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What Inventory Method Should You Be Using?

Choosing an inventory method might not seem that significant, but it can have a significant effect on your business’ financials. This is because your inventory will be reported on two of the four main financial statements created by your accountant.

These financial statements are created to help business owner’s gain a better understanding of how their business functions. Your inventory is reported on the income statement and the balance sheet.

By recording the inventory owned by a business, the owner can better understand their company’s assets and liabilities. They will also understand how this affects their net income and the shareholder’s equity.

So, what are the different inventory methods and what difference would the one you choose make to your business?

The Four Valuation Methods

There are four main valuation methods for determining the inventory owned by your business. These are: FIFO; LIFO; average cost inventory; and specific inventory tracing. The first two, FIFO and LIFO are arguably the more significant as they give the business owner a more sophisticated understanding of their business.

But, what do they mean?

FIFO (First In, First Out) Inventory Method

Whilst the name might seem a little self-explanatory, lets take a deeper look to get a better understanding!

The FIFO method of tracking inventory assumes that you will sell the oldest inventory owned by your company first. This method is extremely reflective of the business practices of those dealing with consumable goods. For example, a greengrocers would ideally sell their oldest stock so that their produce remains consistently fresh.

When you record the Cost of Goods Sold (COGS) using the FIFO method, you would list the unit costs of the oldest inventory at the beginning. This way, the ending inventory would show the value of the most recent inventory purchased by your business.

Let’s take a look at an example to simplify this.

Remember that greengrocer we mentioned before? They’re going to set up a stall at a market fair this weekend, so they decided to buy some batches of fresh fruit in preparation.

The first batch bought by our greengrocer is for 100 units costing £0.20 each.

Our greengrocer decides it’s best to get some more stock, just in case, and buys a second batch of 150 units for £0.25.

Just to cover their back, they buy one final batch of 125 units for £0.40 each.

It’s a hot summer day when the fair comes around and our greengrocer’s stall is a huge success! They sell a whopping 200 units of fresh fruit!

To calculate the COGS for that day, our greengrocer first acknowledges that the oldest fruit in her inventory came from that very first batch. So, they first count 100 of those 200 units sold from the first batch, costing £0.25 each. For the other 100 units sold, as the second batch was bought next, the greengrocer uses that cost of items for the second batch.

So, to calculate the COGS for the market fair, our greengrocer will add up the cost of the first batch with the cost of the remaining sold from the second batch.

COGS = (100 x £0.20) + (100 x £0.25) = £45.00

Now then, how would you calculate the ending inventory using the FIFO inventory method?

This is quite simple. The greengrocer has 175 units of fresh fruit left over after the market fair. The remaining units from the second batch, after those sold have been subtracted, would be 50 units bought for £0.25 each. The final unsold batch of 125 units, bought for £0.40 each, would be added to the total remaining from the second batch to equal the ending inventory.

Ending inventory = (50 x £0.25) + (125 x £0.40) = £62.50

It’s quite common under the FIFO method that the ending inventory is greater than the COGS – as shown in our example. This is because the most recent inventory purchased by the greengrocer was more expensive than the older inventory.

Choosing this method can have two different outcomes, each with their respective benefits. If your initial inventory costs increase over time, your COGS will reduce and ultimately increase your net income. As well as this, your assets will increase as you will be left with a higher inventory value. In this outcome, you can expect a better chance of receiving funding from investors or loans from the bank.

In the other outcome, where inventory costs decrease over time, your net income will decrease. This will lead to a decrease in taxable income.

LIFO (Last In, First Out) Inventory Method

The LIFO method makes the opposite assumption to the FIFO method. With this inventory method, you assume that you sell your newest inventory first. This is a little less sensical than the FIFO method but can ultimately make your business appear more profitable to potential investors.

Lets imagine the greengrocer example above, again, but this time using the LIFO method.

Under that method, the greengrocer would calculate their COGS by taking 175 from the final batch. This is done because the greengrocer assumes that the most recent inventory bought sold first. The remaining 25 would be taken from the second most recent batch. The COGS would look like this:

COGS = (125 x £0.4) + (75 x £0.25) = £68.75

This value is higher than the amount under the FIFO method.

The ending inventory, as a result, would be cost of the remaining 75 of the second batch plus the cost of the first batch – as 200 units were sold and under this method we assume the newest inventory sold first, we are left with the oldest inventory.

Ending inventory = (75 x £0.25) + (100 x £0.20) = £38.75

So, if your inventory costs increase over time under this method, your net income will decrease as your COGS will be higher. Alternatively, if your inventory cost decreases, your net income would increase.

Choosing between these two methods will make a difference as to whether you pay a higher tax on your income or whether you appear more eligible for loans and investment.

The key here is to remain consistent, whichever method you choose.

Average Cost Inventory

This is probably the easiest method of evaluating your inventory costs, but also one of the least reflective. It works exactly as it sounds – you add up the total cost of inventory and divide it by the total unit count.

This method is not very reflective of particular periods of time but it is the simplest.

Specific Inventory Tracing

Unlike the average cost inventory, specific inventory tracing can be quite time-consuming. This method involves tracking all costs that involve inventory purchasing or sales. If you’re a new business dealing with a low volume of products, this might be a good method to choose.

Our Final Word

In summary, whichever method you choose, it’s important to be consistent. Some of these methods take more effort than others, so it’s best to plan ahead and make a decision early on.

If you feel this might be out of your comfort zone, take a look at the professional service offered by Count.

You might not have started your business to track your finances or inventory – but Count did!

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