Inventory valuation methods for small shops, compared

The goods on your shelves are an asset. You paid for them, and you expect to get the money back and more. Knowing what they are worth in dollars tells you how much cash is tied up, how much a stock loss really costs, and what to report to a bank, an insurer or a tax authority. It also determines profit: the cost of goods sold (COGS) for a period depends on how you value what was sold and what is left.

When your supplier's prices never change, every method gives the same answer. The differences start when costs move, which they do. A valuation method is simply a rule for deciding which cost goes with which unit. See the glossary entry on inventory valuation for the short definition.

1. Latest cost

Value every unit you have at the most recent price you paid. It is the quickest, and it needs only a current cost per product. It is close to what it would cost you to replace the stock today, which is useful in a time of rising prices. Its weakness is that old units bought cheaper are valued higher than you paid.

2. First in, first out (FIFO)

Assume you sell your oldest units first. What is left on the shelf is therefore the most recently bought, and carries the newest costs. Sold goods carry the older, usually lower costs. When prices are rising, FIFO shows lower costs of goods sold and a higher profit.

3. Weighted average cost

Every time you receive stock, work out a new average cost across everything you hold: total cost divided by total units. Sell and value everything at that average. It smooths out price jumps and is simple to apply once you have the arithmetic set up.

4. The retail method

Used when you do not track cost per product. You total the retail value of what you hold, then convert it to cost using your cost-to-retail ratio: the cost of goods available divided by their retail value. It suits a shop with thousands of low-priced items and a steady margin, such as a variety store. It is only as good as the margin being consistent.

FIFO as an accounting rule is different from FIFO as a shelf habit. On the shelf, always rotate old stock to the front. See how to handle expired stock. The costing method is a separate choice you make on paper.

You sell one product, a 1 L bottle of juice, for $4.00. Over the month you received three batches, and the supplier's price kept rising.

You sold 70 units, so 30 are left. Sales were 70 x $4.00 = $280.00. Now see what each method says.

How each number was built:

• FIFO. The 70 sold units are the oldest: 20 at $2.00 ($40), 30 at $2.20 ($66) and 20 at $2.50 ($50). COGS is $156. The 30 left are all from the last delivery: 30 x $2.50 = $75.
• Latest cost. Value the 30 on hand at today's $2.50 = $75. COGS is what is left of $231, which is $156. Here it matches FIFO because the units on hand all came in at the latest price.
• Weighted average. $231 / 100 = $2.31. COGS = 70 x $2.31 = $161.70. Closing stock = 30 x $2.31 = $69.30.
• Retail method. Retail value of everything available: 100 x $4.00 = $400. Cost-to-retail ratio = $231 / $400 = 57.75%. Closing stock at retail is 30 x $4.00 = $120, so at cost it is $120 x 57.75% = $69.30.

The profit differs by $5.70 between the two sets. That is not money gained or lost. It is a matter of when the cost is recognised. Over a long time, with stable prices, the totals converge.

Whichever you pick, stay with it. Changing method from month to month makes your profit figures impossible to compare. Tax authorities may also have rules on which methods are allowed or how a change must be reported, so check with an accountant before you switch.

• Out-of-date costs. If your costs are a year old, every report is wrong. Update the cost when you receive a delivery. See how to receive stock deliveries.
• Counting dead stock at full value. If a product will not sell, its value to you is lower than its cost. Consider writing it down. See slow-moving and dead stock.
• Not recording losses. If stock disappears without a record, your system still values it. A stock count corrects this. See how to do a stock count.
• Mixing methods. One method for the whole shop, and the same one each month.
• Forgetting delivery costs. Your true cost per unit includes freight. See landed cost.

Shopkeepa shows inventory value and gross profit where costs are known, and keeps every stock movement on record, so counts and write-offs feed straight into your value. Valuation is based on the cost you enter for each product. It is in development: join the early access list. See inventory tracking.