Inventory Costing MethodChoose which method works best for your business

So, what is inventory?

Directly quoting from IAS 2, inventory is defined as:

“Inventories include assets held for sale in the ordinary course of business (finished goods), assets in the production process for sale in the ordinary course of business (work in process), and materials and supplies that are consumed in production (raw materials).”

If you’re running a business that sells products, you probably have inventory.

Those materials will form part of your raw materials inventory.

Those unsold merchandise will form part of your merchandise inventory.

Even your unsold finished products form part of your inventory, particularly the finished goods inventory (or goods available for sale).

If your business is like any other business that has inventory, you probably had some hiccups with measuring your inventory cost.

Inventory costing is one of the things that you have deal with when you have inventory.

You need to choose the inventory method that best works for you.

It’s an important decision as it can affect how you prepare your financial statements.

Not only that, it affects how you account for costs, potentially affecting your taxes too.

That’s why in this article, we will be learning the different methods of inventory costing.

We will also be having some examples to deepen our understanding of each inventory costing method.

The different inventory costing methods

The method of inventory costing affects how you prepare and report your financial statement.

As such, choosing the method that best suits your business is important.

There is not a one-size-fits-all method of inventory costing.

What works best will differ from business to business.

That said, here are the four commonly known methods of inventory costing:

• FIFO (First In, First Out) – a method in which it is assumed that the oldest stocks are sold first before the newest ones. Thus, the cost of the oldest stocks will be used for determining the cost of goods sold.
• LIFO (Last In, First Out) – the opposite of FIFO. Under LIFO, it is assumed that the newest stocks are sold first before the oldest ones. The cost of the newest products determines the cost of goods sold.
• Weighted Average Cost (WAC) – a method that used a weighted cost that averages the cost of inventory. Whenever stocks go in or out, the cost of each unit of inventory is recomputed to determine the weighted average cost. The cost of goods sold is determined by the movement in inventory.
• Specific Identification – a more particular method in which each product or material is assigned its own cost. This method is most suited for businesses that have products that are very different from each other (e.g. auction houses, personalized items, etc.).

You need to be careful when using the LIFO method though.

The IFRS does not recognize it as a valid method of inventory costing.

So if your business operates internationally, you might want to look at other inventory costing methods.

The GAAP does not mention LIFO, but it does not prohibit its use.

So if your business is exclusively operating within the US, it’s okay to use LIFO.

FIFO (First In, First Out)

FIFO assumes that a business sells its oldest goods first before selling the new ones.

It also assumes that not all inventory is equal in cost.

The goods that you produced or purchased a month ago may cost less than their today counterparts.

Under this method, the cost of the oldest goods greatly determines the cost of goods sold.

For example, let’s say that you own a business that sells sunglasses.

You purchased 10 sunglasses on April 4 for your starting inventory.

On April 15, you bought another 10 sunglasses.

On April 28, a customer bought 5 sunglasses from you.

Under FIFO, we assume that the oldest goods are sold first.

So the cost of the 5 sunglasses that you sold is determined by the cost of the sunglasses you bought on April 4.

If those glasses cost $5 each, then your cost of goods sold will be $25.

This pattern will continue until you sell or dispose of all your oldest goods.

After that, the cost of the next oldest goods will determine the cost of goods sold.

The FIFO method is best suited for businesses that sell their oldest goods first before the newer ones.

It could be because of preference or necessity.

Logically, businesses that sell perishable goods or goods that can become outdated would want to sell their oldest goods first.

You cannot reasonably sell expired products.

And goods that have become outdated are usually sold at a lower price than they would normally sell for.

That said, FIFO is not exclusive to these kinds of businesses.

It’s popular, mostly because of its simplicity and intuitiveness.

In fact, it is the IRS’s default inventory costing method.

If you don’t specify your inventory costing method, the IRS will assume that you’re using FIFO.

Pros and Cons of FIFO

PROS

• You don’t have to perform complicated computations. The cost of inventory and the cost of goods sold are determined by actual costs
• The valuation of inventory is based on the age of the inventory you’re holding
• Popular because of its simplicity and intuitiveness
• Easy to apply as long as you have proper recording of inventory
• Can result in higher immediate profits as the cost of older goods are usually lower than their newer counterparts

CONS

• Can result in higher taxes due to the lower cost of goods sold
• High price variance can cause overstatement or understatement in inventory valuations
• Budgeting may become challenging if inventory costs are constantly changing
• The cost of goods sold may not be representative of the current prices/cost of the product

LIFO (Last In, First Out)

LIFO is the conceptual opposite of LIFO.

It assumes that a business will sell its newest goods first before it sells its older ones.

Just like FIFO, it also assumes that the cost of all inventory is not always equal.

Usually, the cost of goods today is higher than their cost a month ago.

Under this method, the cost of the newest goods greatly determines the cost of goods sold.

For example, let’s go back to the imaginary sunglasses business you have above.

