Do you routinely analyze your companies, but don't look at how they account for their inventory? For many companies, inventory represents a large, if not the largest, portion of their assets; as such, inventory is a critical component of the balance sheet. Therefore, it is important that serious investors understand how to assess the inventory line item when comparing companies across industries or in their own portfolios.

What is Inventory?

In general, when we speak of inventory we are referring to a company's goods in three stages of production: 1) goods that are raw materials, 2) goods that are in production and 3) goods that are finished and ready for sale. In other words, you take the goods that the company has in the beginning, add the materials that it purchased to make more goods, subtract the goods that the company sold, cost of goods sold (COGS), and the result is what remains — inventory.

Inventory accounting assigns values to the goods in each production stage and classifies them as company assets, as inventory can be sold, thus turning it into cash in the near future. Assets need to be accurately valued so that the company as a whole can be accurately valued. The formula for calculating inventory is:

beginning inventory+net purchases-cost of goods sold (COGS)=ending inventory
Formula for calculating inventory. Investopedia. 

Methods of Valuing Inventory — LIFO and FIFO

The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements (financials) — balance sheet, income statement and statement of cash flow. U.S. generally accepted accounting principles (GAAP) allow businesses to use one of several inventory accounting methods: first-in, first-out (FIFO), last-in, first-out (LIFO) and average cost.

  • First-In, First-Out (FIFO): This method assumes that the first unit making its way into inventory is the first sold. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (on income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (on balance sheet).
  • Last-In, First-Out (LIFO): This method assumes that the last unit to arrive in inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.
  • Average Cost: This method is quite straightforward. It takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.

    The Role of Inflation in Valuing Inventory

    If inflation were nonexistent, then all three of the inventory valuation methods would produce the exact results. When prices are stable, our bakery would be able to produce all of its bread loaves at $1, and LIFO, FIFO and average cost would give us a cost of $1 per loaf. But prices do tend to rise over the long term, which means that the choice of accounting method can dramatically affect valuations.

    LIFO and FIFO adjusted for inflation

    Assuming that prices are rising, the three valuation methods would behave as follows:

    • LIFO is not a good indicator of ending inventory value because the leftover inventory might be extremely old, perhaps obsolete, which results in a valuation much lower than today's prices. The LIFO method results in less net income because COGS is greater.
    • FIFO gives us a good indication of ending inventory value, but it also increases net income because inventory that might be several years old is used to value COGS. And although increasing net income sounds good, remember that it also has the potential to increase the amount of taxes that a company must pay.
    • Average cost produces results that fall somewhere between FIFO and LIFO.

    Note that if, instead of increasing, prices are decreasing, then the complete opposite of the above is true.

    In addition many companies will state that they use the "lower of cost or market" when valuing inventory. This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of LIFO, FIFO or average cost.

    Example — ABC Bottling Company

    In the tables below, we use the inventory of a fictitious beverage producer to see how the valuation methods can affect the outcome of a company’s financial analysis.

    We start with the assumption that ABC has a beginning inventory of 4,000 units — 1,000 units purchased at $8 each = 4,000 units.

    Then, for all calculations we assume that there are 1,000 units left for ending inventory — 4,000 units - 3,000 units sold = 1,000 units.

    Month Units Purchased Cost / Each Value
    Jan 1,000 $10 $10,000
    Feb  1,000 $12 $12,000
    Mar 1,000 $15 $15,000
      3,000 = Total Purchased    
    Item LIFO FIFO Average Cost
    Sales = 3,000 units @ $20 each $60,000 $60,000 $60,000
    Beginning Inventory 8,000 8,000 8,000
    Purchases 37,000 37,000 37,000
    Ending Inventory   8,000 15,000 11,250
    COGS $37,000 $30,000 $33,750
    Expenses 10,000 10,000 10,000
    Net Income $13,000 $20,000 $16,250

    Here are the inventory results based on our three GAAP methods:

    • Ending Inventory per LIFO: 1,000 units x $8 = $8,000. Remember that the last units in (the newest ones) are sold first; therefore, we leave the oldest units for ending inventory.
    • Ending Inventory per FIFO: 1,000 units x $15 each = $15,000. Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.
    • Ending Inventory per Average Cost: (1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units = $11.25 per unit; 1,000 units X $11.25 each = $11,250. Remember that we take a weighted average of all the units in inventory.

    LIFO or FIFO? It Really Does Matter.

    The difference between $8,000, $15,000 and $11,250 is considerable! In a complete fundamental analysis of ABC Company, we could use these inventory figures to calculate other metrics — factors that expose a company's current financial health, and which enable us to make projections about its future, for example. So, which inventory figure a company starts with when valuing its inventory really does matter. And companies are required by law to state which accounting method they used in their published financials.

    Although the ABC Company example above is simple, the subject of inventory and whether to use LIFO, FIFO or average cost is complex. Knowing how to manage inventory is a critical tool for companies, small or large; as well as a major success factor for any business that holds inventory. Managing inventory can help a company control and forecast its earnings. Conversely, not knowing how to use inventory to its advantage can prevent a company from operating efficiently.

    Know Your Inventory!

    Pay attention to inventory when analyzing a company. For certain types of businesses, inventory is among the most important items you'll need to analyze because it can give you insight into what is happening with the core business in ways that nothing else can. It might even reveal things you didn't know about a company that you thought you knew — perhaps one of your own holdings, or maybe a stock that you're looking to acquire.