How to Value Inventory When Selling a Business
Your inventory is a business asset, just like your equipment or real estate. But when it comes time to sell your business, inventory isn’t treated in the same way as other business assets.
For one thing, the value of inventory changes. How much your inventory is worth when you begin negotiating the sale of your small business can differ from its value when you close the sale.
The tax treatment on the sale of inventory is also different from the way other assets are taxed.
Depending on your business, the inventory you own, and the agreement between buyer and seller, inventory might be priced separately, included in your business valuation, or excluded from the purchase price altogether.
While buyers need inventory to keep the business running, they might not need all your inventory, and they might not value what they do need the same way you would if you were continuing to run your business.
What Comprises Inventory?
What comprises inventory differs depending on the type of business. Inventory for retail businesses might simply be the merchandise for sale. On the other hand, inventory for a manufacturer might include the finished product, raw materials, and packaging. Distributors might count not only the products they distribute but also freight and duty costs for shipping or importing goods in their inventory valuation.
When deciding what inventory and how much of it to include in your inventory valuation, consider:
- Whether the inventory is saleable
- Whether the inventory is obsolete
- The amount of inventory a new owner needs to run the business
While any business that sells products needs inventory to generate cash flow, not all inventory is created equal. Continuing technological changes can render some electronics inventory obsolete. An apparel retailer might not be able to sell last year’s fashions. Inventory for other businesses might include damaged goods that can’t be sold.
If you’re planning to sell your business, it’s a good idea to implement an inventory management program one or two years before your expected sale date as part of your exit strategy. Buyers generally won’t pay extra for excess inventory on your balance sheet for more than a year, so when it comes time to sell, it might not serve you well to maintain very high inventory levels for rapid turnaround and customer service.
How Do You Value Inventory?
There’s no single way to value inventory. Some business owners use the price they paid for the inventory. Others use the retail price. GAAP accounting rules require business owners to use market value or their cost to buy or make the inventory, whichever is lower.
You’ll need to know the cost of goods sold (COGS) and decide on the metric you’ll use for inventory valuation. You’ll also have to count your inventory and subtract any units you can’t sell.
Calculating Cost of Goods (COGS)
To calculate COGS, take the inventory on hand at the beginning of a given accounting period, such as a year or a fiscal quarter, add the purchases you made or goods you produced during that period, and subtract your ending inventory from that total.
The formula is: Beginning inventory + purchases made or products manufactured - ending inventory = COGS
For example, let’s say you own Sweater Shack. At the beginning of the year, your inventory was 50 sweaters purchased for $20 each. During the year, you purchased an additional 20 sweaters for $25 each, and you sold 50 sweaters by year-end. Your remaining inventory would be 20 sweaters.
But how do you determine the cost of those 20 sweaters? You purchased some at $20 and others at $25. Which ones remain in your inventory at year-end—and therefore the cost of your remaining inventory—depends on the accounting method you use.
Metrics for Valuing Inventory
There are several ways to assign a dollar value to the goods in your inventory, and the accounting method you choose has implications for the gross profit you show and the taxes you’ll have to pay on your income and the sale of your inventory.
Small business owners can choose any one of the following methods to calculate the value of inventory. What’s important is that your calculations are accurate and you use the same metrics consistently. Switching accounting methods from one year to the next will raise the buyers’ suspicions and likely get you unwanted attention from the IRS.
First In, First Out Accounting (FIFO)
The FIFO method assumes that the first goods purchased will also be the first to sell. Because prices tend to rise as time goes by due to inflation, selling the least expensive goods first will likely show you earned a bigger profit at the end of your sales cycle.
If Sweater Shack used the FIFO metric, the sweaters counted as sold would come from its oldest inventory—the sweaters for which it paid $20 each. Because it sold 50 sweaters during the year, it would have sold all of its $20 sweater inventory and none of its $25 inventory using FIFO. Sweater Shack’s remaining inventory would be 20 sweaters that cost $25 each or a total value of $500.
Sweater Shack would show more profit using the FIFO method because its cost basis for the sweaters sold was $20, not $25. The difference between the $20 cost and the retail price would be greater compared to using a cost basis of $25. But while that would make Sweater Shack’s balance sheet look better, the higher profits would also likely result in higher taxes.
Last In, First Out Accounting (LIFO)
LIFO assumes that the last goods added to inventory are the first goods to be sold. That means that the most expensive goods are sold first in the Sweater Shack example. The difference between the cost of inventory and its retail price will be less than it would be using the FIFO metric, so Sweater Shack would show less profit on its balance sheet.
Applying LIFO accounting to our Sweater Shack example, you’d calculate that all 20 sweaters at $25 each were sold and 25 of the remaining 50 sweaters were sold at $20 each.
LIFO is the opposite side of the coin from FIFO. It shows less profit and accordingly, your tax bill will likely be lower. However, if the economy fell into a recession mid-year, the effects of these two metrics might be reversed.
WAC or Weighted Average Cost Accounting
To calculate your inventory value based on weighted average cost, you’d total up the dollar value of all your inventory and divide it by the number of units of inventory sold.
Weighted average cost is a simpler way to calculate inventory value and likely yields a tax bill somewhere between the one you’d have using FIFO or LIFO.
Specific Identification
Just as it sounds, specific identification assigns the actual cost to purchase or make each item in inventory and the actual retail price it sells for. While this method provides the most accurate inventory valuation, it’s also the most complicated to calculate.
Negotiating Inventory When Selling Your Business
During the negotiation process, many aspects of the sale will be discussed, including the determination of the inventory's value. Once you've calculated the cost of goods and determined the remaining units in inventory, you can then multiply this remaining unit count by their individual unit cost to ascertain the inventory's value.
Like most aspects of a business sale, the value of inventory and the way it’s included in your business valuation are open to negotiation. Buyers and sellers might—and often do—have different views on the inventory included and its value.
In most cases, both buyers and sellers will take their inventory count before closing the sale, and they’ll have to negotiate any discrepancies. Another option is to hire an independent third-party firm to count the inventory.
Buyers and sellers will have to reach agreement on:
The Method for Determining the Cost of Inventory
Will inventory be valued using the retail price or the cost to purchase or make the goods? If the business is a manufacturing company, the buyer and seller must determine how the inventory of materials for goods not yet finished (work in process) will be valued.
How Much Inventory Will Be Included in the Sale
If the seller has more inventory than needed to run the business, buyer and seller must agree on how much will be purchased. If inventory levels are insufficient and a buyer must replenish inventory upon closing the sale, the buyer and seller will likely have to adjust the business valuation accordingly.
Whether to Include Inventory in the Purchase Price or Sell It Separately
This point is especially important for sellers because the sale of inventory is taxed as ordinary income which is a higher tax rate than the capital gains tax treatment used for many other assets. Buyers, however, might prefer buying inventory as a separate asset because they can immediately begin depreciating it to get a tax deduction.
How you value your inventory can mean the difference between leaving money on the table or getting the best price for your business. Sellers should engage business brokers, attorneys, and CPAs to assist with achieving the best outcome for their sale. These professionals can guide you in crafting a purchase and sale agreement that outlines how inventory will be handled, managing the inventory count before closing, and negotiating any sale price adjustments that might be needed. Visit BizBuySell’s Broker Directory to find a business broker to help you value and sell your business.