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Best Inventory Valuation Methods and When to Use Them

Frustrated with your wholesale inventory valuation and knowing your true margins?

You are not alone.

Inventory valuation can be tricky. There are lots of moving parts and not all of the information required is available at the same time. Still, you want to increase your wholesale business’s profitability so you have to manage your inventory and knows it’s value.

Why Inventory Valuation Is Critical to Your Wholesale Business

Without proper inventory valuation you are operating in the dark. You may think you know how profitable your business is until you are surprised to find out that your inventory is worth a lot less than you had thought. Your margins are impacted negatively. Eventually it shows up in your cash flow, but tight cash flow can be caused by other factors as well, so you can’t really rely on that to help guide you. You need quality information quickly so that you can adapt when it is relevant.

Here are 3 areas where inventory valuation is critical:

Overall business profitability. Most wholesalers are most familiar with this area. You are working with your accountant to create financials and maybe close out the year. You need to calculate your inventory position which has a significant impact on cost of goods sold. If you record a higher valuation in ending inventory, this leaves less expense to be charged to the cost of goods sold, and vice versa. Thus, inventory valuation has a major impact on reported profit levels.

Borrowing. Many wholesalers borrow against their inventory. Often lenders will lend as a percentage of inventory value so you need to be able to report your inventory value on an ongoing basis.

Margins and Selling.  Strictly speaking you may not consider this an inventory valuation issue. But we think of it as highly related and in some ways even more critical than the first 2 areas mentioned above. Here is where the rubber meets the road. You are trying to make a sale. What is the value of the item? You are evaluating a product line, was it profitable? You are reviewing a major account, did you actually make money? These micro valuations are the building blocks you use on a daily basis that will eventually lead to your overall business profitability.

The Challenges of Inventory Valuation

If you keep track of item costs accurately you are way ahead of the game. The problem is that often you don’t know the true cost of an item until weeks after you shipped it.

The duty rate is normally established early on (unless trade negotiations are in play).  Ocean freight, however, isn’t really known until the goods are finished and packed in cartons. Inspection costs occur randomly at the port of entry. And what about the costs incurred when the goods aren’t picked up from the port in time? For all these reasons wholesalers work off of Estimated Landed Costs until such a time as costs are actualized. It is not uncommon for an item to be sold, shipped, and invoiced, before you know it’s true cost.

For that reason, many wholesalers build a “Load” into their cost structure. Basically it pads the item cost to account for any unexpected costs that may occur. It could be a fixed dollar amount or a percentage of the FOB price. Wholesalers may elect to use differing fixed loads or percentages depending on the product categories or company divisions. For licensed items that require royalty payments some wholesalers elect to build in a higher load than they do for generic goods.

All of the complexity may not impact your overall year-end profitability calculations, because financials operate off of actual costs. But your estimated cost strategy, and critically – it’s implementation,  will likely impact the other 2 critical areas: borrowing and margins.

Choosing a strategy

If you have clarity about the multiple goals around inventory valuation you can develop multiple strategies to get the information you need.  Here are a few tips to keep in mind for the 3 areas we mentioned above:

Overall business profitability:

This is an area where your accountant or CFO will likely carry the ball. General accounting principals and procedures will help you arrive at actual costs for your overall business. However, you can still be lead astray about your margins if you don’t take a realistic look at your older inventory. Old inventory is a great place to hide your losses. So review your inventory aging and take the hit on goods you know are really worth less than you paid. It might be painful to look at but better to realize your mistakes and losses than fool yourself that your margins are higher than they really are.

Borrowing:

In reality, you have goods in house before you know the true costs. If your ERP reporting makes you chose one cost only per report, then it only makes sense to work off of estimated costs for borrowing. If your ERP reporting allows you to chose the actual cost on an item level only when it is available and otherwise use the estimated cost when the actual cost is not yet completed, then your lender might prefer that report instead.

Margins and Selling:

An easy way to think about it is to use estimated cost when looking forward and actual cost when looking back.

In most cases, wholesalers will elect to utilize estimated costs for selling purposes and actual costs when reviewing product categories or account profitability. With estimated costs you have the luxury of a load factor built in. If you received the same item multiple times you may want to use the last estimated cost received rather than the average cost or  FIFO,  as the last cost reflects the new costing reality.

For product and account reviews actual costs are preferred. Keep in mind that actualizing costs takes time and so you may need to run reports that cut off a few weeks earlier.

Set a a calendar or reviews at least twice a year where you evaluate how well you are doing in your estimations. You may find that in one product category you are consistently overestimating costs and in another you are consistently underestimating. Make adjustments in your estimations going forward.

Whatever strategy you employ make sure your reporting reflects those choices.

Your Inventory Valuation Success

One of the primary challenges of running your wholesale business is calculating your inventory value.

Getting inventory valuation right is like turning on the lights when you are measuring of your company’s health, both overall health and in particular areas. Depending on your goal at the time, you may elect to use different methods.

Learn more about the best inventory valuations and when is the most optimal time to use them. Contact us for more.

Wholesale Executive Insider is a publication dedicated to helping owners of wholesale companies stay up to date with the latest industry insights to improve their operations and increase their bottom-line.

Our team has deep industry knowledge, and a network of solution providers that help wholesaler’s efficiently run their businesses. If you’d like to get free advice and recommendations on inventory valuation methods, feel free to book a time to speak 1-on-1 with one of our knowledgeable industry advisors now!

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