8 Inventory Costing Methods That You Might Not Know About
Inventory costing or valuation is an accounting concept that has a direct impact on your gross profit and thus taxable income. Methods of valuing inventory are simply different cost-flow assumptions about how to allocate your cost of goods available for sale. They do not resemble your physical flow of goods, but rather, they allocate costs to either cost of goods sold or your ending inventory.
We’ll start by explaining why inventory costing is important. Next, we’ll cover popular and uncommon inventory methods. Finally, we’ll finish with inventory costing methods that are not based on costs and yet others that are based on estimates. You shall see that the inventory costing method that you pick will have different effects on your income statement and balance sheet.
Why Inventory Costing is Important
Inventory costing is done by accountants so that the cost of goods available for sale is represented fairly on your income statement and balance sheet. Businesses that deal in physical goods should submit financial reports that are true and fair. This is done to meet taxation obligations as well as to inform investors and stakeholders.
Each inventory valuation method has a different effect on your cost of goods sold (COGS) and ending inventory value. Some produce a high COGS, thus lower gross profit in the income statement and a lower ending inventory value. Others result in a lower COGS, higher gross profit and a higher ending inventory value.
Hence, it is arguable, that businesses pick an inventory costing method that best suits their gross profit outcome and thus taxable income. On the other hand, applying a flawed cost-flow assumption to your inventory means that the COGS and revenue aren’t properly matched. This may result in misinformed business decisions.
Finally, if you deal in physical goods, inventory is easily the largest current asset on the balance sheet. And, as a current asset, you are motivated to sell and turnover the inventory in the next 12 months.
I. Popular Inventory Valuation Methods
By far the most popular inventory valuation methods are First-In First-Out, Last-In First-Out, and Weighted Average Cost. The generally accepted accounting principles (GAAP) in the States allow all three to be used. However, the International Financial Reporting Standards (IFRS) does not permit LIFO to be used for reasons we shall see later.
Nonetheless, each method produces a different outcome because they make various assumptions about the flow of costs.
1. First In, First Out (FIFO)
FIFO says that you will sell the oldest goods in your inventory first. So, assuming that prices rise over time (they usually do), the ending inventory is valued higher at recent costs. The COGS is lower because it is based on cheaper, earlier costs. This produces more gross profit and a higher taxable income.
FIFO is popular and is widely accepted because it follows common sense in running a business: that you want to sell your oldest inventory first. Also, recent costs are reported in the ending inventory on the balance sheet. Thus, it comes as no surprise that modern inventory management solutions, such as EMERGE App, are based on these sound FIFO principles.
2. Last In, First Out (LIFO)
LIFO assumes the opposite, that you will sell your newest goods first. When prices are rising, the ending inventory is valued lower at older costs, COGS is higher and thus gross profit and taxable income are lower.
While LIFO is used in the United States, it is not permitted in other countries because it has the effect of depressing gross profits and taxable income. On the other hand, it could be said that it improves the matching of current costs with current revenues as your newest goods are the most recent ones sold.
3. Weighted Average Cost
Weighted Average Cost or Average Cost assumes that you sell your goods all at the same time. Huh? Let us explain.
Commodities such as oil are physically indistinguishable and easily substituted. Crude oil bought earlier isn’t all that different from oil bought today. They are simply poured into holding tanks and mixed up. Thus, they are priced using the average of the cost of all goods in the inventory.
When to Use FIFO, LIFO or WAC?
Let’s illustrate the different effect of these three methods with a completely fictitious example.
Example: Penelope’s Poppin’ Vegan Soaps Inc.
Penelope makes vegan soaps in Colorado that are friendly to the Earth and animals. Her supply chain is well documented and transparent for all to see. She produces soap in small batches at her factory. They are then sold through retailers and wholesalers around the country.
However, her production runs depends on raw materials that are susceptible to swings in supply and the weather. Global warming has resulted in poor yields of coconut oil and palm oil and thus steadily increasing costs for her.
For the financial year from January to December she sold a total of 1,300 bars of soap. She started the year with an empty inventory because she managed to sell and give away everything at a Winter Solstice festival last December.
