Difference Between Absorption Costing and Marginal Costing

Inventory valuation is a major component in the calculation of the cost of goods sold and can be used as collateral for loans. It can be defined as the cost associated with the inventory in an entity at the end of the reporting period. Inventory valuation is based on the costs incurred by an entity to acquire the inventory. 

The importance of inventory valuation is;

  • It impacts reported profit levels whereby if an entity records a higher valuation in ending inventory, fewer expenses are charged to the cost of goods sold. On the other hand, if an entity records a lower valuation in ending inventory, more expenses are charged to the cost of goods sold. 
  • In cases whereby an entity has undertaken a loan amount from the lender, there may be an agreement which restricts the set allowed amount of current assets to current liabilities. The inventory valuation is critical since inventory is the largest part of the current ratio. 
  • Income taxes- Inventory valuation affects income tax, whereby the chosen method of handling cost flow can either reduce or increase the total amount of income taxes paid.