Having an accurate picture of your company's inventory costs is often essential for determining profitability. If you don't know how much your inventory is worth, you can't determine the cost of goods sold and your company's net profit. If you plan to sell the firm, potential buyers will want to know the value of items sitting on your shelves, stacked in your warehouse, and being prepared for sale. Banks, too, will want to understand the value of your inventory before extending credit.

So how do you establish inventory values? In general, you make certain assumptions. You can assume that the oldest inventory is sold first, also called the first-in, first-out (FIFO) method. For many companies, this cost assumption mirrors what actually occurs in the warehouse. Because prices tend to rise over time, this method generally results in a lower cost of goods sold and, therefore, a higher net income (other things being equal). Using another assumption — the last-in, first-out or LIFO method — the cost of goods sold tends to be higher and the profits (as depicted on the income statement) lower. Of course, the lower the company's profits, the lower its tax liability (again, other things being equal). A third method, known as the average cost method, values inventory using a weighted average of inventory costs over time.

Note that each of these methods involves assumptions that may or may not mimic the actual flow of goods. The key to understanding your firm's profitability over time (and for keeping the IRS happy) is consistency. Once selected, you shouldn't change your inventory valuation method without good reasons. The IRS has valuation requirements for certain types of businesses.

Also included in the value of inventory are costs needed to prepare the goods for sale. Such expenses might include the cost of raw materials, factory overhead, and shipping fees. In addition, inventory values should be reduced for the cost of items that have lost their value — say, through waste or obsolescence. A computer store, for example, with a warehouse storing older desktop models or a grocery outlet with perishable goods may need regular reductions in inventory values.

A firm with a limited inventory or large ticket items may also track the cost of each physical item by recording specific invoice amounts.

If you'd like help determining the value your business inventory, give us a call.

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