grow through more thorough accounts and records.
Multiple inventory locations
If a business stores inventory at different locations, coordinating inventory counts and reconciling data can be difficult. Variations in local market conditions, such as currency valuations and regulatory requirements, can also lead to complications during valuation. A proper warehouse management system fitted with inventory management features can help address these issues through proper syncing across different locations.
3PL Complexity
Third-party logistics providers face unique inventory valuation challenges due to their dual role in managing both client-owned inventory and their own operational assets.
While 3PLs maintain precise tracking of clients’ physical inventory counts, locations, and movements, they typically don’t carry these items on their own financial statements. This is because the inventory legally remains an asset of their clients. Instead, 3PLs must create robust data pipelines that allow clients to apply their preferred valuation methods (FIFO, LIFO, weighted average) to inventory stored in 3PL facilities. The compliance stakes are high. Inaccurate reporting or improper segregation of client inventory can cause financial misstatements for multiple companies, creating potential legal and regulatory exposure.
Meanwhile, 3PLs must separately track and value their own operational assets, packaging materials, and supplies using potentially different valuation methods than their clients employ.
Inventory Valuation Best Practices
“Inventory valuation can significantly affect a company’s reported profitability, and choosing the appropriate accounting method is critical to ensuring financial statements reflect economic reality.” —PricewaterhouseCoopers in “Inventory Valuation – IFRS Overview”
Here are some best practices for implementing inventory valuation methods that meet with International Financial Reporting Standards:
Regularly review and update
Regularly reviewing and updating your valuation methods according to present market and business conditions can help mitigate the effects of fluctuating prices and even regulate your income. Financial managers who stay abreast of accounting records can easily spot an opportunity to try another valuation method. This helps them ensure that income remains within or exceeds current levels.
Use warehouse management software.
Good management software like Da Vinci, with state-of-the-art inventory management features, can help automate calculations, track inventory movements, and generate accurate reports. This can reduce errors and improve efficiency.
Conduct physical inventory
To address the discrepancies in physical and recorded inventory, perform a regular physical inventory to verify the recorded inventory levels and identify differences in inventory. This ensures that your inventory valuation reflects the accurate number of inventory at hand.
Collaborate with financial experts
Seek expertise from accountants and financial experts to assess the impact of different valuation methods on your business based on your tax information and financial records. Their knowledge and expertise can help you make more informed decisions.
Monitor market trends
Stay informed of market trends and industry changes to know how these changes can affect your business, help you choose the best valuation method, and make the necessary adjustments.
Take Control of Your Profits with Proper Inventory Valuation
A good warehouse management system with robust configurations directly supports accurate inventory valuation by:
- Tracking inventory costs in real-time, including purchase prices, handling costs, and storage expenses.
- Maintaining precise lot tracking that enables FIFO, LIFO, or weighted average costing methods.
- Automatically flagging and quantifying damaged or obsolete inventory that requires value adjustment.
- Supporting cycle counting that ensures physical inventory matches system records.
- Generating detailed reports that break down inventory by age, location, and value.
These capabilities eliminate the manual reconciliation and estimation that often lead to valuation errors. When your finance team needs to determine inventory value for financial reporting, tax purposes, or business planning, they can trust that the WMS-supplied data reflects your actual inventory position.
Many enterprise WMS solutions, including Da Vinci Unified, allow you to run multiple valuation methods simultaneously—for example, using FIFO for financial reporting while maintaining weighted average calculations for internal metrics. They also offer: configurable dashboards showing current inventory value; automated reporting that provides period-end valuation; integration with ERP and accounting systems to seamlessly share valuation data.Take the first steps to controlling your profits with Da Vinci WMS. Request a demo today.