Advantages & Disadvantages of Valuing and Costing Inventory

Valuing and costing inventory refers to the process of determining the monetary value of your merchandise, raw materials and supplies that physically become a part of the finished product. Valuing your inventory is essential to creating an accurate balance sheet, as the inventory is part of your company's assets. There are no disadvantages in valuing your inventory per se, as as it would be disastrous for your business not to do so, but each of the two main valuation methods, "FIFO" and "LIFO," feature their own advantages and drawbacks.

First-In, First-Out Advantages

The First-In, First-Out valuation method, also known as FIFO, is useful when it is impossible to go through each item in a large warehouse and determine its value, as the Specific Identification Method suggests. Under the FIFO method, the accountant assumes that the first product to be purchased is the first one to be used in the production process or sold. Therefore, the earliest purchase cost is taken into consideration for all items of the inventory. This method tends to lead to a larger margin of profit, as the accountant disregards the inflationary effects on the item's value and maintains the cost of inventory items at low levels.

Last-In, First-Out Advantages

An alternative method accepted by the IRS is the Last-In, First-Out method, or LIFO. Under LIFO, the cost of the last inventory items is taken into consideration, leading -- due to inflation -- to high purchase cost estimates. This is because items purchased earlier are bound to be cheaper, but LIFO uses only the price of the latest items. During periods of high inflation, this method underestimates the profits, but offers tax benefits as it minimizes income tax obligations.

FIFO Disadvantages

The overestimation of a business' income when using the FIFO method can have a series of implications, especially during periods of high inflation. The FIFO method ignores the fact that the inventory has to be constantly replaced with more expensive items. When price rise is steep, the "hole" in the inventory cost can affect the accuracy of the company's balance sheet. Also, these artificially high income figures can be misleading for investors, who risk money based on inaccurate data.

LIFO Disadvantages

Lower profits may lead to lower tax obligations, but they also have a direct effect on the image of the managers and the business in general. Struggling businesses find it more difficult to attract

investors, while it is also a disadvantage for a manager to have low profit figures on her track record. In addition, overestimating one liability -- large inventory cost -- prevents businesses from allocating funds toward other liabilities, such as loans or building lease costs.