Penelope also provided the following production summary from her accounting software package:
Beginning Inventory 0 units Total Sales 1,300 units Production Summary Batch Units Unit Cost Cost of Goods Available for Sale January 500 2 $1,000 April 300 2.15 $645 July 400 2.25 $900 October 600 2.40 $1,440 Total 1,800 $3,985
Remember that FIFO assumes that your oldest goods are sold first. Hence, for the 1,300 bars of soap sold, 500 are taken from the January batch, 300 from April, 400 from July and 100 from October.
Batch Units Unit Cost Cost of Goods Available for Sale January 500 2 $1,000 April 300 2.15 $645 July 400 2.25 $900 October 100 2.40 $240 Total 1,300 $2,785
Penelope’s cost of goods sold is $2,785.
Her ending inventory will be valued thus:
Batch Units Unit Cost Value October 500 2.40 $1,200
The ending inventory is $1,200.
LIFO assumes that your newest goods are sold first. Hence, 600 will be taken from October, 400 from July and 300 from April.
Batch Units Unit Cost Cost of Goods Available for Sale April 300 2.15 $645 July 400 2.25 $900 October 600 2.40 $1,440 Total 1,300 $2,985
Penelope’s cost of goods sold is $2,985.
Her ending inventory will be valued thus:
Batch Units Unit Cost Value January 500 2 $1,000
The ending inventory is $1,000.
Weighted Average Cost
First, we calculate the average unit cost which is simply the total cost of producing the goods divided by the total number made:
Units Produced Cost of Goods Available for Sale Total 1,800 $3,985
Or $3,985 / 1,800 = $2.21 per unit
With this, the average unit cost is multiplied by the number of soap bars sold and the balance inventory.
Units Average Unit Cost Cost of Goods Available for Sale Sold 1,300 $2.21 $2,873 Balance 500 $2.21 $1,105
Thus, if she sold 1,300 bars of soap during the year, her cost of goods sold is $2.21 x 1,300 = $2,873
The ending inventory will be (1,800 – 1,300) x $2.21 = $1,105
Summary of FIFO, LIFO and WAC
In summary, here are the cost of goods sold and ending inventory values from each of these inventory costing methods. As you can see, each one allocates the cost of goods available for sale differently to the COGS and the ending inventory.
FIFO LIFO Average Cost Cost of Goods Sold $2,785 $2,985 $2,873 (Income Statement) Ending inventory $1,200 $1,000 $1,105 (Balance Sheet)
We can also see that in times of inflation (typical in developed economies), FIFO produces the lowest cost of goods sold and thus a higher gross profit in the income statement. The ending inventory is valued at the highest amount on the balance sheet.
On the other hand, LIFO produces the highest cost of goods sold and thus a lower gross profit. The balance sheet sees the lowest ending inventory value.
As expected, the average cost method produced values that were squarely in the middle of everyone else’s. The effect of simple averaging tends to smooth out variations in prices.
Finally, in the real-world, it’s a choice between FIFO or Average Cost. Most businesses choose FIFO to match their physical products better and this is the basis for popular inventory management software. But if you’re selling homogenous stuff with an indefinite life, such as salt and honey (true!), then average cost will work better for you.
II. Other Uncommon Inventory Valuation Methods
Here, we’ll cover three more inventory costing methods that are not approved by GAAP. But nonetheless they are useful to know for comparison purposes. They also illustrate how selecting different methods can smooth out your gross profit and thus taxable income. This is the main reason why they are not accepted for accounting purposes.
4. Highest In, First Out (HIFO)
HIFO takes the view that you will sell your most expensive goods first. This is probably true of salespeople working on commission! It thus gives a short-term bump to revenue. But gross profit and taxable income drops because COGS is higher, and ending inventory is lower.
Example: Jake’s Pre-Loved Lovely Cars LLP.
Jake runs a used-car business in Miami. He buys, sells and restores pre-loved vehicles from the rare and quirky to performance cars. His bestsellers are vintage VW vehicles. Expensive makes in his inventory include 1970s Chevy Corvettes and a couple of original Dodge Chargers.
