The question that is often asked by beginners in accounting and finance, is which inventory costing method to use?
Well, the answer would depend on your business. While some businesses may be able to justify that one method is better than another, there are hardly any businesses where it makes sense to change all their methods at once.
Inventory costing methods is vital part of any business.
These methods determine what portion of the inventory to include in cost calculation, and which method to use for valuation of inventory.
And the final value generated would be the closing stock quoted in the P&L account.
It is not an easy decision to make.
There are several factors that must be considered before choosing a method.
This post will focus on 5 inventory costing methods, and the key factors that should be considered before making the final decision.
The five methods are:
- FIFO (First in First out).
- LIFO (Last in First Out).
- Average Costing Method.
- Specific Identification costing method.
- Market Valuation Method.
After that I’ll answer all the questions you have about valuing inventory.
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FIFO (First in First out)
The FIFO method of valuation is one of the most popular and easy to use methods.
When we apply this concept to inventory accounting, we assume that the first product bought was also the first product sold and vice versa.
However, the cost of the first product bought may not be equal to the cost of the first product sold.
The main advantages
- It minimizes inventories and helps improve working capital turnover ratios, which in turn improves liquidity ratios of your business.
- this inventory costing method is simple to apply, and it dries quickly.
- the balance sheet amount for inventory is likely to approximate the current market value.
The main disadvantages
- It’s not always the most accurate in reflecting the cost basis of an item.
- Results in taxable gains when prices are rising, and taxable losses when they are falling.
- Ignores economic realities that may lead to distorted financial statements.
Inventory is assigned costs as items are prepared for sale. This may occur through the purchase of the inventory or production costs, through the purchase of materials, and utilization of labor.
These inventoriable costs are based on the order in which the product was used, and for FIFO, it is based on what arrived first.
To understand the FIFO method better, we’ll look at an example.
A company purchased 100 products for $10, followed by 100 products for $15.
You would record the cost of the first 100 items sold for $10 each. The new cost of an item after 100 units have been sold is always set to $15, regardless of whether additional inventory purchases are made.
FIFO is good for businesses with a smaller customer base, and those with the desire to remain agile.
It’s also preferred by businesses that seeks lower taxes and want to minimize their inventory holdings.
Tip: if you are planning to switch from your current inventory costing method to FIFO, do not make the switch all at once, This is because some of your previous purchases may be still in stock.
LIFO (Last in First Out).
The LIFO is the inverse of the FIFO.
Under this concept, you value your inventory by assuming that the last item bought was also the first one sold.
However, it is not necessary to do so at all times.
This inventory costing method may show a lower cost of your inventory, but it is not always true.
The main advantage
- The profit on the sale of goods is reduced. This lowers the net income and results in a smaller tax obligation.
- Any costs on purchases that are less than sales prices will also be relatively low.
The main disadvantage
- Overvalues the cost of the first products bought, which results in an overstatement of taxable income.
- Results in lower net income on your financial statements.
- Will not always provide you accurate costs for items on hand at the end of period.
LIFO is not used as a valuation method for inventory. It’s mostly used as an accounting tool to help companies defer tax income into future periods.
The same company that purchased 100 products for $10, followed by 100 products for $15.
The cost of the first 100 items sold is $15 each. After 100 units have been sold, the cost of an item is reset to $10.
LIFO is beneficial to businesses when price ricing, since they can match their revenue with the most recent expenses.
Tip: If you are planning to switch from your current inventory costing method to LIFO, do not make the switch all at once. This is because some of your previous purchases may be still in stock, and this will cause a significant fluctuation in your financial statements.
Average Costing Method.
Average costing method shows the average cost of all items in stock.
When your business decides to sell an item, the average cost of all items in stock will be used to record the sale.
This inventory costing method is beneficial to businesses for a variety of reasons. The weighted average of all the inventory that the business acquired throughout a period of time is used to assign value to COGS.
As long as the length stays consistent, it may be a month, quarter, or yearly period.
The main advantages
- It provides a reasonable approximation of the value of inventory on hand.
- It’s simple to utilize, and a basic formula makes calculating the average cost very straightforward. It may be calculated even if you don’t use an inventory management system.
- With average costing, you’ll get more accurate and realistic data when comparing periods.
