Inventory Valuation Methods for eCommerce: FIFO, LIFO, or WAC?

One of the most important decisions your eComm startup must make is what inventory valuation method to use. Inventory valuation methods are important because they play a direct role in the accurate reporting of Cost of Goods Sold (COGS) and the value of your startup’s remaining inventory. This is important for creating financial statements and ensuring accurate financial reporting, tax calculations and liability, and your startup’s overall cash flow and other unit economics.

There are three primary methods of inventory valuation, and they all have pros and cons regarding how they impact your gross margins and balance sheet strength. It’s important to carefully weigh valuation methods and select the one that best suits your eComm startup, as changing methods requires IRS approval and can result in complex adjustments.

Why Your Inventory Valuation Method Determines More Than Just Your Tax Bill

Your inventory valuation method helps determine your tax liability, but it also impacts your reported profitability, cash flow implications and investor metrics. Here’s a look at how the valuation method impacts COGS, gross profit, net income and ending inventory value:

• COGS and gross profit: COGS is a key determinant of gross profit. Each inventory valuation method impacts profit margins during inflation and deflation. For example, FIFO results in a higher gross profit during inflation and a lower gross profit during deflation, while LIFO results in the opposite during these periods. Weighted Average Cost (WAC) smooths out price fluctuations and results in more stable reporting and less dramatic swings during periods of inflation and deflation. In typical inflationary periods, the various inventory valuation methods can swing gross margins by up to 15 percent in some cases.
• Net income: Fluctuations in COGS also impact net earnings, which may present a misleading picture of your eComm startup’s overall financial health.
• Ending inventory value: The inventory valuation method impacts ending inventory by determining which costs are assigned to the goods that remain in stock. Different valuation methods assign different costs to the remaining goods, thereby changing the monetary end value. For example, since FIFO assumes the oldest inventory is sold first, the ending inventory is based on the most recently purchased goods after beginning inventory is relieved. Conversely, LIFO assumes the newest inventory is sold first, so the end inventory is based on the oldest costs.

The Three Primary Inventory Valuation Methods Explained

The three primary inventory valuation methods are FIFO (First-In, First-Out), LIFO (Last-In, First-Out) and WAC (Weighted Average Cost). Here’s more about each method:

• FIFO: This method assumes the first items purchased or produced are the first ones sold, reflecting the physical flow of inventory. It’s ideal for eComm startups that sell perishable items or products with shorter shelf lives and need to ensure their stock rotates. It’s calculated by allocating the cost of your most recent sales to the oldest inventory purchases first until you account for all units sold.
• LIFO: This method assumes the most recently acquired inventory items are the first ones sold. It’s a common method for eComm startups, where costs are always fluctuating and inventory tends to be higher-volume. To calculate LIFO, find the cost of the most recently purchased or produced inventory items and multiply that by the number of items sold to find the COGS.
• WAC: This method averages out the cost of all inventory purchased during a certain period, thereby creating a single average cost per unit. It’s best for eComm startups with high inventory turnover and products that are challenging to track individually. Calculate WAC by dividing the total cost of goods available for sale by the total number of units available for sale.

Another method is Specific Identification, though it’s best suited for high-value unique items and is not often practical for eComm startups.

FIFO: When You Need Strong Financial Statements

Due to its strategic advantages, the FIFO method tends to be the de facto choice for most eComm startups. For instance, FIFO shows higher inventory values and profits during inflation, which strengthens balance sheets for fundraising. It also most accurately reflects actual physical inventory flow and is accepted under both the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Though FIFO will likely result in a higher tax liability, it presents a stronger overall financial position to investors and lenders through accurate inventory valuation.

LIFO: Tax Savings That Come With Trade-Offs

LIFO tends to reduce taxable income, especially during inflationary periods, by matching higher costs against current revenue. However, there are trade-offs to lower tax liability. For example, LIFO is prohibited under IFRS, resulting in lower reported profits and undervaluing the balance sheet inventory. Additionally, there’s a LIFO “conformity rule,” meaning you have to use the same method for tax and financial reporting.

LIFO isn’t typically used by eComm startups due to these restrictions and the negative impact the method can have on key investor metrics.

Weighted Average Cost: Simplicity for High-Volume Operations

WAC is often viewed as a practical middle ground for eComm startups, especially those with high inventory turnover. WAC calculates the average actual cost across all inventory purchases, thereby eliminating the need to track individual batch costs. It also works well for startups selling the same items from multiple suppliers at various price points and provides stability in gross margin calculations, even with price fluctuations. It’s accepted under GAAP and IFRS and tends to have simpler administrative requirements compared to FIFO.

How Each Method Impacts Your Financial Statements and Tax Liability

Inventory valuation methods impact financial statements and tax liability by impacting COGS. COGS, in turn, impacts profits, tax obligations and other financial metrics. Here’s a closer look at the impact each of the three main valuation methods has on these metrics during inflationary periods:

• FIFO: Lower COGS means higher profits and net income, yet higher taxes. FIFO also shows higher assets and stronger measures of company’s inventory.
• LIFO: Higher COGS results in less taxable income and a lower tax liability, but tends to also result in fewer profits. Unlike FIFO, LIFO shows lower assets and equity.
• WAC: WAC is a middle ground, resulting in more moderate effects on tax liability and gross profit while stabilizing inventory costs.

