Estimating and costing inventory is an important function in manufacturing and retailing. Most manufacturing or assembly organizations use the original cost of materials to report inventory. Since these companies do not typically sell to end consumers, the retail value of their inventory, from raw materials through work-in-process to finished goods, is an unknown factor. Retailers such as Wal-Mart, for example, usually value their inventory at retail. The differences in value can be enormous, depending on the markup retailers use beyond the wholesale cost of their inventory.
Inventory at Cost Methods
Three primary methods are used to value inventory on hand: FIFO (first in, first out), LIFO (last in first out) and weighted average cost. The most common method, widely used by smaller companies, is FIFO. In most manufacturing operations, the materials that are the oldest are often used to create finished products. Some operations, particularly high-tech facilities, may use their most recent component purchases to produce finished goods, indicating the use of LIFO for accounting valuation..
Weighted Average Inventory Cost
Those companies having a diverse mix of pricing for materials often find the weighted average method most effective. This method multiplies materials cost by the number of pieces on hand. These totals are added together. The result is then divided by the number of weighted price categories to arrive at a weighted inventory cost level. For example, the company has 1,000 pieces at $2 each, 2,000 pieces at $2.75 each, and 4,000 pieces at $3 each. One inventory category equals $2,000, another equals $5,500, and the third equals $12,000. Together they equal an inventory of $19,500, or a value of $2.79 per piece.
Retail Inventory Accounting
Many retailers use projected retail cost to value their inventory. Since there is no work in process --they only have finished goods -- the FIFO, LIFO or weighted-cost methods are somewhat easier to compute. Major retailers, such as Wal-Mart and Target, have massive and diversified inventory items. Pre-computer merchandising posed a challenge for large retailers, as staff-intensive physical counts were necessary at least once per year. Now, sophisticated computer software, constantly updated through POS (point of sale) checkout terminals, keep a perpetual inventory of goods on hand. The formerly complex accounting procedure can be as simple as reading and understanding computer printouts.
Regardless of the valuation method selected (FIFO, LIFO or weighted average), there will be large differences between cost and retail inventory-valuation methods. Before current efficient computer software, retailers often valued inventory at wholesale, rather than retail, cost. It was impractical to mark inventory to current retail more than once per quarter or annually. A retailer's wholesale cost is comparable to a manufacturer's cost for raw materials. Depending on a retailer's markup (20, 40, 50 or 100 percent), the accounting value of inventory can be vastly different than its cost. Investors and auditors must analyze the reasonableness of the reported value of a company's inventory depending on the valuation method used.
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