He gave you the following numbers from his cloud accounting software package:
Vehicle Quantity Cost Cost of Goods Available for Sale VW Kombi 10 $4,500 $45,000 VW Beetle 12 $8,000 $96,000 Dodge Charger 4 $28,000 $112,000 Chevy Corvette 3 $25,000 $75,000
Thus, Jakes and his salespeople should try to sell the Dodge Chargers and a good number of the VW Beetles first. Alternatively, if the Beetles don’t move quickly they can also push a couple of Chevy Corvettes.
5. Lowest In, First Out (LOFO)
LOFO says that you will first try to sell the cheapest goods in your inventory. Thus, your COGS is lower and ending inventory is higher. While it produces a drop in revenue, your gross profits and taxable income are higher.
Example: Annabelle’s Watches That You Can Watch Inc.
Annabelle does a roaring wholesale trade in vintage watches in Portland. She trades in all sorts of watches ranging from mass-produced models to limited editions and reissued collections. Some retail customers buy them to add handcrafted embellishments.
She gave you the following numbers from her bookkeeper:
Product Quantity Cost Cost of Goods Available for Sale Timex 200 $15 $3,000 Casio 150 $20 $3,000 Seiko 90 $100 $9,000 Citizen 180 $35 $6,300
In conclusion, Annabelle should push sales of her vintage Timex and Casio watches first.
6. First Expired, First Out (FEFO)
FEFO is of the view that goods that are expiring soon should be sold first. Hence it is typically used in the food industry. It thus ignores the effect of prices of goods and their purchase dates. This means the COGS and balance inventory will vary from time to time.
Example: Maria’s Mexican Munchies LLP.
Maria is a manufacturer and wholesale distributor of fresh Mexican tamales and tortillas. Each small batch is lovingly made in her San Diego factory before being shipped out to restaurants and supermarkets throughout California.
Maria shared with you the following numbers from her cloud accounting software:
Product Quantity Expiry Date Corn tortillas 900 February 2019 Flour tortillas, Batch 2F 400 November 2018 Flour tortillas, Batch 5E 500 March 2019 Tamales 300 December 2018
Hence, Maria should be pushing sales of flour tortillas (batch 2F) followed by tamales, corn tortillas and then more flour tortillas (batch 5E).
III. Inventory Valuation Not Based on Cost
Lower of Cost or Market
The lower of cost or market rule states that inventory should be valued at whichever is lower: original cost or current market price. This is typically used when goods are held for a long time and they have become obsolete or damaged.
Cost means the amount paid to purchase the goods. Market price is the amount paid if you were to purchase a replacement now.
Example: Oliver’s Wines of the World LLC.
Oliver runs a retail business selling artisanal wines from Australia and New Zealand. He likes small batch wines with character. However, large wine companies from South Africa and Chile have flooded the New York market. Retail prices collapsed as a result.
Oliver gave you the following numbers from his bookkeeper:
Wine Quantity Cost Price Market Price Lower of Cost or Market NZ Sauvignon Blanc 1,000 $11 $9 $9,000 NZ Merlot 2,000 $13 $14 $26,000 AU Cabernet Sauvignon 1,500 $20 $16 $24,000
Thus, Oliver realizes a loss of $2,000 for his stock of NZ Sauvignon Blanc and $6,000 on the Australian Cabernet Sauvignon.
Net Realizable Value
Net realizable value declares that inventory should be valued at their estimated selling price less the expenses involved in disposing of them. This method is used when goods are so damaged or obsolete that they can only be sold below their cost price.
Example: Michael’s Furry Eye-Things LLC
Michael jumped on the retail bandwagon after watching a YouTube video that went viral. Furry sunglasses were in vogue. He bought tens of thousands of sunglasses from a Chinese supplier. He could surely sell them all during summer right?
It turned out that Michael was left with a stock of about 25,000 sunglasses worth about $200,000. People quickly realized that furry sunglasses raised their eye temperatures. And all the faux fur stuck to their sunscreen. The fad left as quickly as it arrived.
Michael eventually received a bid of $25,000 for all his obsolete stock from a retail liquidator. He also had to pay $3,000 commission to the agent who found the buyer for him. And $1,000 owed to the warehouse for storage costs.
