Understanding Inventory Valuation

Understanding Inventory Valuation

A mandatory setting that is very helpful to understand in ESC is the Accounting Type. The accounting type options are located in the Company → System Setup → Inventory tab and offers up three different options: FIFO, Average Cost and Last Purchase Price.

Why is it important to know about this feature? Every time inventory parts are sold on an invoice, the cost of those parts are assigned to the bill based upon this feature. So, how inventory is costed is really controlled by which option is selected in the accounting type field. If you are receiving and selling inventory from within ESC, then it is important to understand the differences between these options.

First In/First Out (FIFO) – FIFO is an inventory valuation method which assumes that the first items placed in inventory are the first sold out. For example, if you purchase a quantity of one for Part A at $10 today and another quantity of one tomorrow at $20, when you sold a quantity of one on the third day to a customer, it would cost out on the invoice at $10.

The main benefits of using FIFO are that inventory is moved out of stock in a logical and systematic way and that inventory is always rotated properly by selling the oldest products first. A drawback to using FIFO is that it can be confusing. Installing the same part at two different locations on the same day can result in two different profit amounts if one of the parts was purchased at a discount. Likewise, returning a just purchased item back to a vendor can have unanticipated consequences if you already have some of that same part in stock that were received at a different cost.

For example: Assume you have a quantity of one of Part A sitting on the shelf that you purchased for $10. You then purchase another one for $12. When you go to return the item to the vendor you will actually be telling ESC to send the first one so your inventory value will increase by $2 even though no physical change has occurred.

As a result of this phenomenon, you will most likely have to make a small manual adjustment to your inventory value in your accounting system annually.

Average Cost – This is an inventory valuation method that sets the cost of each inventory item of the same type to the same amount based on the weighted average. It is calculated each time an item is received into your inventory. The average cost of a part will be reset anytime its quantity goes down to zero and will be recalculated when new stock is received in. For example, if you purchased a quantity of one for Part A at $10 today and another quantity of one tomorrow at $20, when you sold a quantity of one on the third day to a customer, it would cost out on the invoice at $15.

The main benefit of using average cost is that it minimizes cost fluctuations on invoices. So the profit you make on installing the same part at two different locations on the same day will be identical (providing you don’t receive more of this part during the day). This is true even if you originally purchased one of the parts at a big discount. This inventory valuation method also does an excellent job of keeping the inventory value in ESC very close to the value in your accounting software (although returns can still cause fluctuations).

Last Purchase Price – This inventory valuation method simply sets all inventory items of the same type to the cost of the most recently received part. For example if you purchased of one for Part A at $10 today and another quantity of one tomorrow at $20, when you sold a quantity of one on the third day to a customer, it would cost out on the invoice at $20.

The main benefit of using last purchase price as your accounting method is that if your inventory cost prices continually increase, you will always be applying the highest costing to sales invoices. This makes it the ideal method for companies dealing with continual price increases that want to minimize the amount of profit shown on their financial statements. The main disadvantage of using this valuation method is that if you purchase inventory at incrementally discounted prices, those lower costs will be applied to your invoices.

Using Last Purchase Price will definitely create differences between the value of your inventory in ESC and your accounting software.

For example: if you purchased nine of part A for $10 each today and another one for $12 tomorrow – your inventory value in ESC would be $120. If you entered those invoices into your accounting software your inventory value would be $102.

This will require periodic adjustments to the inventory account in your accounting software to keep them the same. If you deal with a lot of pricing changes you might need to do this monthly. If the changes are more gradual, you might be able to get by doing this annually instead.

Serialized Parts – Serialized parts don’t use any of these inventory valuation methods. When you use a serialized part ESC is able to recall the exact purchase amount. This amount is what the cost will be when it is applied to an invoice or transferred to a job.

I hope this gives you a better understanding of each of the inventory valuation methods. If you decide you like one method better than the one you are currently using, it is possible to change it. However, doing so is never advisable in the middle of a fiscal year. It is suggested that if a change needs to be made, plan to do it after conducting a physical inventory and at the beginning of new accounting cycle. We would also highly recommend consulting your bookkeeper or accountant for further information on the ramifications of changing the accounting type before making this decision.

Written by Steve Gordon
Featured in February 2010 Newsletter