Inventory costing is a very important control technique and a crucial element in inventory management. It begins when the company assigns value to the products they maintain in their inventory. This process helps to understand how much inventory one needs to hold for driving efficiency.
The process of inventory costing helps to lower the total inventory costs. It informs you of slow-selling items. You can then order less or avoid ordering them entirely. This reduces unnecessary storage costs. Inventory operations involve one of the largest assets that a company needs to maintain. It gives you clarity on losses incurred due to theft and damaged goods. The inventory cost gives you an understanding of how the profits are and where you need to make required adjustments. Inventory methods accounting assists in the financial reporting of the company and has important tax implications.
Did you know? A large number of companies still have regular physical inventories to compare the accuracy stated by the system.
What is the meaning of Cost of Goods Sold and Inventory Cost?
In the world of accounting, the cost of goods sold represents the underlying inventory cost involved in selling the products to the customers. So, companies value inventory as a part of their asset class and are recorded by their respective accountants.
In the company’s balance sheet, the accountants record the inventory balance ending on the current asset side. As and when the inventory increases, the respective asset increases on the company’s balance sheet. Likewise, when the inventory decreases, the assets also decrease on the company’s balance sheet. The change in the inventory is recorded on the income side as an element of the cost of goods sold by the company.
The following shows the change in inventory formula as a cost on goods sold which is given below –
(Beginning Inventory + Net Purchases) = (Goods Available for Sale – Ending Inventory Balance)
A company needs to record the inventory value at the cost paid. However, a manufacturer records the inventory at the cost to produce an item. These include labour charges, overhead charges, raw materials, etc. The inventory of a company plays a significant role in determining the company’s balance sheet.
How to select the right type of Inventory Method?
We need to consider several elements before choosing the right cost accounting methods. Initially, the cash flow and its type is to be considered first for a couple of years.
In the next stage, we need to consider the financial statements of the company. We need to consider whether having a higher net income will be more beneficial or the company’s balance sheet needs higher asset allocation for financing projects?
Thereafter, we need to consider the material inflow in actuality. This selection needs to be substantiated in a specific manner. For Instance, whether we need to consider perishables or not has to be understood from the business perspective.
Finally, we can choose several costing methods like FIFO, LIFO, or the Weighted-Average inventory method. It should be followed based on the business requirement for financial reporting. For businesses that run on sound business principles, one needs to know the implication of all these methods. These help the management to analyse the operating results.
Different Types of Inventory Costing Methods
Inventory costing is a crucial element in presenting the financial statement of a company. The cost of inventory should include a comprehensive understanding of the income received or the financial position of the company. There are mainly three types of methods of inventory costing. These are Last in First out (LIFO), Last in Last out (FIFO), and Weighted-Average costing method.
1). First In First Out (FIFO)
The FIFO method for inventory costing method is a simple concept. It is based on the principle of a business model that first sells its oldest inventory while not all inventory items are created equally. FIFO calculation is done by multiplying the oldest inventory cost involved by the amount of the inventory sold to customers.
Businesses that deal with perishables use this type of inventory costing method. The reason is simple. It allows the outdated and old inventory to get accounted for first and get sold off. The same method is also used in the garments industry as such products need to be sold off before they perish or before they become out of fashion.
This inventory method is widely used in many industries. The intuitiveness, simplicity, and accuracy in measurement allow many businesses to use this accounting model. Moreover, it is more likely to give higher profit margins as the inflation of material costs is taken into account. Also, businesses try to match the lower production cost of older inventory product items with a higher current cost revenue structure.
This method assumes that the goods purchased first are the ones that are sold first and used by customers. Moreover, this costing method can be deployed for businesses that deal with short demand cycle products. For instance, restaurants and bars can use this inventory cost method for a better profit margin.
FIFO Inventory Method Formula:
As mentioned above, the formula for calculating the FIFO method for inventory costing is: -
Cost of the Oldest Inventory (per unit) X Inventory units sold.
If you want to calculate the Cost of Goods Sold using the FIFO inventory costing method, you need to account for the cost of the oldest inventory first. Once it is found out, we need to multiply it by the total amount of inventory sold.
Also read: What is the List of Accounting Standard
Benefits of Using FIFO Inventory Method:
- FIFO method can be deployed for perishable and short demand cycle products.
- It can help to reduce waste by selling products before their expiration period.
- It helps to earn a much higher net income.
- It lowers the overall overhead costs of storage as depreciation cost is reduced.