- Due to its simplicity, the average costing technique is also the most cost-effective method since it requires little input.
The main disadvantages
- This inventory costing method is works only with identical items – You can’t utilize average cost of inventory in industries with non-identical goods, such as the electronics industry. The term “computer” refers to a wide range of equipment that includes different characteristics, such as color, size, model, and so on.
- Reporting Issues – If the cost of a stocked product fluctuates, it can cause reported sales profit to differ. Your pricing may not be able to recoup the expenses of things that are more expensive, resulting in revenue loss. You might even find yourself eliminating the product and never recovering your losses.
- Aggregated costs – The average cost method calculates and distributes all costs as a single transaction before dispersing them across all items.
The total cost of producing 40 haircuts at “The Clip Joint” is $320.
So to determine the average price of a haircut, divide the total cost by 40. $320/40= $8 per haircut.
Tip: Average costing is most effective when the costs of individual products stay relatively consistent over time, such as through use of production or purchasing contracts.
Specific Identification Costing Method
This method assigns an individual cost to specific goods. When a product is sold, the cost of that product (specifically identified) will be removed from the balance sheet.
Specific identification becomes beneficial when you are trying to price your goods correctly. It’s the only cost allocation method that uses costs specifically attributed to an item or product.
It’s beneficial and practical, when a firm is able to identify, label, and track each item or unit in its inventory.
The main advantages
- You’ll know the direct costs and expenses of items that you’re selling.
- It’s easy to track and report because it assigns an individual cost for each item.
The main disadvantages
- Complexity – It may require you to keep a vast amount of information on hand. You’ll need to identify different products as well as their components, such as material and labor.
- Costly – It requires a high level of effort, time and money. If you plan to take a cost-effective approach to implement this method, it’ll require a lot of preparation and work from your team. Depending on the number of items that need specific identification, this will be much more costly than other methods.
This inventory costing method is good for car dealerships, jewelry stores, art galleries and furniture stores.
In August 2019, the firm sold 1,100 units. Of the total sales made, 400 units were sold out of purchases made on 01-Aug-2019; 200 units were sold out of purchases made on 08-Aug-19; 200 units were sold out of purchases made on 22-Aug-19; and the remaining 300 units were sold on 31-Aug-19.
Then the closing stock calculation would be as follows:
The value of the closing stock on August 31, 2019, is $ 2,420.
Calculation of the cost of goods sold:
The cost of goods sold for August, 2019, is $ 1,315.
Market Valuation Method.
Market valuation method is the most widely used inventory costing method by small and medium-sized business owners.
The market valuation method is a way to estimate the value of an asset by comparing it to the values of similar assets.
In some cases, such as that of residential real estate or publicly traded stocks, there is usually a lot of data accessible, making market research straightforward. It can become quite difficult to find comparable transactions in markets like shares in private businesses or alternative investments such as fine art or wine.
The main advantages
- The market approach is based on publicly available data on similar transactions, so it may require fewer subjective assumptions than other techniques.
The major disadvantage
- it may be difficult in scenarios where there are few if any comparable transactions, such as when a private firm operates in a specialized sector with few rivals.
Assume you’re looking for a new home and come across one that is listed for $200,000 in your desired location. The apartment has a bedroom area of 1,000 square feet and a single bathroom. It’s in excellent structural condition, but some renovations are required. Despite its prime location, the view is blocked.
You believe the asking price is too high, despite the fact that you appreciate the place. You begin to wonder if you’ll be able to negotiate a fair offer past them even if it’s under their asking price after the apartment has been on the market for over a month.
You’ll need to figure out the fair market value of your apartment by looking up comparable rental properties that have recently sold in the same area. You create a table consisting of your findings as follows:
|Transaction 1||Transaction 2||Transaction 3||Transaction 4||Transaction 5|
|Price Per Square Foot||$275||$220||$135||$175||$140|
|In-Suite Washer and Dryer?||Yes||No||Yes||No||No|
You may begin to make some broad conclusions after looking at these statistics. To begin with, you may observe that the price per square foot of the apartments ranges from $140 to $275, with prices increasing as more bedrooms and bathrooms are added, greater views are available, in-suite appliances are present, and no renovations are required.
