LUTZ BUSINESS INSIGHTS
Inventory valuation methods for manufacturing entites
jeff paesl, audit manager
The selection of an inventory valuation method can be a major decision for a manufacturing entity. Generally accepted accounting practices (GAAP) identify four common inventory valuation methods, including:
- Last in, First Out (LIFO)
- First in, First Out (FIFO)
- Weighted Average Cost (WAC)
- Specific Identification (SE)
Inventory value impacts cost of goods sold, taxable income, and profitability. That’s why manufacturers should understand the valuation method being used for accounting purposes. Once a method is in place, a manufacturing entity must ask the IRS for permission to change methods, which is never a simple or fast process.
LAST IN, FIRST OUT (LIFO)
LIFO assumes that the most recent items brought into inventory are the first items sold. Take, for example, the automotive or computer industries. The latest car model, smartphone, or laptop are more likely to be the first sold. People want this year’s car model or the fastest laptop with a just-released processor. Implementing LIFO could reduce a manufacturing company’s taxable income; however, LIFO is only applicable within the United States as it is not recognized by the International Financial Reporting Standards (IFRS) as an accepted valuation method.
Using LIFO keeps the revenue from goods sold closer to the expense of the item. For example, manufacturing costs $100.00 per item, but last year the cost was $90.00. The price for the item has remained steady at $125.00 for both years. The $10.00 difference changed the profitability from $35.00 for the last year to $25.00 for the current year.
LIFO is an excellent strategy during inflationary periods because it reduces taxable income as prices increase. It is especially beneficial for manufacturers that experience rising costs for labor and materials as it keeps the cost of goods sold (COGS) close to the production costs.
FIRST IN, FIRST OUT (FIFO)
FIFO assumes the first items into inventory are the first items sold. It is the most common inventory valuation method because of its simplicity. The method facilitates cost-flow assumptions when moving products from inventory to COGS. FIFO lowers taxable income when prices fall.
In general, the price of goods increases from year to year. That means that FIFO valuation shows a higher financial value for inventory with a lower COGS. These conditions result in greater gross profits but also higher taxable income. The FIFO method can help smaller manufacturing entities that struggle with cash flow when trying to secure short-term funding.
If the lag time between sale and payment is significant, manufacturers may need a revolving line of credit to help with cash flow. These are short-term, usually a year or less. Typically, the amount borrowed cannot exceed 80% to 90% of inventory less than 180 days old. Increasing inventory value increases the amount available for borrowing.
FIFO may not be the best valuation method for every manufacturer. In volatile environments, prices for raw materials and finished goods can change rapidly, especially during inflationary periods. Higher prices result in added taxable income.
WEIGHTED AVERAGE COST (WAC)
Manufacturers with multiple product lines may find WAC is a better method to establish an inventory value across all manufacturing. The WAC method uses a weighted average to determine what funds fall under COGS versus inventory. While WAC simplifies inventory valuation, it does not provide the actual costs associated with each product line. A weighted average is the total cost of goods produced divided by the units available for sale. It does not correlate inventory with cash flow.
Taxable income under the WAC method usually falls between the LIFO and FIFO value for the same inventory. In general, WAC provides a more accurate financial picture across an enterprise with numerous products because it standardizes expenses associated with COGS. Consistent evaluation criteria make it easier to identify trends in inventory value and can help minimize the impact of market changes on taxable income. However, it lacks the specificity that some manufacturers need for tracking costs per product line.
For companies that need strict inventory controls, WAC may not be the appropriate valuation method. WAC simplifies the valuation process while reducing the impact LIFO or FIFO may have on taxable income; however, it may not deliver the detail required for high-value or unique product lines. In most situations, WAC evaluations can be calculated with minimal record-keeping.
Specific Identification (SE)
SE may appear to be a labor-intensive method of inventory valuation; however, inventory management systems can help ease the burden of tracking the cost of each inventory item. The SE method requires that each item and its price are recorded and then added together to determine the cost of inventory. This method is useful for manufacturers that produce complex or custom items for purchase or use similar components across multiple product lines.
For example, circuit board manufacturers need SE inventory valuation because of the diverse number of components used to deliver a single circuit board. When the price of a single component such as a microchip increases dramatically, companies need data on how that increase impacts production costs and product pricing. The WAC method could disguise the chip price increase if other components’ costs decline to offset the increase. Per-component pricing provides a more accurate picture that can minimize taxable income.
Knowing the best inventory valuation method for your manufacturing business helps make the right decisions. Although you cannot control the market for your products, you can control the variables used to determine inventory valuation. Working with our experienced team of experts can help you select the right inventory valuation method to achieve your goals. Contact us to learn how we can help or visit our website to learn more about our manufacturing accounting services.
ABOUT THE AUTHOR
JEFF PAESL + AUDIT MANAGER
Jeff Paesl is an Audit Manager at Lutz with over ten years of accounting, auditing, and consulting experience. He specializes in providing accounting, auditing, and consulting services for privately held companies and state and local governments.
AREAS OF FOCUS
- State and Local Governments
- Privately-Held Companies
- Suprise Custody Audits
- Manufacturing Industry
- Tax Compliance
- Employee Benefit Plans
AFFILIATIONS AND CREDENTIALS
- American Institute of Certified Public Accountants, Member
- Nebraska Society of Certified Public Accountants, Member
- 2015 AICPA Leadership Academy, Graduate
- Certified Public Accountant
- BSBA in Accounting and Finance, University of Nebraska, Lincoln, NE
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