Valuation Methods Comparative Analysis.
Through inventory valuation, companies can give monetary estimations of their inventory or stock. Generally, stocks make up the most significant portion of the current assets of a company and are as critical as cash at hand or in the bank. In other words, inventories are a form of cash but in un-liquidated form as current assets. Therefore, the proper and accurate valuation of these inventories is crucial as it consists of a significant part of the current assets and the company’s total assets in general. Stocks represent up to 60 percent of total assets for manufacturing companies. When inventory is not appropriately valued, it can contribute to a lack of matching investment and revenue and also to poor business decisions that affect the profitability of the company. Asset valuation is crucial as it may be attributable to the many benefits the company would obtain from accurate inventory valuation.
For a manufacturing company, their inventory includes raw materials, semi-finished or work in progress goods, and finished goods. All these components indicate the company’s linkages between sales and production, thus providing the company with the necessary information that aids its pricing strategies.
The valuation methods vary depending on various factors, including the current economic conditions and the management style of a company. For example, a company the aggressively seeks to increase its profit margin may use a particular valuation method that reveals lower profits, to use extra disposable funds to expand its activities. Such a company may opt for one specific valuation method that aligns with its objectives and discard other methods. On the other hand, an enterprise dealing with perishable commodities favors a valuation method that considers the outflow of items that were first in inventory (FIFO- first in, first out).
There are several methods of determining the monetary estimate of inventory or stock. The underlying reason and logic behind the valuation of merchandise are to aid in the determination of production costs on a realistic and consistent basis. Regardless of the firm’s choice of method, all methods operate on the principle of costs. That is, when choosing an inventory model, there is a comparison between revenue and expenses, and the most suitable is the one that mirrors periodic income. Some of the methods adopted by various cost accountants include replacement price method, latest purchase price, highest-in, first-out, average price method, Cost Price Method (FIFO and LIFO).
Replacement price uses the prevailing market prices in the valuation process of their inventory. Although for specific reasons, this method may be suitable, it is highly challenging to obtain the prevailing cost for each inventory item. However, for the latest purchase price method, inventory valuation is determined using the cost of the most recently acquired item. For the Highest in, First out approach, batch with the highest cost are issued first until each item in the set is exhausted. The average price method, on the other end, uses the weighted average values of all items in inventory for a financial period and uses this value to determine the cost of goods sold and the closing stock.
The cost price method includes First-in- First out (FIFO) and Last-in- First out (LIFO). In FIFO, commodities issuance is in adherence to specific chronological order. The oldest stock offered first, and also, at the same rate, it was obtained. In other words, materials supply out of the store are as per their receipt order. In case the company has opening stock, the opening stock is offered first before the first purchase. This valuation method becomes unsuitable amid inflation and rising prices. In that, the cost of replacement materials will be higher than the issue price to production materials.
FIFO approach is ideally suited for assessing perishable and relatively rapidly degrading agricultural products as time goes by. It can also apply to grocery stores dealing with highly perishable goods. Furthermore, this approach regulates obsolescence, waste, and degradation of products. This inventory valuation method guarantees that the issued commodities match the costs and thus prevent unrealized gain or loss that could be caused by a random outflow of items. Further, it also reflects prevailing prices and therefore avoids the use of obsolete values in the valuation of closing stock.
LIFO, on the other hand, is based on the assumption that commodities acquired recently are used or sold first. The items remaining in the store are presumably those purchased earlier. In this valuation method, the monetary value given to the closing stock of a financial period is determined by the cost of the earliest items. Amid inflation and an increase in prices, the LIFO method gives a lower value for the closing inventory, lower gross profit, and higher costs of goods issued compared to the FIFO method. However, the LIFO method will significantly underestimate inventory value during extended inflationary cycles because replacement costs are considerably higher than the amount shown in the financial statement.
The assumption of the LIFO method is also applied to the system of product valuation based on the presumption that the items are sold or used in the opposite corresponding sequential order in which those acquired first are the last out (FILO, first-in last-out). In this method, the cost of the commodities acquired first represents the cost of items out last. In times of inflation and rising prices, this method starts its records with the sale of the most recent commodity. This is the same case as with LIFO; therefore, the two approaches are the same.
If the economy existed without inflation or rise in prices, all the methods of inventory valuations would yield the same results. However, in the real world, this is a highly rare existence. These fluctuations in prices imply that the choice of inventory valuation method has an impact on the company’s value of stock and profits for the year.
In the case of rising prices, the LIFO valuation method would yield a higher cost of goods sold, since the valuation is based on the more expensive new inventory. For the FIFO method, however, the recently acquired stock is left in the company’s balance sheet. In effect, this method can result in higher net income as the commodities acquired earlier are valued at the current higher prices in the determination of the company’s cost of goods sold. On the flip side, however, higher net income attracts higher tax liability. Generally, the average price method yield results that fall between LIFO and FIFO. In the event of deflation in the economy or decrease in prices, the scenarios played out in the various valuation methods occur oppositely. Additionally, many firms state that they use to market or lower cost during their inventory valuation. This implies that in case of a decrease in the inventory values, their inventory valuations will settle at the replacement or market value rather than average price cost, FIFO, or LIFO.