Like any company, your business needs the best inventory costing method that works for you. It’s a big decision, and can be difficult to change since the method you choose affects your taxes, bank loans, management/shareholder reporting, and your ability to understand your broad financial picture; more specifically, your profit, costs, and budgets.
Finance employees that come from established companies may be tempted to start with a sophisticated costing method right away. However, the wrong method could hamper your ability to expand, obtain needed capital, and entice investors. That is why it is vitally important to choose the best costing method for your business upfront.
Main considerations for selecting the best inventory costing method
The decision of the best inventory costing method to use can be boiled down to your capacity—specifically the human resources you have available, the amount of historical cost information you have, and what financial and analysis data outputs you want to see in the end.
- How many people can you dedicate to managing your accounting processes? Do your team members wear multiple hats? Or, do you have a defined cost accountant, controller, accounting manager, and CFO? If you have a few people who are responsible for many things, then a method such as FIFO or Average may be easier to manage. If you have established baselines and enough people to manage your system, you may be ready for a costing system such as Standard Cost that will provide visibility into where and how you can optimize your spending.
- Do you have enough historical information on your inventory costs and amounts to determine a solid baseline for what is normal? If you don’t have a good baseline of how much you have, or how much it costs, you could experience wild variances that throw off your accounting. In the absence of historical information that allows you to identify Standard Costs for your items, you may want to select a method that allows for automatic cost capturing, such as FIFO or Average Costing.
- What do you need from your data output at the end? Do you want inventory valuations to fluctuate with the cost of components, labor, etc.? Or do you want to standardize your valuation and be able to analyze variances as costs fluctuate with shifts, such as market changes?
To help you select the best inventory costing method for your business, we have identified some of the pros and cons of each of the three methods: Standard Cost, FIFO, and Average Cost.
The Standard Costing method involves assigning “set”, predetermined costs to your inventory items for valuation. With Standard Costing, any differences between the actual costs and the standard costs will appear as variances, which can be flagged for investigation. We often see this as the costing method of choice for manufacturers because it provides the most feedback to identify areas of optimization in your inventory. However, this method requires more maintenance than other costing methods and takes more people to manage it, such as a designated cost accountant. This method is also trickier to implement and often benefits from engaging an experienced software consultant. Standard costs are great for more established businesses with strong processes already in place and stable inventory levels. For others, it can be cumbersome if there are not enough employees or historical information to maintain the system.
First-in-First Out (FIFO) is a costing method that assumes that your oldest goods are sold first. Companies who need a low-maintenance inventory accounting system that will give them clear views of their actual costs at point of sale, but do not yet have the data to help establish standard costs, may find that FIFO costing is best for their business. We often see this method used in distribution companies where variance analysis is not as necessary.
Like FIFO, Average Cost may be considered easier to implement and maintain than Standard Cost. As the name indicates, the Average Costing method calculates and applies an average product cost. This option is particularly useful if you like to see your costs averaged out over time, rather than using exact actual costs like in FIFO. However, for companies that deal with large purchases, at higher or lower prices, the variance in averages can result in overstating or understating the value of your current inventory.
Best Inventory Costing Method Considerations
Regardless of which inventory costing method you choose, the outcomes should be similar. With the best inventory costing method for your business, you should be able to:
- Run an accurate inventory valuation
- Conduct an internal audit and pass an external audit
- Analyze variances for stronger management of your costs and inventory over time
- Revalue inventory that is not costed correctly
Keep in mind that while it is possible to change your inventory valuation method, it is an arduous and time-intensive process. We recommend putting in the work upfront to identify and implement the right costing method that will last you the lifetime of your ERP. If you truly must make a change, your partner can guide you in planning for and implementing the necessary changes in your ERP. Be aware that you will need to notify the IRS if you deviate from your original costing method.
Always consult a financial professional if you are thinking of changing your costing method and consult a software professional when you are considering a new system. Regardless of who you partner with, spending the time to establish an accurate inventory valuation before implementing a new system will help to ensure an accurate baseline. The information in your new system will depend on it. Armed with this intel, you are hopefully in a better position to choose and implement the best inventory costing method for your business.