- It helps to match the flow of goods more efficiently.
- It is simple and easily understood by most people in the industry.
- It requires less training for the accountants and finance people to work on the deployment.
Disadvantages of Using FIFO Inventory Method:
- Using the FIFO inventory method allows you to pay higher taxes.
- Old products come with lower costs and higher margins. This leads to higher taxable income.
- The FIFO method tends to overstate gross margin, especially during inflation resulting in misleading financial statements.
2). Last In First Out (LIFO)
The concept of Last in First Out is based on the principle that a business will sell its latest products first. This allows you to match the current cost structure against the revenue. This helps in increasing the inventory valuation and helps in lowering the net income of the business. It is of great use in the accounting space as many favour this method.
Most retail businesses favour the FIFO method rather than the LIFO Method. This is because of the fact that the latest product item is used over outdated or old inventory while accounting.
This method assumes that the latest or the newest product item is taken into account rather than the old one. So, the cost of goods sold and the products available for sale are calculated based on the valuation of the latest product items.
This inventory method is widely used in businesses where the prices of product items increase very often. Therefore, the latest items are more expensive and are being sold first.
Also read: A Complete Guide on Cost Inflation Index
LIFO Inventory Method Formula:
As discussed earlier the formula for the LIFO inventory method is given below –
Cost of the recent most inventory (per unit) X Inventory Units Sold to Customers
Advantages of LIFO Inventory Method:
- The LIFO inventory method is useful for non-perishable product items. These types of products do not diminish in value and have more shelf life.
- It helps in increasing inventory carrying costs and can lead to lowering the inventory items.
- It is also a widely used accounting method when prices become more volatile.
- Selling new product items with high price volatility is more desirable in order to limit losses and for a greater profit margin.
- It helps us in paying less taxes as selling the recent most products which are highly-priced reduces profit margins and paying less taxes.
Disadvantages of Using LIFO Inventory Method:
- One of the disadvantages of using the LIFO inventory method is that it is banned by various industry organisations. This is due to the distortion of reported financial numbers.
- This method leads to lesser income as the products sold have the highest value of goods sold. And as such, the profit margin and the income of the business are considerably lower.
3). The Weighted-Average Inventory Cost Method:
The weighted average cost method is another method used to calculate the inventory value. It is done by dividing the cost of a product available for sale by the number of available units of sale. It uses a weighted price by averaging the inventory price of all the purchased goods.
Therefore, the inventory value is determined somewhere in the range between the latest and the oldest price of the product items.
The average costing method is widely used where product lines are mostly identical. Also, it is used in areas where it is impossible to assign specific costs to identical products. This method is considered to be one of the easiest and simple ways to track and calculate inventory costs.
However, this method assumes that the product items are identical. So, it is very difficult to identify the cost of expensive product items when the price fluctuates. Also, the valuation of product items does not bear a perfect relationship with the respective prices paid to suppliers in actuality.
The weighted average inventory method is simple to calculate. It is calculated regardless of the actual cost of each product item. It can be applied to every product item as well. Thus, it provides standardised expenses across multiple product items and several inventory batches. For instance, if a product batch has higher than average waste, the cost is standardised across multiple batches keeping the cost the same for all the items.
However, the weighted average inventory method has some disadvantages. The inventory flow is not matched properly while the expenses are not assigned to the respective products items sold.
Moreover, while considering the net income, the weighted average inventory method provides a lesser amount when compared to the LIFO and the FIFO inventory methods. This reduces the number of future tax benefits and other cash-flow benefits.
The weighted average cost method helps to assign inventory costs by averaging the inventory purchase costs. It uses a non-sequential pattern while calculating the change in inventory costs. This provides a more reliable and steady cost structure when compared to other inventory cost methods.
Any business operation that uses the weighted average cost inventory costing method uses the inventory items sold and assigns it to the costs involved. This is done by calculating the average costs involved in all the inventory items bought. Thereafter, each inventory item is assigned to the above, average cost instead of assigning the cost involved while purchasing them.
Although this method is more accurate in calculating the inventory cost by virtue of its nature, it needs to be recalculated each time a product is added or sold from the inventory.
As we have seen earlier, choosing the right investing costing strategy from among the various inventory methods will depend on several factors. This involves how the business functions and how the industry performs. Moreover, it also depends on how the inventory is to be handled in case of exceptions and on a normal basis. Additionally, inventory costs include the operations related to order processing, and the several key characteristics of the product items will determine the right type of costing strategy for your business. Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.