In the business world, accurate inventory valuation is a linchpin of financial clarity. Inventory costing, a critical subset of inventory accounting, delves into how businesses assign costs to inventories. Understanding these costs allows business owners to make better decisions when choosing suppliers, writing orders, and forecasting stock needs.
In this article, we’ll explore the intricacies of inventory accounting, including some key inventory valuation methods and best practices for applying them.
What is inventory costing?
Inventory costing, also known as inventory valuation, is a process by which companies assign monetary costs to items in stock. Some of these costs include incidental fees, like storage costs or market fluctuation in product prices.
Inventory costing is a component of inventory accounting, a broader set of activities related to managing and reporting inventory. Generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS) apply to both. These are standardized accounting rules that prevent companies from overstating costs.
The two main metrics inventory costing determines are cost of goods sold (COGS) and ending inventory balance (remaining inventory cost at the end of an accounting period).
Why is inventory costing important?
A business’s inventory usually ranks among its most significant assets. Inefficiencies or unwieldy costs can have a ripple effect on the rest of an organization’s finances. A small adjustment to inventory will trigger a corresponding change in reported income.
Inventory costing also provides a certain level of inventory control, which can help reduce total inventory costs and avoid over- or understocking. Finally, proper inventory measurement ensures a business’s financial statements—the documents often reviewed by regulators and investors—are accurate and in line with GAAP and IFRS.
Common inventory costing methods
Although the goal of inventory costing is to establish financial clarity within a company—and a key aspect thereof is achieving accuracy in financial statements—it’s important to note that different inventory costing methods can produce different reporting results. As such, once your organization selects a costing method, regulators will expect you to adhere to it year after year.
These methods can be divided into three categories: cost-flow assumptions (FIFO, LIFO, and weighted average), specific identification, and alternative methods (HIFO, LOFO). GAAP and IFRS only accept the cost-flow assumptions and special identification.
FIFO
With the first-in, first-out (FIFO) inventory costing method, the oldest inventory cost (i.e., the first in) is sold or used first. The method assumes that cost of goods sold (COGS) corresponds with assets assigned the oldest costs. An accountant then matches remaining inventory assets (ending inventory) against assets more recently purchased or manufactured.
Let’s illustrate this with an example. An electronics store starts with an inventory of 100 smartphones, at a cost of $200 each.
Initial inventory = 100 units x $200 = $20,000
Let’s say the store makes a subsequent purchase of 50 smartphones at a cost of $220 each.
Cost of new inventory = 50 units x $220 = $11,000
The store then sells 120 smartphones. Calculating COGS using the FIFO method, we would allocate the first 100 units sold to the original cost of $200 each, followed by 20 allocated to the more recent cost.
COGS = (100 units x $200) + (20 units x $220) = $24,000
To calculate ending inventory cost using FIFO, we’d allocate the remaining unsold 30 smartphones to the more recent inventory cost.
Ending inventory = 30 units x $220 = $6,600
LIFO
The last-in, last-out (LIFO) inventory costing method records the most recently purchased inventory or produced items (i.e., last in) as sold first. The cost of these recent inventory purchases is expensed as COGS, while the lower cost of old products is reported as ending inventory.
Let’s apply this to the previous example. If our electronics store starts again with an inventory of 100 smartphones at a cost of $200 each, beginning inventory would be:
Initial inventory = 100 units x $200 = $20,000
In the next purchase, the store buys 50 more smartphones, once again at $220 each.
Cost of new inventory = 50 units x $220 = $11,000
Again, the store sells 120 smartphones. Using the LIFO method, the last 50 smartphones from the recent purchase are assumed to be the first inventory sold, followed by the first 70 from the initial inventory.
COGS = (50 units x $220) + (70 units x $200) = $25,000
To calculate ending inventory, the remaining 30 unsold smartphones are allocated to the older cost amount.
Ending inventory = 30 units x $200 = $6,000
Weighted average
Weighted average cost inventory costing (WAC) is a method that uses average unit cost to calculate COGS and ending inventory. That average cost is calculated using a simple averaging formula.
Using the same example, our initial inventory is the same: $20,000. Our cost of new inventory also remains the same at $11,000. Once again, let’s say the store sells 120 smartphones. The calculation for WAC is as follows:
Total cost = initial inventory + cost of new inventory = $31,000
WAC per unit = total cost / total units = $31,000 / 150 units = $206.67
With WAC calculated, we can then proceed to determine COGS and ending inventory:
COGS = 120 units x $206.67 = approximately $24,800
Ending inventory = 30 units x $206.67 = approximately $6,200
Specific identification
The specification identification method uniquely identifies and assigns the actual cost of each unit, usually using item serial numbers. The result is a more precise calculation of COGS and ending inventory.