Selling price – Selling costs = Net realizable value
$25,000 – ($3,000 + $1,000) = $21,000
All in, Michael realized $21,000 from the sale of his dead stock. He lost almost $180,000 in his e-commerce venture. Ouch!
IV. Estimated Cost Inventory Valuation
Sometimes it’s not feasible or practical to physically count stock. Hence inventory value is estimated instead. The two methods here give a quick approximation of inventory value. But do remember to factor in the loss of stock from shoplifting, damage and employee theft.
Retail Inventory Method
The retail inventory method does not use inventory units. Instead, it takes the total retail value of goods, subtracts their total sales, then multiplies that amount by the cost-to-retail ratio (percentage of markup from wholesale purchase price).
Example: Melissa’s Mauritian Gifts & Handicrafts LLP
Melissa sells handicrafts from Mauritius at various festivals and fairs in Hawaii. Coconut shells, natural fibres and indigenous wood are used to make trinkets and such. She imports them in batches of hundreds for sale at her kiosk and retail partners.
Her accounting software provided the following figures:
Cost of inventory at start $4,000 Cost of inventory purchased: $2,000 Retail price of inventory at start: $8,000 Retail price of inventory purchased: $4,000 Total sales for the year: $5,000
How to Calculate Retail Inventory
1. Find the Cost of Goods Available for Sale.
Cost of inventory (beginning) + Cost of inventory (purchased) = Cost of goods available for sale
$4,000 + $2,000 = $6,000
2. Get Retail Price of Goods Available for Sale.
Retail price of inventory (beginning) + Retail price of inventory (purchased) = Retail price of goods available for sale
$8,000 + $4,000 = $12,000
3. Calculate the Cost-to-Retail Ratio.
Cost of goods available for sale / Retail price of goods available for sale = Cost-to-retail ratio.
$6,000 / $12,000 = 0.5 or 50%
4. Calculate the Retail Price of Ending Inventory.
Retail price of goods available for sale – Sales for period = Retail price of ending inventory
$12,000 – $5,000 = $7,000
5. Estimate Ending Inventory at Cost.
$7,000 x 0.50 = $3,500
Thus, the cost of Melissa’s ending inventory is $3,500.
The gross profit method does not use inventory units either. It uses the previous year’s average gross profit margin. This is sales less cost of goods sold, then divided by sales.
Example: George’s Beaming Bright Beads Inc.
George sells hand-painted beads imported from Peru. Each one is meticulously handcrafted before being fired in a clay oven and then painted with natural pigments. He imports them in the hundreds and thousands sells them to hobbyists and crafting shops throughout Arizona.
He provides you with these figures:
Cost of a box of beads: $5 Selling price of a box: $12.50 Total sales: $24,000 Purchases of beads: $4,000 Previous inventory value: $8,000
How to Calculate Gross Profit
1. Calculate the Gross Profit Margin
(Selling Price – Cost Price) / Selling Price = Gross Profit Margin
($12.50 – $5) / $12.50 = 0.60
If George earns a gross profit margin of 60% of sales, his cost of goods sold must therefore be 40% of sales.
2. Calculate the Sales Value of the Goods Sold
Sales x (1 – Gross Profit Margin) = Cost of Goods Sold
$24,000 x 0.40 = $9,600
Thus, the cost of goods sold must be $9,600.
3. Add the Cost of the Goods Purchased
Previous Inventory Value + Value of Purchases = Cost of Goods Available for Sale
$8,000 + $4,000 = $12,000
4. Estimate Cost of Goods in Inventory
Cost of Goods Available for Sale – Cost of Goods Sold = Cost of Goods in Inventory
$12,000 – $9,600 = $2,400
Hence, George’s estimated cost of goods in inventory is $2,400.
We’ve covered 8 ways of valuing your inventory. In reality, most businesses use either FIFO or Average Cost to comply with accounting reporting standards around the world. However, other methods are useful to illustrate how they can be used to achieve the desired income statement and balance sheet figures. Finally, these methods show that costing your inventory need not follow the physical flow of your inventory.