On the other hand, the apartment you are looking to buy is valued at $200 per SF and has fewer of these characteristics than even the cheapest priced apartment in your table.
You’ve gathered as much information as you can and now it’s time to make an offer. Based on the information you have, you decide to offer $150,000.
The retail inventory Costing method
The retail method measures the cost of inventory compared to the price of goods to get an ending inventory balance for a business. In other words, it determines how much expense should be recognized in this time versus the next.
The retail method is a great way to sell products and make money. If you have consistent markup, it’s simple for your business because everything has the same price tag on all of its items as well!
This approach is based on the relationship between a product’s cost and its retail price.
The main advantage
- It’s simple to calculate and may be used even if you have a poor inventory cost tracking system.
The main disadvantage
- If your markup varies widely among products, then the estimated costs will not be very accurate.
The company sells home coffee roasters for an average of $200, with a cost of $140. This is a cost-to-retail ratio of 70 percent. it has an inventory start cost of $1 million and purchases worth $1.8 million during the month while raking in sales totaling $2.4 billion:
Tip: Do not put too much faith in it to provide comparable results to those of a physical inventory count.
The following table demonstrates that the quantity of gross profit and ending inventory can differ significantly depending on the inventory method chosen:
While the total sales is the same for all alternatives, COGS, gross profit, and ending inventory vary significantly. Because 12 units were sold in each case, the overall amount of sales would be $36 per item.
However, with COGS calculations, the distinctions are apparent:
- The oldest costs were used under FIFO for COGS, which was generally the cheapest prices.
- The newest costs were utilized under LIFO, which are usually the most expensive.
- Average costs were employed, resulting in a cost per unit that was somewhere between the highest and lowest costs.
To summarize, the gross profit is the difference between COGS and sales. The table displays these computations. FIFO has the lowest costs and therefore generates the greatest gross profit. LIFO has the highest costs and hence produces the lowest gross profit. The weighted average is in the middle of things.
What is inventory cost?
The costs to a company of maintaining stock, or money that is locked up in inventory, are referred to as inventory expenses. Inventory expenditures are the fees incurred by a business for keeping goods on hand.
How to calculate inventory cost?
By adding the beginning inventory to inventory purchases, and then subtracting the ending inventory.
For example, at the start of the period, the firm values inventory at $50,000. During the time, he makes a total of $15,000 in purchases. The value of the company’s assets at the conclusion of $25,000.
When does the cost of inventory become an expense?
When a firm generates revenue by selling its goods/service to clients, the inventory cost becomes an expense. The expenses of inventories are shown in the income statement as costs of goods sold and flow through to the cost of goods manufactured.
Which technology has most lowered inventory costs in industry?
Just-in-time manufacturing has the most lowered inventory costs in industry.
As part of Japanese management thinking, Just-in-time (JIT) manufacturing is a technique used in production that insists on having the right product in the proper quantity and quality at the proper time.
It has been stated that JIT manufacturing’s actual usage has resulted in increased productivity, quantity, efficiency, and improved communication while reducing waste and costs. As a result, inventory expenses have been reduced.
How to calculate weighted average cost of inventory in excel?
To compute this weighted average in Excel, first enter the two values for the number of outstanding shares into adjacent cells.
For example, if 150,000 shares were sold in January and the price is $20.09, then B2 contains the value $20.09.
In September, the firm bought back half of these shares, resulting in a reduction in outstanding shares to 75,000.
In cell B3, enter the most recent value (n). The number of months for which these values were true should be input in the next row.
From January to September, or 9 months, the initial quantity of shares was kept at 75,000, indicating that only 75,000 shares were outstanding for the remaining three months of the year.
You can perform this calculation in Excel by entering the following formula in cell C2: The lower-right corner of the table is at R1, which contains data for row B. The right side of each column represents a single value, while the bottom tells you how many values are represented in that column.
For example, if your table includes four
Finally, in cell E2, input the formula =(B2*D2)+ (B3*D3) to calculate the weighted average.
The calculation of the weighted average number of shares outstanding is 131,250.
There’s no need to stay in the dark when it comes to inventory management.
Understanding how these inventory costing methods work and which one is best for your business will help you keep track of the costs associated with every product sold so you know what margins to expect from each transaction.
Which inventory costing method is the best for your company?
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