What Is Inventory Valuation? Which Valuation Method is Best for Your Business?

The Internal Revenue Service allows you to choose between FIFO, or first-in-first-out, LIFO, or last-in-first-out, and specific identification only to evaluate the inventory of your taxes, although the other valuation methods may be helpful under various circumstances. The IRS has determined that, for tax purposes, the FIFO method is the only inventory-costing method that you are allowed to use if your company has international locations. Many businesses do use FIFO inventory; however, this may lead to higher total revenue and taxes.

FIFO usually results in higher gross margins, as it is common for acquisition costs to increase over time. For example, if prices increase throughout the year, then FIFO would lead to higher values of closed inventory. Because prices for components and other stocks can rise over time, using FIFO means closing inventory is valued higher, since it incurs higher cost per item to estimate. For a more accurate costing, use this approach, since it assumes the oldest, least expensive items are those sold first. Under the FIFO method, the cost of goods sold is based on the cost of materials purchased first in a given period, while the cost of finished goods is based on the cost of materials purchased next.

FIFO method assumes that inventory produced first would be the first units(s) sold and fulfilled. Under a First-In-First-Out (FIFO) estimation approach, the inventory items are sold in the order they were purchased or manufactured. This method is based on the premise that the first purchase of the inventory is the first sold.

The LIFO method is based on the premise that all goods available for sale are equal, and that each units value is calculated using the weighted average value of equal initial goods in order to determine how much was sold. With LIFO (Last In, lowest value old products would be reported as stock. With LIFO, recent costs of goods sold are aligned to the most recent sales revenues, helping determine real revenue, while being a cost-based method, a company is receiving whatever profit/loss is not accurate.

Using the FIFO method, a business cannot manipulate revenue by selecting what items to sell, since the cost of individual items sold is always the older cost. For instance, this method would provide the lowest profit since the last inventory item purchased is typically the most expensive, whereas LIFO would provide the highest profit since the first inventory item is typically the least expensive.

While there are a lot of different methods to calculate inventory costs, we are going to focus on five of the most common ones: FIFO, LIFO, WAC, SE, and FEFO. FIFO is typically the most straight forward inventory costing method retailers can use, as it is most aligned with actual inventory costs and inventory movements.

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