To determine how much inventory a company has on hand, the following formula can be used. It is pretty straight forward, take the inventory at hand at the start of the reporting period and add any new inventory purchases and then subtract the cost of any inventory that has been sold.
Inventory valuation and management is a very important part of managing the current assets account on the balance sheet. If this aspect is not done properly, the ramifications are far reaching; total assets and shareholders equity wil be affected on the balance sheet while net income will be affected on the income statement.
In order to properly manage and match up revenues derived from the cost of inventory, companies use the following inventory valuation methodologies; First-In First-Out (FIFO), Last-In Last-Out (LIFO), Average Cost, and Specific Identification.
FIrst-in First-out (FIFO)FIFO matches up sales with inventories in a sequential manner by matching the revenues from the first sale with the costs associated with the first product that was made. For example, assume that a textile company created 500 tablecloths at a cost of $1.00 per unit and then created another 1000 with a unit cost of $1.25. The revenue from the sale of the first 500 tableclothes will be matched up with the tablecloths which have a cost basis of $1.00.
Last-in First-Out (LIFO)LIFO takes the opposite approach to FIFO; it matches in the reverse order. The first sale is matched against the last product produced and therefore, the last good sold will be matched up with the first good produced. Basically, LIFO is assuming that a company sells off its last product produced, first. The diagram below takes the same example from above and depicts LIFO inventory management.
The average cost method of inventory management is pretty straight forward. This method values inventory costs as the average unit cost between the assets in the beginning inventory and the newly acquired assets. There is no inventory matching required.
Specific identification is more manually intensive method of managing inventory. Companies will literally identify each item in inventory and record the capital gain(loss) when that specific item is sold. Each item will remain in the inventory until it is sold.
Choosing the appropriate methodology is a difficult task as there are many unknown variables that go into the decision, such as inflation or shelf life. With high inflation, or in markets with prices increasing, companies will achieve a higher profits by matching sales against inventory which was produced at lower prices; earnings per share will increase but so will tax liability due to an increase in profits. Using LIFO on the other hand will produce the opposite effect. In essence, you will be matching new sales against higher production costs, thereby lowering net income and EPS. Some companies may actually prefer this to keep their tax liability down. Companies cannot use different methodologies when reporting to the government and their shareholders so choosing either one may be a gift or a curse. Also remember, when analyzing inventory valuations, it is important to compare one company against another company in the same industry.