# Business and Personal Finance: Four Ways to Value Inventory

## The Inventory-Cost Connection: Four Ways to Value Inventory

There are four ways to keep track of how much your inventory is worth:

• Last in, ﬁrst out (LIFO)
• First in, ﬁrst out (FIFO)
• Average cost
• Speciﬁc identiﬁcation

The method that works best for your business depends on what type of inventory you keep. When you offer more than one kind of product for sale, you can use a different inventory valuation method for each, because what makes sense for one may seem somewhat ridiculous for the other. This section can help you ﬁgure out which version will work best for your company.

Because different methods will give you different outcomes, prevailing accounting principles make you pick a method and stick with it. If you need to make a change, you have to have a good reason. You also may have to recalculate prior years’ numbers to show the impact of the change, and you have to stick with the new method going forward. You cannot keep switching your inventory valuation method to make your numbers come out better.

### The LIFO Method

Using the LIFO method makes a lot of sense when your most current merchandise is the ﬁrst to ﬂy off the shelves. This happens with books on the bestseller list, newly released DVDs, and the latest fashions. LIFO follows that pattern, turning the most recently received inventory into the merchandise that just got sold.

When you use LIFO, your inventory system (periodic or perpetual) can make a difference in the end-of-period value of your inventory asset. Here’s why: Under a perpetual system, you track the cost of goods for every single sale, and you would use the most immediate cost at the time under LIFO. When you value the inventory only periodically, those costs are lumped together and only the most recent (at the end of the period) would be included.

LIFO is a favored valuation method among tax accountants. In periods of rising prices (and when have we really seen anything else?), the LIFO method gives you the highest cost of goods sold, and that translates into the lowest taxable income. Lower taxable income means lower income taxes, and that is what tax accountants like.

### Average Cost Method

The average cost method (sometimes called the weighted average cost method) works well for companies that sell a large number of very small, identical items. Think of a hardware store, with bins of nuts and bolts and nails and screws. Trying to assign a speciﬁc cost to each would just drive you crazy. It’s much easier to treat each unit as part of a whole.

The main drawback of the average cost method is the math: Every time you buy more inventory, you have to recalculate the average cost. If you use accounting software, you may not even notice that the recalculation has taken place. With a fully manual system, though, get ready to pull out your calculator.

### Speciﬁc Identiﬁcation

The speciﬁc identiﬁcation method works well with unique or uniquely marked inventory items. A one-of-a-kind designer dress would be perfect for this method, and so would a Honda Accord with its unique vehicle identiﬁcation number. Here, every time you sell a product, you remove that speciﬁc unit from inventory. Whatever you paid for that particular item now becomes the cost of goods sold number, no math, no fuss.