Inventory Valuation Methods: Formulas, Examples, and Application

The cost of goods issued directly affects the cost of goods sold, the value of inventory, and the company’s profit. If the wrong inventory costing method is chosen or applied, accounting data can be skewed, making it difficult to prepare financial statements and evaluate business performance. This article will help you understand the common inventory costing methods, their formulas, and practical examples.

What is inventory?

According to Article 23 of Circular 200/2014/TT-BTC, a company’s inventory consists of assets purchased for production or for sale during a normal production or business cycle

Including:

• Raw materials, materials; tools, supplies
• Work in progress
• Finished goods, merchandise; goods on consignment
• Goods in transit
• Goods stored in the company’s bonded warehouse

Inventory issuance transactions:

• Issuing goods for sale
• Issuing goods for production
• Issuing goods for internal consumption
• Other issuance cases

Why is it necessary to calculate the cost of goods issued?

Calculating the cost of goods issued is a mandatory task that helps businesses accurately determine the cost of goods sold, which serves as a basis for setting competitive selling prices, measuring gross profit, and accurately reflecting the value of inventory assets on financial statements.

Currently, businesses can flexibly apply one of the following three common valuation methods to optimize their accounting processes:

Currently, businesses can flexibly apply one of the following three common valuation methods to optimize their accounting processes:

• Specific identification method
• Weighted average method
• First-In, First-Out (FIFO) method

The choice of method depends entirely on the specific nature of goods flow and the management requirements of each entity. However, accountants must ensure consistency throughout the accounting period so that reported figures are comparable and transparent.

See more: [FREE DOWNLOAD] 5+ most detailed asset management templates in Excel for 2023

Inventory Costing Methods and How to Choose the Right One

Specific Identification Method

The specific identification method is an approach based on the actual cost of each item purchased or produced. For each product, this specific cost is the actual value corresponding to its purchase or production process.

Applicable to: This method is applicable to businesses with a small number of items, especially products that are stable and easily identifiable. It is also suitable for businesses dealing in high-value items with frequently fluctuating prices, such as in the automotive and motorcycle industries. For businesses that need to control inventory by expiration date, such as in the pharmaceutical and cosmetic industries, it helps to strictly manage the issuance of goods by batch and expiration date.

Under this method, when a product, good, or material is issued, its cost is determined by the purchase price of the corresponding batch. This ensures transparency and accuracy in recording the cost of each issued product or batch.

Advantages: This method ensures high accuracy and strictly adheres to accounting principles. The value of inventory sold is determined precisely, accurately matching the revenue it generates.

Disadvantages: 

• Implementing this method requires careful and strict inventory management. Tracking and clearly identifying the purchase batch for each item upon every issuance demands attention and meticulous management. Therefore, it can be quite difficult to identify the correct batch when there are multiple purchase batches at the same time.
• For businesses with a wide variety of inventory items and frequent fluctuations in stock movements, applying the specific identification method can be challenging. Inventory accounting becomes more complex, and decision-making can be delayed. Therefore, in practice, many businesses prefer more flexible inventory costing methods.

– Example: On May 1, 2023, XYZ Manufacturing and Service Co., Ltd. dispatched 30,000 mobile phones from the warehouse, belonging to 3 detailed import batches as follows:

• 15,000 units imported on September 2, 2022 – unit cost: VND 5,000,000/unit – import value: VND 75,000,000,000;
• 10,000 units imported on June 1, 2022 – unit cost: VND 7,000,000/unit – import value: VND 70,000,000,000;
• 5,000 units imported on January 2, 2022 – unit cost: VND 6,000,000/unit – import value: VND 30,000,000,000.

=> Therefore, the total value of goods dispatched on May 1, 2023 is: 75,000,000,000 + 70,000,000,000 + 30,000,000,000 = VND 175,000,000,000.

Weighted Average Method

Definition: This method calculates the value of inventory by taking the average value of each type of inventory at the beginning of the period and the value of each type of inventory imported or produced during the period. The average value can be calculated for the entire reserve period (also known as the periodic weighted average method) or after each import (also known as the moving weighted average method).

Periodic Weighted Average Method

When applying this method, at the end of the accounting period, we use the quantity of beginning inventory along with all imports during the period for each type of inventory to calculate the value of goods issued from stock during the period.

Formula for the periodic weighted average cost:

In some special cases, when there are sales returns/allowances or purchase returns/allowances, this information can be included in the process of determining the cost of goods sold.

Applicable to: This method is often applied by businesses with a wide variety of products, stable prices, or in cases where it is not necessary to know the value immediately upon dispatch.

