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If you have inventory, then you need a way to value it for tax purposes. Fortunately for you, there are three ultra simple methods to choose from to decide what works best for your business situation. In the rest of this article, we’ll teach you how to easily assign a value to your inventory.
If you’re a business that sells products to customers, those products are considered inventory. More likely than not, you paid or exchanged something to acquire those products. This means that your inventory has a cost associated with it. You can figure this cost by deciding on an inventory valuation method. This becomes especially important towards the end of the year, with different impacts for each method.
The three most generally-accepted valuation methods are the weighted average cost method (WAC), last in first out (LIFO), and first in first out (FIFO). The basic concepts of FIFO and LIFO are similar, but the product timing is flipped, whereas WAC is basically a combination of the two.
Weighted Average Cost (WAC)
Weighted average cost is a universally fair way of finding the average cost you pay to acquire your inventory. Rather than just looking at first or last price paid, WAC looks at the prices you paid throughout the entire year and makes an average out of them. It may not be accurate for specific purchases, but for a general overview of inventory price, it works great. Here are some great situations to use WAC for:
- Fluctuating product price. When dealing with certain products and vendors, prices may not always be set in stone. Especially when you’re a newer business, you’re likely to having a varying price you pay to acquire your goods. Using WAC allows you to see the average across the year, which may be a better representation than just the beginning or end of the year.
- Single product businesses. For businesses with only a single product, using WAC is a quick way to determine the cost of inventory. Having multiple products can muddy the numbers, meaning your WAC of inventory won’t show you the individual cost of products in inventory.
Last In, First Out (LIFO)
Last In, First Out (LIFO) is less used than the other two methods. This method uses the assumption that you sell your newest acquired products first, rather than older existing ones that have already been purchased. Aside from being counterintuitive, LIFO is only accepted by the generally accepted accounting principles (GAAP), meaning only businesses operating in the US can even use it. Here are some good reasons to use LIFO:
- Drastic market changes. Some markets can be highly volatile, leading to changing prices to acquire inventory. Especially when the price is trending upwards, it can be helpful to use LIFO to accurately report the current market value of your inventory. Even if you acquired product cheaper before, since you now acquire product at a higher price, the higher price is representative of the current situation.
- Endless demand, established production. If you’re a business with limitless demand and established production, you already know the cost of your product. It won’t change over time, so there isn’t a difference between LIFO and FIFO in this scenario.
First In, First Out (FIFO)
First In, First Out (FIFO) is the exact opposite of LIFO. Rather than selling the newest acquired product, you would sell the product you acquired earlier first. You would continue to sell the older products first, only switching to a newer product once you run out. This especially makes sense for businesses involved with perishable goods, as using FIFO is necessary to prevent waste. This is the most commonly used method. Some good reasons for using FIFO:
- Perishable goods. Businesses with expiring products need to use FIFO. If they don’t, they’ll risk having their products expire and cause waste. This is especially important with quickly-perishing goods, like those you’d find at a grocery store. It makes sense to sell what goes bad sooner first.
- Older items are already paid for. Acquiring new product is always important, but if you have existing product, you already paid for it and need to sell it. When you don’t sell old inventory first, you essentially are paying to store the product. Constantly selling new product never lets you get rid of the old, so it will consistently sit unsold in inventory.
Seek Professional Advice
Choosing an inventory valuation method can be complicated and ultimately depend on your situation. Don’t feel bad if you aren’t sure which works best for your business, because it takes an accountant to understand the impact of your choice. Depending upon what you choose, you may end up with a different net income figure across methods. This is why it is important to stick with whatever method you choose, so you’re consistently reporting the correct income.
Lucky for you, there are well trained experts available that know exactly what you need. We can take a look at your business and see what your inventory and supplier situation looks like. After some in-depth analysis, we can give you an informed decision on what your best option is to make sure you save the most money.
Hiring a professional accountant can do wonders for your business! Rather than fumbling and trying to find answers on your own, seeking a pro can save you time and money. Plus, choosing to use professional accounting services is essentially risk-free, considering that, more often than not, the savings you’ll earn will be well worth it and even pay for itself!
When you need food, you go to the grocery store. When you need your oil changed, you go to a service station. Picking an inventory valuation method is no different. If you want the best treatment, you have to find an accountant! Only they have the knowledge to understand the best financial moves for your business. Don’t delay! Seek out the new bountiful best friend you never knew you had in the accounting field today.