Valuation Methods or, Inventory Valuation Methods are techniques with the main goal of selecting and applying a specific base to evaluate inventory in monetary terms. Valuation is a vital process when acquisition unitary prices have been different.
There are many Inventory Valuation techniques, however those commonly used by Organizations today are:
- Specific Identification.
- First in, first out.
- Last in, first out.
- Constant average or, Weighted average cost.
Given that Specific Identification consists in the individual identification of each of the articles, which increases their degree of certainty in equal proportion to their degree of complexity of its application, we will study the remaining methods.
First in, First Out
Commonly known has FIFO, this inventory valuation method is based on the logic interpretation of the movement of the units in the inventory system, thus the cost of the last purchases is the cost of stocks, in the same order that they entered the warehouse. Such as:
In this case the output of units on February 16 is for 450 units, from the first batch of entries 250 units are taken at the cost of $ 620 and from the second batch the remaining 200 units are taken at the cost of $ 628.
The advantage of applying this technique is that inventories are valued at the most recent costs, since the oldest costs are the ones that make up the first sales or production costs (output costs). The main disadvantage of applying this technique is that the low production and sales costs that it usually shows, logically increases profits, thus generating a higher tax.
It is worth remembering that the physical “FIFO” flow is irrelevant in the application of the technique, what is really in this case is the “FIFO” cost flow.
Last in, first out.
Also known as LIFO, this method of valuation is based on the fact that the last items that became part of the inventory, are the first ones to sell, of course, it is based on the unit cost, that is to say that the physical flow is irrelevant, here the important thing is that the unit cost of the last inputs is the one applied to the first outputs. Such as:
In this case the output of units on February 16 is 450 units, from the last batch of entries the first 250 departures are taken at a unit cost of $ 633, and from the second batch of entries the remaining 200 units are taken at a cost from $ 628.
The advantage of applying this technique is that inventory will be valued at the oldest cost, which supposes an inventory cost lower than its average value, being very useful in times of inflation when costs are constantly increasing.
Constant average or, Weighted average cost
This is a reasonable approximation valuation method where the balance in monetary units of inventories is divided by the number of units in stock. This procedure that causes an average cost to be generated, must be recalculated for each entrance to the warehouse. Such as:
In this case, at the moment of leaving the warehouse of 450 units, the average cost must be calculated, dividing the balance ($ 470,250) by the number of stocks prior to the exit of the merchandise (750), that is, 470250/750 = 627. This cost will be the one applied to all 450 output units.