However, it’s difficult to achieve unless items are distinct and their costs are easily traceable. Remember, specific identification is not a cost-flow assumption, but it is still a GAAP- and IFRS-accepted technique for inventory costing.
Let’s use a different example: Perhaps an online store specializing in buying and reselling handmade garments. You would calculate COGS by adding the specific costs of each distinct garment sold. Likewise, you would calculate the ending inventory by adding the specific costs of each distinct garment that remains in inventory.
COGS = cost of item 1 + cost of item 2 + cost of item 3
Ending inventory = cost of item A + cost of item B + cost of item C
It sounds simple, but if your inventory is large or items aren’t easily distinguishable from one another with precisely documented costs, the specific identification inventory method can quickly become onerous.
HIFO
The highest in, first out (HIFO) inventory costing method assumes a company will sell its highest-cost inventory items first. So, if our initial inventory is $5,000, reflecting 50 inventory units, and our cost of new inventory is $5,500, reflecting an additional 50 units, and customers purchase 60 units:
COGS = (50 units x $110) + (10 units x $100) = $6,500
Ending inventory = 40 units x $100 = $4,000
LOFO
The lowest in, first out (LOFO) method assumes a company will sell its lowest-cost inventory first. Like the FIFO/LIFO dichotomy, LOFO is essentially the opposite of HIFO. Using the above numbers:
COGS = (50 units x $100) + (10 units x $110) = $6,100
Ending inventory = 40 units x $110 = $4,400
How to choose an inventory costing method
- When to choose FIFO
- When to choose LIFO
- When to choose WAC
- When to choose specific identification
- When to choose HIFO
- When to choose LOFO
There are different circumstances and business climates that might necessitate selecting one inventory costing method over another. You might also select a method based on its effect on the company’s balance sheet.
Here’s an overview of when to choose each method:
When to choose FIFO
FIFO is best used when you want to keep pace with the actual physical flow of goods. It’s suitable for industries where products have a short shelf life or when you want to align COGS with the actual order of inventory acquisition.
FIFO is also ideal for inflationary environments, when prices are rising, as it results in lower COGS and higher reported profits.
When to choose LIFO
LIFOis most suitable when you want to match current costs with current revenues. LIFO assumes you will sell the most recently acquired inventory first, making it best for businesses that want to reflect the current cost of goods sold.
It can also provide certain tax advantages in some places by reducing a company’s taxable income during a period of inflation.
When to choose WAC
WAC is useful when there is no specific identification of individual units or items are homogeneous. It provides a smooth average cost for inventory items and is appropriate for industries with stable or predictably fluctuating prices and market values.
WAC simplifies record keeping but is best when there is no significant inflation or deflation.
When to choose specific identification
Specific identification is ideal only when you can uniquely identify and track the cost of individual units. This method is really only suitable for businesses dealing with high-value or distinct items, like art galleries.
Specific identification provides the most precise matching of costs with revenues, but depending on the size of your inventory, can be more complex and time-consuming to implement.
When to choose HIFO
HIFOhelps a company decrease taxable income, since the company will realize the highest cost of goods sold. However, HIFO usage is rare and not accepted by GAAP and IFRS.
When to choose LOFO
LOFOis used rarely in multilayer inventory companies where inventory expenses are extremely low. It’s best when you want to maximize your profit on paper.
By selling the cheapest items first, you’re left with more expensive inventory, which could result in higher reported profits. Like HIFO, LOFO is not GAAP- and IFRS-accepted, and it can lead to businesses over-reporting profits.
Inventory costing FAQ
What is the difference between inventory costing and COGS?
COGS—or cost of goods sold—is a cost measurement determined as part of the inventory costing process.
Which inventory costing method is easiest?
The weighted average method is widely considered the easiest inventory costing method, as it relies on a simple averaging formula and assumes stable and predictable inputs.
What are the three main inventory costing methods?
The three main inventory costing methods, also known as cost-flow assumptions, are FIFO, LIFO, and WAC.
Does Shopify offer reports to help with inventory costing?
Yes, Shopify offers monthly inventory reports that provide you with the necessary data to carry out your preferred inventory costing method.
