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by QT9 MRP Software on May 5, 2025 11:22:14 AM
Customers are king and quality products key, but its numbers that rule the day-to-day inventory management world. That’s because inventory is a major asset. So it’s important to monitor and analyze the cost of inventory against the profit it garners for a business - otherwise known as inventory valuation.
Understanding the value of inventory to a business enables it to have an accurate picture of the success of its operations and purchasing practices. Proper inventory valuation enables a business to more precisely discern and report earnings to stakeholders and governing bodies, and is an important indicator of a business’ health.
This article explores the role of valuation in inventory management, the most common methods of inventory valuation and the software integrations that simplify and streamline proper valuation accounting.
Contents
Cost of Goods Sold (COGS)
Gross Profit Margin
Cost of Inventory
Why is inventory valuation important?
Benefits of accurate inventory valuation
Common inventory valuation methods
First In, First Out (FIFO)
Last In, First Out (LIFO)
Weighted Average Cost (WAC)
Specific Identification (Spec ID)
How can QT9 MRP simplify inventory valuation?
What is inventory valuation?
Inventory valuation is the process of assigning a monetary value to a company’s unused inventory at the end of an accounting period. It calculates the cost of inventory - raw materials, work in process and finished goods - including associated labor costs, expenses and carrying costs.
Inventory valuation determines the total value of a company’s inventory in order to accurately reflect earnings, determine future pricing and aid in creating inventory management efficiencies that boost profitability.
Inventory valuation terms
Any discussion of inventory valuation practices requires a clear understanding of the following financial concepts:
Cost of Goods Sold (COGS)
COGS encompasses the direct costs associated with producing or purchasing goods during a specific timeframe. Direct costs include the cost of materials, labor, factory overhead, handling and import duties.
COGS has an inverse relationship with gross profit. So as a company’s COGS increases, its profit decreases, and vice versa. The accounting method used to value inventory will affect these values.
Gross profit margin
Gross profit margin is an assessment of a company’s financial health and refers to the profit remaining after subtracting the cost of goods sold. It can be calculated using the following formula: (Net Sales – COGS) / Net Sales
Cost of inventory vs COGS
Another important distinction is between the cost of inventory and the cost of goods sold. Inventory costs are associated with holding and managing inventory, costs such as purchasing, in-bound shipping, storing and any losses from theft or expired product.
These costs are recorded on a per-unit basis whether or not the goods are sold. From a valuation perspective, inventory costs are still recorded in the asset column. Once goods are sold, inventory costs are recorded as an expense, becoming a COGS.
Why is inventory valuation important?
Proper inventory valuation accurately determines profitability and ultimately improves inventory control processes. Making changes to inventory practices based on insights garnered from valuation data can help manufacturers make operational changes where necessary, proactively managing inventory and risk.
Inventory valuation directly affects the cost of goods sold, which in turn, affects a company’s gross profit and the monetary value of any remaining inventory. This can affect a business’ potential value, its outlook to stakeholders and potential investors, and, potentially, market perception regarding its products.
What’s more, proper inventory valuation is essential for ensuring accurate financial reporting, optimally addressing tax liabilities and complying with financial regulations.
Benefits of accurate inventory valuation
Robust inventory cost data can offer valuable insight into current operations and better inform decisions for improving profitability.
Key benefits of accurate inventory valuation include:
Accurate financial reporting
The accuracy of your inventory valuation directly impacts profit and net income by specifying the cost of goods sold as well as ending inventory values.
Inventory optimization
Proper inventory valuation enables a business to better optimize inventory by drawing attention to slow-moving or obsolete stock. Manufacturers can more easily see if and where price reductions may need to be implemented and better forecast future production and purchasing needs. Better optimized inventory reduces the costs of maintaining unused stock.
Improved cash flow potential
More effective cash flow management is derived from a clear understanding of what capital is available to reinvest, helping avoid overstocking and missed opportunities.
Better-informed business decisions
A solid picture of inventory value helps inform crucial business decisions, such as product pricing, purchasing, overstocking and stockouts, and can identify inefficiencies in production or procurement.
Regulatory compliance and taxes
Proper inventory valuation ensures compliance with accounting standards and regulations, such as GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).