Advantages: This method is simple, not complicated, only needs to be calculated once at the end of the period, making it a suitable choice for any business.

Disadvantages: The accuracy of the data is often not high, leading to businesses having to accept a certain margin of error. Furthermore, the calculation of the cost of goods sold is only performed at the end of the accounting period, which can affect reports from other departments and does not provide complete accounting information at the time of occurrence.

Moving weighted average cost method

When using the moving weighted average cost method (also known as the perpetual weighted average or immediate average), the crucial step is to recalculate the inventory value after each receipt of goods for each item type. This ensures that the cost of goods sold can be different for each dispatch.

Formula for the moving weighted average cost method:

Applicable to: Businesses with few types of inventory and low fluctuations in goods receipts and issues.

Advantages: The business will immediately have information on the cost of goods sold after each transaction, which is more effective than using the weighted-average method for the entire period.

Disadvantages: The calculation is complex, repetitive, and labor-intensive.

What is the First-In, First-Out (FIFO) costing method?

First-In, First-Out (FIFO) is an inventory valuation method based on the assumption that the first goods purchased are the first ones sold or used.

This method has the following characteristics:

• Inventory consists of the most recently purchased or produced goods.
• The value of inventory is closest to its replacement cost.
• In a context of rising prices, this method can lead to a lower reported cost of goods sold, thereby creating the impression of higher profits. 
• Suitable for goods that are prone to obsolescence or degradation.

Applicable to: The First-In, First-Out method is a reasonable choice in conditions of stable or falling prices, especially for businesses that strictly manage expiration dates, such as in the pharmaceutical, cosmetic, and food industries. By prioritizing the issuance of goods that were received first, the company can optimize inventory management and minimize the risk of holding products with short shelf lives.

Advantages: 

• The cost of goods sold can be calculated immediately for each transaction, ensuring timely and accurate information.
• On the financial statements, the value of inventory calculated using this method will be closest to the market price of the goods. This is a result of the assumption that the first batch received is the first one issued. In particular, when market prices fall, this method can help businesses save on corporate income tax expenses.

Disadvantages: Businesses with a wide variety of goods, products, and materials, along with a continuous process of receipts and issues, may face challenges when applying the FIFO costing method. This can increase the workload and management costs due to the complexity of tracking and maintaining detailed information for each batch of goods.

Example: In March 2023, XYZ Company LLC conducted the following transactions for the item “bread”:

• Beginning of March, no inventory on hand;
• March 2, received 600 units – unit cost: 8,000 VND/unit;
• March 3, received 450 units – unit cost: 10,000 VND/unit;
• March 4, issued 250 units;
• March 5, issued 400 units;
• March 6, received 350 units – unit cost: 12,000 VND/unit;
• March 7, issued 700 units.

The unit cost and value of goods issued for each transaction are determined as follows:

• March 4, issued 250 units from the March 2 receipt;

Cost per unit: 8,000 VND/unit – value: 2,000,000 VND;

• March 5, issued 300 units from the March 2 receipt and 100 units from the March 3 receipt;

Cost per unit: (300 x 8,000 + 100 x 10,000) / 400 = 8,500 VND/unit – value of issue: 3,400,000 VND.

• March 7, issued 400 units from the March 3 receipt and 300 units from the March 6 receipt;

 Cost per unit: (400 x 10,000 + 300 x 12,000) / 700 = 10,857 VND/unit – value of issue: 7,600,000 VND.

Impact of the inventory costing method on financial statements

The choice of an inventory costing method not only affects the inventory figures on the books but also directly determines the cost of goods sold, profit, and tax obligations of the business. To understand better, here is how each common method impacts a company’s financial statements.

Impact on Cost of Goods Sold (COGS)

The inventory costing method directly determines the cost of goods sold.

• With FIFO, the cost of goods sold is lower when commodity prices are trending upward, as the first items sold are the earliest ones purchased at a lower price.
• With the weighted-average method, the cost of goods sold is smoothed out and less volatile.
• With the specific identification method, the cost of goods sold accurately reflects each specific batch of goods.

For example: During a period of rising steel prices, a business using FIFO will have a lower COGS compared to the weighted-average method → resulting in higher reported profits.

Impact on Gross Profit and Corporate Income Tax

Changes in the cost of goods sold lead to fluctuations in gross profit.

• Lower COGS → higher profit → increased corporate income tax.
• Higher COGS → lower profit → decreased corporate income tax.

This requires businesses to carefully consider their choice of method, ensuring compliance with accounting standards while optimizing taxes.

