Getting Started: Inventory Valuation

Jonas Elmerraji

Did you know that a company can materially affect its assets and income (see earnings ) just by choosing a certain method to value its inventory? As investors, it's something that we don't often think about, but inventory valuation can leave a lot of space between what a company reports on its financial statements and what you should really know about its operation.

Why is Inventory Valuation Important?

Inventory is the merchandise (or products) a company has on hand to sell. Because the cost of acquiring inventory -- either through purchase (buy it) or manufacturing (build it) -- changes over time (usually increasing), it's hard for most companies to give an exact dollar value to the items in their inventory.

Let's say that you're in the business of selling pairs of socks. You buy socks at various prices from their manufacturer, and toss them all into your inventory room. Until you actually sell a pair of socks, you know what your inventory is worth, because you can add up what you paid for all those socks.

It's when you sell your first pair, that this question is raised: "What did the pair of socks I just sold cost me?" If the socks you sold were one of your first (less expensive) sock purchases, your costs are lower and profit is higher. If, however, the socks you sold were a later purchase that cost you more, your profit will be lower.

This question of "How much did a sale cost?" is what creates the need to estimate the value of the inventory that companies sell, so that you can determine the company's profit as well as the value of the remaining inventory. (For refresher lessons on profits and assets, check out "Getting Started: The Income Statement" and "Getting Started: The Balance Sheet." )

On a company's income statement, the "cost of goods sold" (or "cost of sales") is an expense that's deducted from revenue to get net income, so an undervalued inventory can result in an artificially inflated number for net income.

And manipulated income inflation can happen. For example, Bristol-Myers Squibb (BMY Quote - Cramer on BMY - Stock Picks), was put on probation for an inventory valuation scandal that involved "channel stuffing" (see "Bristol's Probation Ends").

So, How Do Companies Value Inventory?

Generally speaking, companies value their inventory at cost -- the price they paid for it. But when the market value of an inventory item is less than the cost, companies revert to that lower market value. This method of valuation, known as "lower of cost or market" (or LCM), ensures that bad situations are reflected on financial statements as soon as possible, not when the inventory is sold later at a loss.

This inventory value shows up in two places. First, the company's inventory is reflected in the assets section of the balance sheet , usually under a header titled "Ending Inventory." This number is the value of the physical inventory that the company has on hand at the end of a given period of time.

Inventory also shows up on the income statement as the period's "Cost of Goods Sold" (or COGS). COGS (which is subtracted from revenue) is the value of the inventory items sold during the period.

And, since these numbers can have a direct effect on a company's assets and income, it's important to understand where they come from.

COGS and Ending Inventory Valuation

The four major methods used to value a company's inventory include last in first out, first in first out, average cost and specific identification. No one method is more "correct" than any other and they each can result in a different amount. Here's a breakdown:

1. Last in First Out (LIFO): Let's go back to the sock example. The LIFO method assumes that when you sell a pair of socks, it's the last pair you bought from the manufacturer. In an economy where costs are increasing (because of inflation), LIFO results in higher COGS and lower profit. This method is attractive because it results in a lower taxable income amount.

2. First in First Out (FIFO): Under the FIFO method, the first pair of socks you sell is valued as the first you bought for your inventory. This method usually results in a higher income amount.

3. Average Cost: With the average cost method, you take the average of what you paid for all your socks, and calculate a single unit price that you can assign to every pair of socks in your inventory. If you actually manufactured the socks yourself, then the average cost method can get more complex.

4. Specific Identification: Specific identification assigns each pair of socks a unique identifier (like a serial number), so that you can track what you actually paid for it. For example, when you sell the 84th pair of socks, you can look up how much the 84th pair cost you, and assign that amount to COGS. Specific identification is more popular with companies that sell high-priced items that are easy to keep track of (like a car dealership).

As you can probably imagine, each of these valuation methods has advantages and disadvantages. However, keep in mind that the only numbers that are changing are your cost of goods sold and ending inventory. The actual amount of cash you have in the bank from your sales isn't affected by the valuation method that you decide to use.

Analyzing a Company's Inventory

When it comes to inventory valuation, the magic word is "footnote." The footnotes to financial statements are home to all sorts of information about inventory valuation, including the valuation method used, changes in valuation method and the effects of LCM on a company's inventory.

Analyzing inventory is often less about the actual numbers than it is about understanding the thought processes used by management. Why did they choose this method for valuing inventory? Why was it necessary to devalue the inventory under LCM?

(For a course of action on what to do if you ever have the opportunity to meet with a company's management team, check out the special five-part series "Talking to Management," starting with "Part 1: The Big Questions.")

Because disclosure is paramount in the wake of the legal implications Sarbanes-Oxley has brought to corporate management, footnotes are required reading for anyone who wants to know about the skeletons in any company's closet.

While uncovering fraud like that at Bristol-Myers Squibb is best left to professional auditors , having a solid understanding of how a company values its inventory and how that valuation can affect the company's balance sheet and income statement can be valuable for any investor.

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