Common inventory valuation methods
Choosing the right inventory valuation method for your business depends on several factors, including your financial governance, type of inventory and profit goals. In the United States, companies are required by the IRS to pick a single method the first year of filing taxes and must continue using the same method in subsequent filings unless getting IRS permission to change.
Some of the most-used inventory valuation methods include:
First In, First Out (FIFO)
FIFO is an inventory valuation and management method where it is assumed that assets are sold or used based on the order in which they are acquired, ensuring that the oldest products are used first. Valuation under the FIFO principle assigns cost of goods sold to the oldest items in inventory. This allows for the most recent inventory to be valued at a recent price that better reflects its actual cost.
The FIFO method is often used by businesses that produce perishable goods, such as in the food and beverage or pharmaceutical industries. This helps avoid waste and spoilage because older inventory is sold first to avoid expired product. FIFO inventory management allows businesses to sell older, lower-cost items first, resulting in lower COGS and higher gross profit.
The advantages of using the FIFO method:
- Results in a higher gross income
- Cost flows correspond to the actual flow of merchandise
- Relative ease of use
Disadvantages of FIFO:
- Not as accurate in times of inflation
- Leads to a higher tax burden
Last In, First Out (LIFO)
LIFO is the counterpart to FIFO, requiring that the newest inventory be used first. In this valuation method, the cost of goods sold is generated from the cost of the most recent inventory, allowing businesses to assign higher-cost items to be sold first.
LIFO is often employed during inflationary periods for its tax advantages, since higher-cost purchases are matched with current sales. This reduces income tax costs and thereby improves cash flow.
LIFO is banned by countries that comply with International Financial Reporting Standards (IFRS), including the UK, Canada and Japan. However, it is permitted under Generally Accepted Accounting Principles (GAAP) guidelines, which govern financial practices in the United States.
The advantages of LIFO:
- Reduced tax liability
- Improves cash flow
Disadvantages of LIFO:
- Reported net profit is lower
- Not appropriate for companies doing business globally
- Inventory data can seem misleading
Weighted Average Cost (WAC)
As the moniker implies, the weighted average cost method determine the cost of goods sold based on the average price of all units sold over a certain period, usually a year. WAC assigns an average cost per unit to all goods in stock, regardless of the purchase date.
This method is often used by companies that produce identical items in large quantities, whose price is relatively stable. While the WAC method avoids the need to track the cost of separate inventory purchases, WAC costing can lead to inaccurate reporting during periods of market instability, such as times of inflation.
Advantages of weighted average valuation:
- Simple and straightforward method
- Less record-keeping
- Reporting consistency
Accepted by most regulatory bodies
Disadvantages of using the weighted average valuation method:
- Less accurate during periods of frequent price fluctuations
- Assumes items identical, so not good for companies with complex inventory
Specific Identification (Spec ID)
The specific identification valuation method is generally used to track the cost of unique, individual items, such as art or rare antiques. Spec ID tracks the actual cost of each item in inventory and can therefore be more time-consuming and complex, often involving tracking serial numbers as well as physical counts of each item, so it’s not the best fit for businesses with a large number of SKUs or rapid turnover
How can QT9 MRP simplify inventory valuation?
QuickBooks, Xero and Sage Integrations
QT9 MRP integrates with popular accounting solutions, QuickBooks, Sage and Xero, enabling manufacturers to choose the most appropriate valuation method for their business.
With QT9 MRP, you get:
- Integration with popular accounting software
- Real-time inventory tracking
- Barcoding and scanning
- Purchasing control
- Material Resource Planning (MRP)
- Lot and serial traceability
- Manufacturing operations integration
- Supplier management
- Compliance management
For highly regulated businesses, QT9 MRP seamlessly integrates with QT9’s highly rated Quality Management System (QMS) software.
What’s more, with all QT9 software solutions, you get unlimited training, unlimited customer support, free software updates and tailored implementation support, all at an affordable price point.
Conclusion
Inventory valuation is more than just a financial exercise—it’s a critical aspect of effective inventory management and overall business success. By accurately assessing the value of inventory, businesses can gain deeper insights into their profitability, optimize operations and make better-informed decisions.
Leveraging advanced inventory management software, like QT9 MRP, can simplify this process by integrating valuation methods seamlessly into day-to-day operations. With real-time tracking, robust accounting integrations, and tools like barcoding and material resource planning, QT9 MRP helps manufacturers and businesses of all sizes achieve precise inventory valuation.