Getting Started: Inventory Valuation

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." )