Choosing the Right Method for Your eCommerce Business Model

What’s the right inventory valuation method for your eComm startup? It largely depends on your startup’s growth stage, strategic priorities and various other factors. Here are some of the factors to weigh when deciding:

• Do you sell perishable goods? If so, this tends to align well with the FIFO method, while non-perishables offer greater flexibility and align better with the LIFO method.
• What stage is your startup in? Pre-revenue eComm startups tend to use the FIFO method, while LIFO is a better method during times of growth or inflation, thanks to its tax benefits. WAC is another practical method after your startup begins earning revenue.
• Assess your inventory characteristics. For example, single-supplier consistent pricing tends to favor the WAC method, while multi-supplier variable pricing is best suited for the FIFO method.
• Does your eComm startup sell internationally? If so, LIFO is immediately eliminated due to IFRS compliance.

GAAP vs. IFRS: Regulatory Constraints You Need to Know

Two accounting standards you’ll want to weigh as you make your inventory valuation decision are GAAP and IFRS. Violating them could result in steep penalties.

Per GAAP standards, all methods of inventory valuation are permitted. However, IFRS regulations prohibit LIFO, thereby preventing startups that have international subsidiaries or foreign investors from using this method.

Want to switch inventory valuation methods? It can be challenging and costly. You need to file IRS Form 3115 to receive the proper approval. This form must be filed after the first day of the tax year to request a change in the accounting method so it takes effect for that tax year. There are often significant adjustments that your eComm startup must make to accommodate any changes.

An additional consideration is the LIFO conformity rule. If you’re using LIFO for tax purposes, you must also use it for your financial reporting.

When and How to Switch Inventory Valuation Methods

If you do decide you need to switch inventory valuation methods, you have to file IRS Form 3115 and then comply with specific adjustment period rules. For example, negative adjustments must be reported fully in the change year, while positive adjustments can be spread out over four years.

It’s best to time changes during low-inventory periods or before significant growth phases. These changes are often best done with a Fractional CFO or financial professional to ensure all obligations are met and also to manage the financial model.

Common eCommerce Inventory Valuation Mistakes That Cost Money

As you implement your inventory valuation method, you’ll want to avoid some common pitfalls that many eComm startups encounter. These include:

• Inconsistent application across all sales channels. Make sure you’re using the same method universally.
• Not accounting for landed costs in overall inventory valuation.
• Failure to adjust for inventory obsolescence or write-downs, which can overstate asset values.
• Switching methods without proper IRS approval.

How Your Fractional CFO Should Handle Inventory Valuation

The best way to handle inventory valuation is to work with a qualified professional, such as a Fractional CFO. These professionals work externally of your startup, but are experts in optimizing inventory valuation strategy and maintaining compliance. They can also model multiple scenarios to optimize for tax efficiency and financial statement strength, implement inventory tracking systems, manage annual inventory counts and reconciliation processes, and prepare documents for audits and to support investor due diligence while improving inventory management discipline.

Get Your Inventory Valuation Strategy Right From the Start

Don’t play the guessing game when it comes to selecting the right inventory valuation method for your eComm startup. Work with Graphite Financial and ensure that you get it right from the start. While you can always change it, doing so can be complex and costly. Contact Graphite today for more information and to schedule a consultation.

FAQ

What is the best inventory valuation method for an eComm startup?

The best inventory valuation method for an eComm startup largely depends on the product type, market conditions and tax implications. FIFO, or First-In, First-Out, is a common inventory method for startups with perishable goods, while WAC, or Weighted Average Cost, tends to be the preferred method for startups that sell non-perishable items. Specific Identification and LIFO (Last-In, First Out) are two other options that you might select from. Specific Identification is uncommon but best for eComm startups selling high-value items, while LIFO tends to be the preferred method if your startup sells items with fluctuating price points.

Can I use FIFO for financial statements and LIFO for taxes?

The financial statements your startup prepares should fall under the Generally Accepted Accounting Principles (GAAP). For example, if your startup uses LIFO for tax purposes, it also has to use it to prepare its financial statements due to the LIFO conformity rule. Based on this, you typically cannot use FIFO for financial statements and LIFO for taxes at the same time.

How does the inventory valuation method affect my eComm profit margins?

The inventory valuation method impacts eComm profit margins by changing the Cost of Goods Sold (COGS) calculation. This is subtracted from revenue to determine gross profit.

Each inventory valuation method impacts profit margins during inflation and deflation. For instance, FIFO results in a higher gross profit during inflation and a lower gross profit during deflation, while LIFO results in the opposite during these periods. WAC smooths out price fluctuations and results in more stable reporting and less dramatic swings during periods of inflation and deflation.

What is the difference between FIFO and weighted average cost?

FIFO assumes that the oldest inventory items are sold first, thereby using their original costs for COGS. Conversely, the weighted-average method calculates a single, blended average cost for all available units and applies it to COGS and the ending inventory. FIFO can also result in higher profits and COGS during inflation since the older, cheaper goods are sold first, while weighted-average cost results in steadier price fluctuations.

Can I change my inventory valuation method after my first year?

Yes, but you need to file IRS Form 3115 to receive the proper approval. This form must be filed after the first day of the tax year to request a change in the accounting method so it takes effect for that tax year. However, changing inventory valuation methods is more complex than just filing a form and receiving proper approval. There are often significant adjustments that your eComm startup must make to accommodate any changes.

Does Amazon FBA affect which inventory valuation method I should use?

No, your choice of inventory method isn’t dictated by whether you use Amazon FBA. However, the FBA system’s unique characteristics should influence your decision.