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.
What to Consider When Selecting an 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.
1. 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.
2. 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.
3. 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.
Standard Cost Method
What is Standard Costing?
The Standard Costing method does not use historical cost to build inventory value or determine cost of goods sold, but instead 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.
Standard Inventory Costing Example
For example, if a company purchases sunglasses on the following days:
If a pair of sunglasses is sold on 5/1/2021 the Standard Cost method would remove the item from inventory at standard cost: $105.00. This would bring the inventory balance to $315.00 and the cost of goods sold would be reported as $105.00 on the income statement.
The standard costing method is often preferred by manufacturing companies because manufacturing environments are rigid and expected costs are planned. Management needs to closely monitor any deviations from the planned cost so efficiencies can be identified and leveraged, and inefficiencies can be found and corrected.
Standard Costing Pros and Cons
Table by Silverware, Inc.
|Revaluing Standard Costs at the Item Level is relatively simple to do at the item level.||Involves more up-front planning and analysis to implement accurate initial standard costs.|
|Variances in production and purchasing are broken out for ease of understanding.||Can be more expensive to implement due to additional employees, time, etc.|
|Improved cost controls as the costs a re set internally.||Requires strong undestanding of processes and cost allocations to avoid large variances.|
|Variances analysis of costs will allow you to analyze your costs and understand where costs can be reduced.||Items may be valued incorrectly if the standard costs are understated or overstated and not well maintained.|
|Budgeting becomes an easier process with consistent costs.|
FIFO Cost Method
What is FIFO Inventory Costing?
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. For example, if a company purchases sunglasses on the following days:
The company would report an inventory on the balance sheet for $423.
FIFO Inventory Costing Method Example
If a pair of sunglasses is purchased on 5/1/2021, the FIFO method would assume the sunglasses purchased on 4/6/2021 should be removed from inventory because they were the first to be purchased. This would bring the inventory balance to $323 and the cost of goods sold would be reported as $100 on the income statement.
FIFO is a realistic way to report inventory value because most companies will try to sell their oldest products first to reduce the risk of the item becoming obsolete. Ultimately, the company has little control over which specific pair of sunglasses a customer selects from the rack and the cost of the item is based on an assumption.
FIFO and Inflation/Deflation
When there is inflation, FIFO will allow companies to report a higher inventory value and higher net income. This is because the items which were purchased first at the lower cost would be removed from inventory first, thus the higher value items would be held on the balance sheet. In addition, the lower cost items would increase the profit margin of the item being sold when it is reported as cost of goods sold on the income statement.
However, if there is rapid inflation, FIFO may cause a company to incorrectly budget for upcoming periods if the accountants are analyzing historical costs to determine how much to allocate to each department.
When there is deflation, FIFO will allow companies to report a lower inventory and lower net income. This is because the newer items being brought in will have a lower cost while the higher valued items will leave inventory first. Thus, the lower valued items will be held on the balance sheet while the higher valued items will be reported as cost of goods sold on the income statement, decreasing the profit margin.
FIFO Costing Pros and Cons
Table by Silverware, Inc.
|Easy to apply and utilize immediately as costs are recorded at actual cost.||Periods of high or low-price fluctuations can cause severely overstated or understated inventory valuations.|
|Valuation of inventory based on the age of the inventory that is held.||Cost of Goods Sold may trend behind current prices/costs as older inventory is sold.|
|Widely used and acceptable costing method.||Decision making is more challenging without clear view of production variances.|
|Easy to understand and see the inventory costs sold at the point of sale.||Budgeting becomes much more challenging to control and maintain as inventory costs are constantly changing.|
Average Cost Method
What is Average Costing?
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.
The Average Costing Method assumes that the cost inventory is sold at the average amount it was purchased for during the period. For example, if a company purchases sunglasses on the following days:
The company would report an inventory on the balance sheet for $423.
Average Cost Inventory Method Example
If a pair of sunglasses is sold on 5/1/2021, the Average Cost method would assume the sunglasses purchased on 4/6/2021 should be removed from inventory at a cost of $105.75 because that is the average of the inventory on hand ($423 divided by 4). This would bring the inventory balance to $317.25 and the cost of goods sold would be reported as $105.75 on the income statement.
The average costing method is considered to be a fair way to value inventory because it looks at current inventory as a whole and the influence of inflation/deflation isn’t as apparent as in a costing method such as FIFO.
Average Costing Pros and Cons
Table by Silverware, Inc.
|Adjusts to random periods of high or low-price fluctuations as it averages out.||If large lots of inventory are purchased during times when costs are higher or lower than average, this can result in overstated or understated inventory valuations for current inventory.|
|Easy to apply and utilize immediately as the unit costs are averaged.||Decision making can be more difficult without clear view of production variances.|
|Can be the most difficult method for which to correct any costing “mistakes” as the impact of every costing adjustment can affect many inventory entries since they are all averaged together to establish the cost.|
Final Thoughts on Inventory Costing Methods
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
Avoid Changing Costing Methods
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.
Talk to a Professional
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.