Inventory Valuation

Inventory valuation is the cost associated with an entity’s inventory at the end of a reporting period. It forms a key part of the cost of goods sold calculation, and can also be used as collateral for loans. This valuation appears as a current asset on the entity’s balance sheet. The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a condition that makes it ready for sale, and have it transported into the proper place for sale. You are not allowed to add any administrative or selling costs to the cost of inventory. The costs that can be included in an inventory valuation are:

  • Direct labor
  • Direct materials
  • Factory overhead
  • Freight
  • Handling
  • Import duties

It is also possible under the lower of cost or market rule that you may be required to reduce the inventory valuation to the market value of the inventory, if it is lower than the recorded cost of the inventory. There are also some very limited circumstances where you are allowed under international financial reporting standards to record the cost of inventory at its market value, irrespective of the cost to produce it (which is generally limited to agricultural produce).

Inventory Valuation Methods

When assigning costs to inventory, one should adopt and consistently use a cost-flow assumption regarding how inventory flows through the entity. Examples of cost-flow are:

  • The specific identification method, where you track the specific cost of individual items of inventory
  • The first in, first out method, where you assume that the first items to enter the inventory are the first ones to be used
  • The last in, first out method, where you assume that the last items to enter the inventory are the first ones to be used
  • The weighted average method, where an average of the costs in the inventory is used in the cost of goods sold

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