Impact on the Balance Sheet and Financial Ratios

The inventory costing method also affects the value of ending inventory. Whether inventory is valued higher or lower will change the ratio of current assets, liquidity ratios, and the overall financial health reported.

The Impact of Price Volatility and Supply Chain on Inventory Costing Methods

In a volatile global economy, raw material prices and transportation costs can change rapidly. This directly impacts a company’s choice of inventory costing method.

When Prices Rise Continuously (Inflation)

• The FIFO (First-In, First-Out) method often results in a lower cost of goods sold and higher accounting profit, but this also means a higher corporate income tax liability.
• The Weighted-Average method helps to “smooth out” price fluctuations, providing a more stable reflection of actual costs.
• Businesses must consider whether they want to report “attractive” profits for investors or maintain stable cash flow for reinvestment.

When Prices Fall (Deflation or Inventory Liquidation):

• FIFO can cause a business to record a higher cost of goods sold than the current market reality, temporarily reducing profits.
• The Specific Identification method, on the other hand, accurately reflects the value of each batch, which is suitable for high-value or rapidly changing goods.

Impact from the Supply Chain:

• If the supply chain is stable, traditional methods (FIFO, weighted-average) work effectively.
• Conversely, during periods of supply chain disruption (e.g., COVID-19, material shortages), the choice of method needs to be flexible to accurately reflect costs and avoid significant reporting discrepancies.

Price volatility and supply chain stability are critical factors in determining which inventory costing method a business should use. Regular evaluation will help the company optimize profits while ensuring transparency in its financial reporting.

Effective Inventory Management Solutions Amidst Rising Costs

In the context of rising raw material prices, escalating logistics costs, and increasingly fierce competition, inventory management has become a critical survival factor for manufacturing and trading businesses. An effective inventory strategy not only helps companies reduce costs but also ensures stable cash flow and the ability to meet customer demands promptly.

Below are practical solutions for effective inventory management:

Applying Smart Warehouse Management Technology

• WMS/ERP Systems: help automate the receiving, issuing, and inventory processes, and synchronize data with accounting and sales.

• Barcode/QR Scanning, RFID: support tracking products by batch, expiration date, and location in the warehouse.

• Real-time Reporting: helps managers make quick decisions about receiving goods, dispatching goods, and adjusting inventory.

Benefits: Reduces manual errors, saves labor, and improves data accuracy.

Choose the appropriate inventory dispatch method

There is no “standard” method that applies to all businesses. Depending on industry specifics, businesses can choose:

• FIFO (First-In, First-Out): suitable for the food and pharmaceutical industries to avoid expired goods.

• LIFO (Last-In, First-Out): suitable in an environment of rising prices, helping to reflect costs closer to current prices.

• Weighted Average: balances price fluctuations, suitable for the retail and manufacturing industries.

• Specific Identification: manages by individual orders or specific batches.

Benefits: Optimizes costs, accurately reflects the cost of goods sold, and supports precise business decision-making.

Determine safety stock levels

• Establish minimum stock levels to avoid stockouts and maximum stock levels to prevent capital from being “tied up” in goods.

• Apply the EOQ (Economic Order Quantity) model to calculate the optimal order quantity, reducing holding costs and ordering costs.

• Classify products using ABC analysis (A: high-value items, B: medium-value, C: low-value but high-frequency) for flexible management.

Benefits: Maintains a balance between holding costs and the ability to meet demand.

Enhance periodic inventory counts and reconciliation

• Conduct periodic inventory counts or cycle counting to detect discrepancies.

• Compare actual data with system data to promptly

  During implementation, many businesses make errors when calculating the cost of goods sold, leading to skewed data, inaccurate reports, and increased audit risks.

  Identifying these errors early and taking timely corrective measures will help businesses ensure transparency and accuracy in inventory management.

  Incorrectly entering formulas or calculation data

  Errors in Excel functions or inaccurate data entry can skew the entire inventory value.

  • Solution: Standardize Excel file templates, apply Data Validation, and use accounting software with automatic error-checking features.

  Changing methods mid-stream

  Some businesses apply FIFO and then switch to the weighted-average method, causing inconsistency and violating accounting regulations.

  • Solution: Consistently adhere to one method throughout the entire accounting period; if a change is necessary, there must be a valid reason, and the tax authorities must be notified.

  Not tracking individual batches in detail

  Lack of batch management makes it difficult for businesses to determine the exact cost of goods sold, especially for products with expiration dates.

