A: For many business owners, inventory valuation is a major issue that impacts their P&L, balance sheet and taxes. The general rule of thumb is that inventory should be valued at what you paid for it and the market value (what it's worth). Unless the inventory is obsolete, your inventory is generally valued at cost. But what is cost? Is it the last price you paid, the first price or the average price? In addition, what does cost include? Does cost include labor and overhead and freight or only the cost of the purchases? Consider the following:

• What is the effect of valuation inventory on the P&L? Your P&L and balance sheets are interconnected. How you value inventory determines costs of sales and therefore profit. The formula is as follows:

  Costs of sales = (beginning inventory) + (inventory purchases) - (ending inventory)

  Ending inventory depends on how you value inventory on your balance sheet. Therefore, the lower the inventory, the higher the costs of sales, which results in lower profit. Conversely, a higher inventory valuation results in lower cost of sales and higher profits.

• What are the different valuation methods? The three main valuation methods are:
  1. First-in-first-out (FIFO): This means your costs of sales is determined by the cost of the items you purchased the earliest. Inventory is comprised of the cost of the items you purchased the latest.

  2. Last-in-first-out (LIFO): This means your costs of sales is determined by the cost of the items you purchased the latest. It should be noted that depending on your industry, LIFO is not allowed for tax purposes.

  3. Weighted average cost (WAC): Means that your costs of sales is determined by the average cost of the items you purchased determined at the time of sale