Remember on April 28, a customer bought 5 of your sunglasses?

Under LIFO, the cost of those glasses is determined by your newest stocks.

Meaning that the cost of the glasses you bought on April 14 will determine the cost of goods sold.

If those glasses cost $6 each, then your cost of goods sold will be $30.

One of LIFO’s benefits is that it uses the most recent inventory to determine your cost of goods sold.

It’s usually easier to extract information about your newest stocks than your older ones.

Another benefit of LIFO is that it usually results in a higher cost of goods sold.

This ultimately translates to a lower net income, meaning lower income taxes.

In actual practice, LIFO is rarely used.

There’s rarely a good reason to sell the newest inventory over the oldest ones.

Additionally, if your business operates internationally, do note that the IFRS does not recognize LIFO as a valid inventory costing method.

That said, while the GAAP does mention LIFO as one of the inventory costing methods, it does not prohibit its use.

So if your business exclusively operates within the US, then LIFO is still an option for you.

You’ll need to seek permission from the IRS first before you can use LIFO though.

Pros and Cons of LIFO

PROS

• You don’t have to perform complicated computations. The cost of inventory and the cost of goods sold are determined by actual costs
• LIFO uses the most recent cost of inventory for your cost of goods sold
• Can result in a higher cost of goods sold which ultimately translates to lower income taxes

CONS

• High price variance can cause overstatement or understatement in inventory valuations
• Budgeting may become challenging if inventory costs are constantly changing
• Is not recognized by the IFRS as a valid inventory costing method
• Allowed under GAAP, but requires permission from the IRS

Weighted Average Costing (WAC)

The weighted average costing method is unlike the previous two methods that uses the cost of the newest or oldest goods for inventory valuation.

Instead, WAC uses the whole inventory for inventory valuation.

It averages the price of all inventory to determine the cost of goods sold.

It does this by dividing the cost of goods available for sale by the number of units available for sale.

This is particularly useful if you want to have your costs averaged out over time, rather than using actual costs like LIFO or FIFO.

Here’s an illustration of how WAC works:

As can be seen from above, the WAC changes whenever there’s an increase in inventory.

This happens when the per-unit cost of purchased goods is not equal to the WAC.

The cost of goods sold is determined by the WAC on the date of sale.

For example, the cost of goods sold on August 9 amounted to $20.12 per unit, which is the WAC on the same date.

The WAC method is best suited for inventories that have almost identical products.

It can also be used when it’s more costly than beneficial to assign specific costs to each item.

And while there is computation involved, it’s still one of the easiest methods of inventory costing.

You only need to use one formula after all.

That said, this method isn’t suited for goods that aren’t equal, more particularly in costs.

If there is a high variance in prices, using the WAC method might be more harmful than beneficial.

It can cause an overstatement or understatement of inventory valuation.

So if you’re dealing with goods that greatly vary in price, you might want to reconsider using the WAC method.

Pros and Cons of the WAC method

PROS

• Averages the cost of inventory over time. You don’t have to rely on actual costs
• Only uses one formula, so it’s easy to use. Can be applied and utilized immediately
• Lessens the effect of differences in cost of stocks as the WAC method averages them out

CONS

• Not suitable for goods that vary greatly in price
• If a large volume of inventory is purchased when the cost per unit is significantly or lower than the WAC, there would be a great effect on the new WAC. This may result in an overstated or understated inventory valuation
• Can be the most difficult inventory costing method to correct if there are any costing mistakes or errors. The impact of a single adjustment can affect many inventory entries, especially if the error was detected very late

Specific Identification

The specific identification method meticulously assigns a cost for each unit of inventory.

This method of inventory costing requires more effort as you need to keep track of the cost of each unit of product.

The trade-off is that you can have a more accurate recording of inventory costs.

Determining the cost of goods is pretty simple.

Whatever is the assigned cost of the sold product will be its cost of sale.

For example, my inventory is currently composed of three units of products: A, B, and C.

Product A is assigned a cost of $25, product B $21, and product C $29.

A customer chose to buy product A.

What do you think my cost of goods sold would be?

If your answer is $25, then you get the basics of specific identification method.

This method is more suited for businesses that have a low volume of sales but have products that greatly vary in price.

It can also be suited for businesses that only produce and sell personalized products.

That said, it’s virtually impossible to use for businesses that have a high volume of sales.

It’s costly, both in effort and time, to keep track of the thousand, even millions of units of inventory.

The benefits you get from using this method do not make up for it.

If you decide to use this inventory costing method, make sure to perform inventory counting regularly.

This is to account for theft or spoilage, as well as prevent them.

Pros and Cons of the Specific Identification method

PROS

• Can result in more accurate inventory valuation
• Suited for businesses that sell products that vastly differ from each other

CONS

• Requires more time and effort than the other inventory costing methods
• Not suited for businesses that have high volumes of sales