Overview
Inventory costing is an integral part of inventory control and inventory management. It helps a business determine its cost of goods sold and eventually in gross profits.
Different inventory costing methods can bring the different cost of goods sold results. Although a business can use any inventory costing method. Certain methods have discrete benefits and limitations.
Let us discuss some key inventory costing methods with examples.
What is Inventory Costing?
Inventory costing refers to assigning costs to the products in inventory. Inventory items can be in the form of raw material, work in progress, or finished goods.
Inventory costing also helps a business in maintaining accurate records of inventory count. Although large businesses can use automated inventory controls, inventory costing is an essential step in calculating the cost of goods sold.
Inventory costing can also affect a business’s tax liabilities. Since inventory costs directly affect the pricing and gross profits of the business.
Inventory costs are major direct expenses for a product. Hence, accurate costing of inventory will directly affect the pricing of the product. Inventory costing can help a business in merchandize valuing to make better costing decisions.
Inventory Costing Methods
A business can use one of the several inventories costing methods available. For companies in the US, the allowed method for inventory costing is FIFO.
Here are the top inventory costing methods.
- First in First Out (FIFO)
- Last in First Out (LIFO)
- Weighted Average Cost
- The Specific Identification Method
Inventory Costing – First in First Out (FIFO)
It is the most widely used inventory costing method. It is also an allowed method for US companies. In this method, inventory purchased first would be used first. In other words, the oldest inventory would be counted first.
FIFO Example
Suppose a company ABC purchases inventory items in different months with different pricing as following.
| Month | Items Purchased | Price Per Unit |
| Month 1 | 200 | $ 100 |
| Month 2 | 300 | $ 130 |
| Month 3 | 300 | $ 150 |
Suppose the company sold 600 items out of the total 800. If the company uses the FIFO method, its COGS costing will be calculated as:
200 × 100 = $ 20,000
300 × 130 = $ 39,000
100 × 150 = $ 15,000
Total COGS = $ 74,000
Whenever the company sells the next items, they will be priced at $ 150 and then the new purchases will continue to roll in. Thus, the oldest available inventory at any stage will be accounted for first in the FIFO method.
Advantages of FIFO Method
The FIFO method comes with several advantages over other inventory costing methods.
- It is the most widely used method for its simplicity and accuracy.
- It reduces the obsolescence of inventory.
- It reduces the impacts of inflation.
- It provides an accurate costing method as it aligns the inventory with cash flow.
Disadvantages of FIFO Method
The FIFO inventory costing method has some limitations as well.
- It results in higher profits that lead to overstated profits at times.
- Higher profits due to the FIFO method can incur a higher tax liability.
- During hyperinflation periods, the FIFO method may not provide accurate costing options.
Inventory Costing – Last in First Out (LIFO)
The LIFO method is the mirror procedure of inventory costing to the FIFO method. LIFO uses the last inventory first and then counts it backward. It means the latest purchased inventory is used first.
LIFO Example
Suppose a company ABC purchases inventory items in different months with different pricing as following.
| Month | Items Purchased | Price Per Unit |
| Month 1 | 400 | $ 100 |
| Month 2 | 300 | $ 130 |
| Month 3 | 300 | $ 150 |
Suppose the company sold 700 items out of the total 1,000. If the company uses the FIFO method, its COGS costing will be calculated as:
300 × 150 = $ 45,000
300 × 130 = $ 39,000
100 × 100 = $ 10,000
Total COGS = $ 94,000
The LIFO method accounts for the latest inventory first. It means the company will record the latest inventory costs first. This method can help a company record accurate inventory costs during inflation times.
Companies in the US can use the LIFO method as well. However, special permission from the IRS will be required to use the LIFO method instead of FIFO.
Advantages of LIFO Method
The LIFO method offers some advantages over other inventory costing methods.
- It avoids overstatement of profits due to the use of the latest costing for inventory.
- It provides an accurate costing method as it matches the latest inventory costs against the recent revenues.
- It can offer a tax advantage as it shows lower profits.
Disadvantages of LIFO Method
The LIFO method has some limitations as well.
- It results in lower income due to higher COGS costs.
- It can understate inventory costs.
- It may not offer accurate ending inventory figures.
Inventory Costing – Average Cost Method
The average cost method is a simple and accurate inventory costing method. It spreads the inventory costs uniformly across all inventory items regardless of the purchase dates.
The average cost method can be useful for companies that have a large number of inventory items.
Average Cost Method Example
Suppose a company ABC purchases inventory items in different months with different pricing as following.
| Month | Items Purchased | Price Per Unit | Cost |
| Month 1 | 400 | $ 150 | $ 60,000 |
| Month 2 | 300 | $ 200 | $ 60,000 |
| Month 3 | 300 | $ 250 | $ 75,000 |
| Total | 1,000 | $ 195,000 |
The average cost per unit for the company is $ 195. Suppose the company sold 800 items out of the total 1,000. If the company uses the FIFO method, its COGS costing will be calculated as:
Total COGS = 800 × 195 = $ 156,000
Advantages of Average Cost Method
The average cost method has several advantages.
- It does not require substantial resources and is the cheapest inventory costing method.
- It provides an accurate and simple inventory costing approach.
- It is a useful tool for companies with a large number of indistinguishable inventory items.
- It controls the income manipulation practices as compared to other methods.
Disadvantages of Average Cost Method
The average cost method has some disadvantages as well.
- It is not suitable for companies that have a continuous flow of inventory items.
- It may require a consistent update on average cost calculations.
- It may not offer suitable ending inventory costs.
- It does not consider the costs of individual units purchased at different times.
The Specific Identification Method
As the name suggests, this method considers the identification of costs related to each item in the inventory. It is a suitable method for companies with a low number of inventory items.
Companies with large inventory items such as in the automobile sector can use the specific identification method.
Example
| Date | Items Number | Cost Per Unit |
| Day 1 | 401 | $ 150,000 |
| Day 2 | 402 | $ 200,000 |
| Day 3 | 403 | $ 250,000 |
Advantages of Specific Identification Method
The advantages of specific identification method include:
- It is a highly accurate method of inventory costing.
- It provides accurate costing, pricing, and profit figures associated with each item.
- It monitors and tracks each item in inventory.
- It can be used easily by companies with large-sized items in inventory.
Disadvantages of Specific Identification Method
Despite several benefits, the specific identification method has the following drawbacks.
- It cannot be implemented for inventory systems with a large number of items.
- It requires significant time and resources to track and monitor each item from inventory purchase to sale.
- If used for large inventory stores, it can be a costly method as compared to other inventory costing methods.
