Inventory Costing Methods

One of the first decisions you'll have to make related to Inventory Software will be deciding which costing method you will use. You should make this decision before you even commit to specific software because not all software offers all options.

I'm going to focus on explaining the most common costing methods used. This would include Average Cost, FIFO (First-in-First-Out), LIFO (Last-in-First-Out), and Standard Cost.

Global setting versus item-based.

Some inventory software has the Inventory Costing method set up as a Global variable, meaning you set it in one place, and it applies to all items. Other software may allow you to set up inventory costing methods by item, though it's unlikely you would actually do this. When both settings are available (Global and item-based), the item-based setting will typically override the global setting.

Average Cost

Average Cost is rather easy to understand, though there sometimes is some confusion about what actually gets averaged. Average cost gets calculated/recalculated every time an item is received into inventory.
In the following example, we currently had 30 units at $10 per unit in stock. That gave us a total inventory value of $300 dollars. We then had a new receipt of 50 units at $11 per unit for a total receipt value of $550 dollars. We need to add the values of all inventory ($300 plus $550) to get a total inventory value of $850. Then divide that by the total units of inventory (80 units) to get a new average cost of $10.63 per unit. Note this is not the average of the base costs per unit ($10 and $11), but rather the average of the total value divided by the total units. This is why it's sometimes referred to as Weighted Average Costing, but that can be confusing because other calculations use weighted averages that are a very different calculation.

Average Cost Calculation

This calculation is very simple because you don't need to maintain any old data related to receipts. All you need is the current average cost and the costs associated with the new receipt. Once average cost is recalculated, you no longer need the old average cost or the cost of the receipt. The average cost is the cost that will be applied to COGS when you sell something, regardless of which units you actually sell.

FIFO and LIFO

FIFO and LIFO are two costs that assume an association between costs and the actual units sold/consumed. Note these are purely for accounting purposes and don't mean that you need to ship the units based on the costing method. For example, if you use Last-In-First-Out, it does not mean you need to actually ship your newest inventory first.

The choice between FIFO and LIFO is a financial decision that has many implications. In times of rising costs (typical), LIFO will result in higher COGS, lower Profits, and lower inventory investment. This will generally mean lower tax exposure. And this is why the IRS doesn't like companies switching costing methods each year. You need to choose one and live with it. In fact, there are additional limitations on what you can do with your financial reporting if you use LIFO. So if you're going to use LIFO, make sure you know what you're getting into.

FIFO

Calculating FIFO requires your inventory system to track quantities and dates associated with certain costs. In the following example, we had 3 separate receipts of 50 units at different costs. We then sold 90 units, which would result in all 50 units from the first receipt and 40 of the 50 units from the 2nd receipt. That results in $940 being applied to COGS, and leaves us with an ending inventory of 60 units with a value of $710. The next 10 units sold will be sold at $11, then the next sales will use the inventory at $12.

FIFO Calculation

You can see that this requires the inventory system to track the dates and costs associated with the inventory units until the entire quantity associated with that date is consumed or sold.

LIFO

LIFO is where things can get a little funky.

Here we'll use the same example as we used with LIFO. However, the sale of 90 consumed the newest inventory first, which resulted in 50 units from the 3rd receipt and 40 units from the 2nd receipt. That applied a COGS of $1.040 and gave us an ending inventory value of $610. So we ended up with $100 more in COGS (expense account) and $100 less in our inventory account compared to FIFO.

LIFO Calculation

The funky part is that under certain circumstances, you can end up with units on the books at very old costs. For example, if you never ran your inventory down to zero, you could have inventory from that first receipt on the books 10 years from now. And then, if you sold it, it would register that old cost of $10 per unit, even though your current cost would likely be significantly more than that.

Standard Cost.

Standard Cost is a "Fixed Cost". Meaning it doesn't change when you get new inventory at a different cost. It's popular with manufacturers that don't like the cost of their manufactured items changing every time the cost of a component changes. It also prevents your costs from going haywire when a production worker accidentally enters an incorrect quantity or time in a production-reporting program.

The problem with Standard Cost is that it requires more work. When the cost of the manufactured item is frozen, WIP variances are created whenever you have a cost change of one or more of the components. And you occasionally need to do a "Cost Rollup" to recalculate your standard cost based on the costs of components, labor, and machinery. The Cost Rollup can be a big process since you will need to review cost inputs if you have a perceived problem with the rolled-up cost. Cost inputs would include component costs, BOM setup, Costs and Quantities on Routings, including labor costs, run quantities, and setup times. And that leads to the arguments between Accounting/Marketing, which believe the costs and times are inflated in the routings, and manufacturing, which believe them to be correct.

I describe Standard Cost in reference to manufactured items because that is where it is frequently used, but it can also be used for purchased goods. Especially if you want greater control over how landed costs are applied.