Financial Survival Guide: Strategies for Profitability, Burn Rate Management, and Long-Term Business Success
Shopify Inventory Valuation Models
November 7, 2022
Shopify
Inventory valuation models are a critical aspect in determining your Shopify inventory, along with good bookkeeping and other financial management practices.
Accurate inventory numbers are vital for tax and financial planning to ensure money is invested and earning the best rate of return.
While some businesses think it best to keep more than enough stock to meet increasing customers’ needs, others stick to smaller quantities to avoid wastage. Truth is, both strategies may seem smart, but there may be better approaches to your inventory valuation.
Too much inventory on hand, can lead to loss, while too little inventory can lead to shortages and missed business opportunities. Hence, there should be a balance between the two approaches. Also, regarding inventory valuation, knowing the appropriate method for assigning value to your goods helps your business stay profitable.
Although there are several inventory valuation techniques, this article examines the three major ones. If you can determine which works best for your business and apply it, you’ll be one step ahead in your business management.
3 Major Inventory Valuation Techniques for a Shopify Business
The three major inventory valuation methods you can use to run your inventory include: Just-In-Time (JIT), Last In, First Out (LIFO) and First In, First Out (FIFO). The following explains the salient features of each of these in greater detail:
1. The Just-In-Time Inventory Valuation
The just-in-time (JIT) inventory valuation technique receives inventory or stock from suppliers as and when needed rather than preordering them. Here, you do not need to forecast the consumer’s schedule, instead, you work with a demand schedule that delivers products right when the consumer requests them.
This lean valuation strategy seeks to have the minimum inventory to meet consumers’ demands. By having sufficient materials to produce just what you need, you can keep overhead costs low and eliminate waste. It also promotes efficiency in operations since you’re doing high-volume production but with the least amount of stock.
Here is a run-down advantage of the just-in-time inventory valuation model:
- Less wastage
The JIT inventory valuation technique checks overordering and overproduction. Low production levels reduce product defects, scrap costs, and the risk of having a pile of unsold stock in the warehouse eventually obsolete.
- Greater productivity
JIT ensures that you don’t spend all the time and resources manufacturing products that are not needed. In other words, it helps you achieve a faster turnaround. Also, your products can be certain of superior quality products to a large extent since goods are produced on demand.
- Improved cash flow
Positive cash flow is a vital factor in business success. You can have a better cash flow if your cash is not tied up in inventory.
- Smoother production flow
A major setback with high-volume production bottlenecks. The production process is usually slow, making production take longer time. Production delays can be avoided and products reach customers quickly using this inventory model because there’s a shorter production cycle.
Also, it’s easy to check defective items. You can easily spot production mistakes and correct them.
- Greater efficiency
With JIT you can streamline production to what is needed at the moment. You’ll need fewer people to handle production, which saves you a significant cost. The cost of raw materials inventories and product storage are also eliminated and diverted to more critical operational needs.
- Improved customer service
JIT focuses more on efficiency, which makes the business arrive at better outcomes, resulting in increased customer satisfaction.
However, the JIT inventory valuation technique has some downsides, including:
- Lack of preparedness
Although JIT seeks a conservative production process, a lean framework can affect the organization’s workflow. Also, if the company receives a massive impromptu order, it may not meet up with delivery since there are only a few or no finished goods at hand.
- Dependence on supplier
Businesses that use the JIT inventory method often rely on suppliers to meet demand schedules. The production process suffers if the supplier fails to deliver goods on time or lacks the necessary amount.
- Supply Chain Disruptions
Any problem in the supply chain can a disruption negatively affect the production process.
- Sudden price changes
The market is hardly predictable. Prices of raw materials can go up at any time. In such cases, the company’s profit margins drop.
- Local sourcing costs
Manufacturers can’t incur outrageous shipping costs to buy a limited number of goods, so they rely on local sourcing. This can seriously impact the cost of production and, ultimately, profitability in the long run.
- Order Inconsistencies
If the company is out of stock or experiences shortages, it can disrupt the inventory system.
2. LIFO Inventory Valuation
Last In, First Out (LIFO) inventory valuation is more related to inventory valuation, as a key aspect of inventory valuation. This method assumes that the most recent items are the first to be sold off, hence the name last in, first out.
The LIFO model projects higher inventory costs since it calculates the cost of goods sold based on the latest items purchased. This eventually lowers businesses’ profits and minimizes tax liability.
