Choosing the correct inventory valuation methods for balance sheet valuation ensures a company remains legally...
compliant to internal and external financial reporting, while also ensuring the same valuation methods achieve their own financial objectives, such as minimizing tax liabilities and achieving higher profitability.
When there's an inventory movement in the SAP ERP Materials Management (MM) component in SAP ERP Central Component (ECC), such as raw material issuance for a manufacturing order, a finished goods issuance against a sales order or a packing materials receipt against a purchase order, it entails not only an update to the quantity of materials, but also a value update that takes place simultaneously in the Financial Accounting (FI) component of ECC. This inventory's financial value eventually becomes part of balance sheet statement.
For reporting purposes, here are the five inventory valuation methods from which to choose in SAP.
Standard price control
Standard price control ensures that finished goods or semi-finished goods are always priced the same, regardless of how much it costs to manufacture a product. Any price difference shows up in a specially created price difference account.
It is common to update the standard price of a material at least once a year using transaction code MR21 to reflect the price changes that have taken place in the price difference account.
Moving average price control
With moving average price control, the system constantly and automatically updates the price of a material each time there's a goods receipt or a goods issue of the material. The moving average price is calculated by dividing the total value of a material with the total quantity in stock.
Weighted average method
If several products have the same characteristics, it can make it difficult for an inventory controller to distinguish one product from another, especially when these products can easily and quickly be substituted. In this situation, then weighted average method for inventory valuation is a viable option. The weighted average method uses average costs over the reporting period to calculate inventory balance.
LIFO valuation method
With the last in, first out (LIFO) inventory valuation method, the oldest and least valuable inventory remains on the balance sheet, while the latest inventory is consumed or sold first. The older material's price is not affected by the higher price of the newly purchased material, thereby preventing the value of older stock from increasing.
LIFO reporting prevents a material from an artificial overvaluation and, thus, prevents profit illusion.
By using the most recent inventory in valuation, the cost basis is higher on the current income statement, which reduces the gross profit and, ultimately, the net income. Since LIFO reporting results in lower profit reporting, it leads to reduced tax liabilities for a company and, therefore, it is the preferred inventory reporting option for many companies.
FIFO valuation method
With the first in, first out (FIFO) inventory valuation method, older inventory is consumed first, while the newest, most valuable inventory remains on the balance sheet. With this valuation method, the stock is identified by the date it is received in inventory, and it moves through each stage of production in order by that date.
FIFO reporting can increase the income on the income statement when the cost of older inventory is lower than the cost of the newer inventory. This means that the cost of goods sold is, accordingly, lower, thereby resulting in increased gross income and, therefore, gross profit, too. This increased profit means greater tax liabilities during the inflationary periods. But this reporting method also acts as a buffer or hedge during unusual periods of deflation.
The FIFO reporting method suits those companies that want orderly valuation of their inventory reporting by ensuring that the items received first are consumed or sold first. The FIFO procedure calculates the value of the stock based on last receipt and enables stock valuation in the most realistic way.
Inventory valuation methods are part of the ECC Materials Management component, which is integrated with the ECC Financial Accounting component. Due to the integrated nature of inventory valuation and its reporting, it's best if MM and FI teams work together to ensure that the quantity and value reporting of inventory serves the defined business purpose.
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