  • Solution: Use batch codes and entry dates for detailed management; implement ERP/Accounting software to automate batch tracking.

  Lack of original document storage

  If goods receipt notes and goods issue slips are incomplete, it will cause difficulties during audits and tax finalization.

  • Solution: Standardize storage processes, switch to digital storage (scanning documents, using electronic signatures) for easy retrieval.

  Important considerations when applying inventory costing methods

  When determining the method for calculating the cost of goods sold, the inventory accounting department must adhere to the consistency principle, as stipulated in Vietnamese Accounting Standard No. 01 – General Standards, as follows: “The accounting policies and methods chosen by the enterprise must be applied consistently for at least one annual accounting period. In case of a change in the chosen accounting policies and methods, the reasons for and the effects of such change must be explained in the notes to the financial statements.”

  

  Thus, the choice of an inventory costing method must be applied consistently:

  • For at least one accounting period, which is one year
  • It’s not just about applying one method to all types of goods, products, materials, or all inventory accounts. Instead, this principle suggests consistency of method for each group of goods or each inventory account, creating flexibility and suitability for the specific characteristics of each type of item in the accounting process.

  See more: Simple and effective warehouse management business process

  For example, a business might choose to apply the periodic weighted-average method to determine the cost of goods sold for regular retail inventory. However, for goods produced for a large project’s custom order, the business may prefer to use the specific identification method when issuing stock.

  The manager’s task is to select the appropriate method to ensure the business can sell at market prices and effectively resolve issues of stagnant inventory.

  Each inventory costing method has its own advantages and disadvantages. Businesses need to choose a suitable method based on the characteristics of their inventory and management conditions. This not only reduces difficulties in management and accounting but also fully meets the requirements of inventory administration.

  With the application of information technology in accounting, the process of calculating the cost of goods sold is automated, reducing the workload for the accounting department.

  Trends in inventory management and costing in the digital age

  Technology is changing how businesses manage inventory and calculate the cost of goods sold. Instead of relying entirely on Excel or manual records, many companies have switched to integrated management software to increase efficiency and accuracy. Below are the prominent trends in inventory management and costing that businesses need to grasp to maintain a competitive edge.

  • Application of integrated ERP and accounting software: Software like MISA, FAST, 1Office, and SAP helps automate the calculation of cost of goods sold, reduce manual errors, and link directly to the general ledger.
  • Automation and Artificial Intelligence (AI) in warehouse management: AI can predict demand, automatically suggest reordering, and alert to unusual inventory levels. Large retail or manufacturing businesses often apply this to reduce storage costs.
  • Real-time inventory management with IoT and sensors: Devices like sensors, RFID, and barcode scanners allow for instant updates of inventory quantities upon receipt and dispatch, enabling more accurate inventory control.
  • Digital transformation and big data management in supply chain management: Big Data and cloud platforms help businesses not only manage internal inventory but also link data with suppliers and logistics partners, thereby optimizing the entire chain.

  Frequently Asked Questions about Inventory Costing

  Can a business apply multiple inventory costing methods at the same time?

  Yes. A business can apply different methods for different groups of goods (e.g., using the weighted average method for components, but the specific identification method for high-value machinery). However, for the same type of goods with similar characteristics, the business must consistently use one method throughout the accounting period.

  Is it possible to change the inventory costing method in the middle of a fiscal year?

  It is not recommended. The business must apply the method consistently for at least one fiscal year. If a change is made, the reasons and the extent of its impact must be explained in the notes to the financial statements.

  Which method offers the most tax benefits when market prices are rising?

  The Weighted Average method. When prices rise, this method results in a higher cost of goods sold compared to FIFO, leading to lower profits and, consequently, a smaller corporate income tax liability.

  Why do food and pharmaceutical businesses prefer the FIFO method?

  Because these items have strict expiration dates. The First-In, First-Out (FIFO) method ensures on the books that older batches are dispatched first, helping the business closely monitor the product lifecycle and prevent goods from expiring or being damaged in the warehouse.

  When should a business switch from managing with Excel to automated software?

  When the number of items grows to hundreds of types or when inventory receipts and issues occur daily, using manual spreadsheets can easily lead to formula errors. At this point, a business should use software to have the system automatically finalize inventory levels and calculate the cost of goods sold after each transaction, ensuring immediacy and absolute accuracy.

  Conclusion

  1Office hopes the information above helps our readers better understand the various inventory costing methods, as well as the benefits and challenges of each. This will assist you in choosing the costing method that best suits your business’s specific needs and characteristics. We wish you great success in your accounting management and business development!