Below is a practical example of the LIFO inventory valuation method:
Company XYZ produced goods in four batches in a certain accounting year. In January the company produced 500 pairs of shoes at $250 each. In April, the company produced 300 pairs at $280 each and 200 pairs at $200 each in August, 200 pairs at $200 each. Finally, in December, the company produced 300 pairs of shoes at $400 for each pair.
- Total produced: 1,300 pieces.
- The total cost of production:
- Batch 1: 500 × 250= $125,000
- Batch 2: 300 × 280= $84,000
- Batch 3: 200 × 200= $40,000
- Batch 4: 300 × 400= $120,000
The total cost of production is $369,000
- The average cost of production for one pair: is $284
In calculating the cost of goods sold to determine profit, the company works with the cost of production of the last batch, which is $400 instead of the average COP. So, if the company sold 1000 pairs in the entire year at $500 each pair, COGS; $4000 × 1000 = $4000.
If you choose to adopt the LIFO inventory method, you’ll have to use one of the two IRS-approved methods for valuing LIFO, which are:
- The dollar-value method, in which you group goods or products into classes, depending on their nature.
- The simplified dollar-value method, with multiple inventory classes in general categories. This method is often for businesses with average annual gross receipts of $5 million or less for the previous three tax years.
This model works for various goods, especially non-perishable goods or products with minimal risk of obsolescence. Examples of these goods are jewelry, automobiles, and oil.
The LIFO method also comes with some drawbacks. First, this method aligns differently from most businesses’ typical physical flow of goods. Doing this may put the value of the goods at stake and increase the chances of wastage and loss.
Also, the LIFO method tends to exaggerate COGS and reduce the value of the closing stock which isn’t acceptable by most taxation authorities.
3. FIFO Inventory Valuation
First In, First Out (FIFO) is the direct opposite of the last in first out inventory valuation technique. With the FIFO technique, the business owner assumes that the first items acquired by the company sell out first.
Unlike the LIFO, FIFO is much more a straightforward method for calculating profit, cost of goods sold, and managing your Shopify business’s inventory. With FIFO, the cost of goods is usually lower, resulting in higher profit and of course, higher tax liability.
From the above example, the FIFO method will calculate the cost of goods sold based on the unit price of production for the first batch of shoes. At $250 for each pair, the cost of goods sold is $250 × 1000 = $250,000.
The first in, first out inventory valuation method works for some products, including:
- Health care products
- Technology
- Produce
- Dairy
- Dry grocery goods
- Horticulture
- Alcohol
LIFO vs. FIFO
LIFO and FIFO are acceptable Shopify inventory valuation models. However, they have some key differences based on the following:
1. Type of Goods Sold
The type of goods a company produces majorly influences the choice of the inventory valuation model.
LIFO is most suitable for companies that deal with products that can linger in inventory or non-perishable goods. On the other hand, FIFO works more for products with shorter life span. Examples are food products and other products that can expire or become old if not sold within a given time frame.
2. Accounting Calculations
Calculating profit and losses could also influence the model you use. During inflationary periods when prices go high, LIFO value the more recent stocks higher than old stocks.
This is in line with the matching principle which requires that businesses match expenses incurred with revenues in the same accounting period. Using FIFO, a company values its remaining stock at an amount closer to the market price after depreciation.
3. Tax Payments
LIFO offers offer tax efficiency. This model seeks to arrive at a high cost of goods sold, resulting in lower profit and lower tax liability. In contrast, under the FIFO model, a company assumes a higher profit (based on lower COGS) so, the tax liability is higher.
So, if a business seeks an inventory valuation model that offers tax advantage, the former will be the best fit.
4. Flow of Goods
In the case of inventory flow, FIFO is a more practical technique. Normally, the first goods are sold off first to limit wastage and obsolescence. Many businesses adopt this inventory valuation method for this purpose.
However, oil-producing companies, for example, may find LIFO more suitable since they distribute more recent products for sale first.
So, if a business seeks an inventory valuation model that offers tax advantage, the former will be the best fit.
Conclusion
Inventory valuation is important to your business success and all the three techniques mentioned in this article can give you a head start. However, they all have their downsides. Do well to consider them before choosing.
Also, you may need professional assistance to choose help you choose right or at some point in your inventory valuation journey. An expert Shopify bookkeeping service can be a great option to help you get an accurate financial picture of your business.
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