Valuing Inventory – 6 Inventory Costing Methods
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 companies may be able to justify that one method is better, there are hardly any businesses where it makes sense to change all their forms at once.
Inventory costing methods are a vital part of any business.
These methods determine what portion of the inventory to include in cost calculation and which form to evaluate a stock.
And the final value generated would be the closing stock quoted in the P&L account.
It is not an easy decision to make.
Several factors must be considered before choosing a method.
This post will focus on 5 inventory costing methods and the key factors to consider 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 your questions about valuing inventory.
FIFO (First in, First out)
The FIFO valuation method is one of the most popular and easy-to-use forms.
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 equal the price of the first product sold.
The main advantages
- It minimizes inventories and helps improve working capital turnover ratios, which improves your business’s liquidity ratios.
- 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, the purchase of materials, and the 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 price of an item after 100 units have been sold is always set to $15, regardless of whether additional inventory purchases are made.
FIFO is suitable for businesses with a smaller customer base and those wanting to remain agile.
It’s also preferred by businesses seeking lower taxes and minimizing inventory holdings.
Tip: if you plan to switch from your current inventory costing method to FIFO, do not make the switch all at once because some of your previous purchases may still be 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 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.
- We will not always provide accurate costs for items on hand at the end of the period.
LIFO is not used as a valuation method for inventory. It’s mainly used as an accounting tool to help companies defer taxable income into future periods.
The same company 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 price of an object is reset to $10.
LIFO benefits businesses when price ricing since they can match their revenue with the most recent expenses.
Tip: If you plan to switch from your current inventory costing method to LIFO, do not make the switch immediately. This is because some of your previous purchases may still be in stock, and this will cause a significant fluctuation in your financial statements.
Average Costing Method.
The 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 company’s inventory acquired throughout a period 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 simplifies calculating the average cost. It may be estimated 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 works only with identical items – You can’t utilize the average inventory cost in industries with non-identical goods, such as electronics. The term “computer” refers to a wide range of equipment with different characteristics, such as color, size, model, etc.
- 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 more expensive things, 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 prices 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 production or purchasing contracts.
Specific Identification Costing Method
This method assigns an individual cost to specific goods. When a product is sold, the price 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 can identify, label, and track each item or unit in its inventory.
The main advantages
- You’ll know the direct costs and expenses of your selling items.
- Tracking and reporting are accessible because each item is assigned an individual cost.
The main disadvantages
- Complexity may require you to keep a vast amount of information on hand. You’ll need to identify different products and their components, such as material and labor.
- Costly – It requires high effort, time, and money. If you plan to take a cost-effective approach to implementing 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 suits 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.
A market valuation is small and medium-sized business owners’ most widely used inventory costing method.
The market valuation method is a way to estimate the value of an asset by comparing it to the importance of similar assets.
In some cases, such as residential real estate or publicly traded stocks, there is usually a lot of data accessible, making market research straightforward. Finding comparable transactions in markets like shares in private businesses or alternative investments such as fine art or wine can become tricky.
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 not be accessible in scenarios with few comparable, able 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 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, even though you appreciate the place. You begin to wonder if you can 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 determine your apartment’s fair market value 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. First, 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, more incredible 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 characteristics than even the cheapest-priced apartment on your table.
You’ve gathered as much information as possible, 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 at 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 also has the same price tag on its items!
This approach is based on the relationship between a product’s cost and retail price.
The main advantage
- It’s simple to calculate and may be used even with a poor inventory cost-tracking system.
The main disadvantage
- If your markup varies widely among products, the estimated costs will be inaccurate.
The company sells home coffee roasters for an average of $200, costing $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 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 are 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 were generally the cheapest.
- The newest costs were utilized under LIFO, which are usually the most expensive.
- Average costs were employed, resulting in a price per unit between the highest and lowest prices.
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 most significant gross profit. LIFO has the highest prices 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 regarding inventory management.
Understanding how these inventory costing methods work and which is best for your business will help you keep track of the costs associated with every product sold. Hence, you know what margins to expect from each transaction.
Which inventory costing method is the best for your company?
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