In this 3 part series, I’ll explain the fundamentals of the inventory valuation, define all the measures used, and explain the importance of considering perspective.
Part I: Inventory Balance Set Overview
The inventory balance set is quite possibly the most important calculation in the retail industry. These equations document and measure the value of your inventory, or more significantly, your working capital. Investment firms rely on this analysis for publicly held retail companies because it predicts future sales and margin with sharp accuracy. (Check out The New Science of Retailing by Marshall Fisher and Ananth Raman for more in-depth discussion on this topic.)
These equations are equally important for anyone that has merchandise planning, replenishment, or allocation responsibilities. The concepts that follow from these equations will assist you in how to think in dimensions, as all planning tools are designed.
An inventory balance set describes how the inventory valuation is calculated from one time period to the next.
Businesses measure their assets using a balance sheet with debits and credits. They measure cash flow using sources and uses. Balancing the inventory is a combination of both, and it’s a surprisingly simple calculation. The most important concept is to remember that the equation MUST balance. This means: to go from a beginning onhand from one period to the ending onhand of another, there must be a set of measures that describe how you got there. Inventory must be preserved.
EOP = BOP + Additions – Reductions
EOP = Ending of Period Inventory
BOP = Beginning of Period Inventory
Below is a handy graphic you can use to visualize the big picture. I will explain all these metrics in detail later, but I introduce this graphic now so you can see where we’re heading.
Valuation jumping refers to the metrics needed to move from one inventory valuation to another.
For example, to go from a unit valuation to a cost valuation you would use the average unit cost, or AUC.