Different inventory costing methods help companies put a dollar sign on what’s typically their most valuable asset.
It's crucial to understand inventory (see what is inventory) and how to calculate ending inventory.
Inventory valuation methods help businesses assign values to inventory, gauge their financial performance, and identify areas of opportunity. It is a vital inventory KPI for any business.
Here’s all the information you need to get acquainted with the most common, yet different, inventory costing methods.
FIFO Method Accounting
What Is FIFO Method?
The first-in first-out method, or FIFO inventory costing system, assumes that the goods you purchase first are the goods first sold.
The FIFO inventory method is for businesses with perishable stock or short demand cycles. Most restaurants and bars use this inventory system.
Here’s how it works.
FIFO Method Example: FIFO Method Step by Step
Let’s consider BlueCart Coffee Company, a coffee company we made up right now.
Step 1: Imagine that, on 1/1/2020, BlueCart Coffee purchases 50 pounds of green coffee beans for $5 per pound.
Step 2: Now let’s say on 1/3/2020 they purchase 50 more pounds of green coffee beans for $6 per pound.
Step 3: Assume 50 units sell during this period. Using the FIFO method, the assigned cost of those 50 items is $5 per pound. That makes the COGS of the units $250.
After that, the new cost of the items rises to $6 per pound.
FIFO Method Formula
Here’s the FIFO method formula for COGS:
FIFO Method = Cost of Oldest Inventory per Unit x Inventory Units Sold
So if you’re calculating COGS using the FIFO method step by step, you’ll first figure out the cost of your oldest inventory. Then multiply that by the amount of inventory sold up until the total amount acquired at the oldest price. Then you can multiply the rest of the inventory sold by the later price. Adding those together will give you a complete picture of your COGS.
Pros of FIFO:
- Good for perishable items. You can limit waste and shrinkage by using your products before expiration.
- Yields a higher net income. As the older products become the first sold, you won't have high overhead costs of storage. You also won't deal with much depreciation since you sell the products before they lose too much value and maximize bar profitability.
- Matches your flow of goods. It's harder to get confused about on-hand inventory and in transit inventory levels when using the FIFO method. Every item comes in and goes out in the same order. You have a better understanding of your inventory and can use this when making decisions.
- Everyone's using it. This may sound like it's not important, but there's a reason nearly every restaurant does the same thing. FIFO just makes sense for the industry. You can always find accountants or finance people to work for your business without the need for a lot of training.
Cons of FIFO:
- You pay higher taxes. Prices generally increase. This means the earliest purchased goods had the lowest costs and will have a higher margin when you sell them. This also gives you a higher taxable income. That’s why folks use LIFO to defer taxes (more on that below).
- Your revenue and cost don't match. Products sold are accounted for at prices that are obsolete but revenue is calculated at current levels.
This makes accounting slightly more complicated with LIFO. The SEC's Generally Accepted Accounting Principles (GAAP) don't particularly like it.
LIFO Method: What Is LIFO Method?
The LIFO method, or last-in first-out, is a different inventory costing system that assumes a company’s most recently acquired inventory has been sold first. That means COGS and the cost of goods available for sale are based on the valuation of the most recent products.
The LIFO inventory method is for businesses where prices of goods increase often. So the newer, more expensive stock is used first. It’s unlikely to see a bar or restaurant using this method.
LIFO Method Formula
Here’s the LIFO method formula for COGS:
LIFO Method = Cost of Most Recent Inventory per Unit x Inventory Units Sold
Let’s see this system's formula in action with a LIFO method example.
LIFO Method Example
Let’s again consider BlueCart Coffee Company. And let’s use the same numbers we used for the FIFO example above.
On 1/1/2020, they purchase 50 pounds of green coffee beans for $5 per pound.
On 1/3/2020, they purchase 50 more pounds of green coffee beans for $6 per pound.
Now let’s say 50 units sell. Using the LIFO method, the assigned cost of those is $6 per unit. That makes the COGS $300, $50 higher than FIFO accounting. That eats into BlueCart Coffee Company’s profit, but also provides a tax break.
And that $50 difference is the LIFO reserve. It’s the amount that a company’s taxable income is deferred with the LIFO system.
Pros of LIFO:
- Good for non-perishable items. Since they don't diminish in value or expire, these types of items can sit in warehousing for some time. That increases inventory carrying cost and even inventory shrinkage. Newer items may also be more desirable by customers.
- Good when prices are volatile. If prices often fluctuate, selling the newer items first may be desirable. This will limit losses and ensure a return on your goods.
- You pay lower taxes. Adherents to LIFO sell their most recently purchased goods first, which are also the highest priced. This results in lower profits and lower taxable income.
Cons of LIFO:
- Banned or restricted by certain organizations. The International Financial Reporting Standards (IFRS) bans the use of LIFO accounting due to its use by unscrupulous businesses to distort reported numbers. The GAAP also restricts its use for the same reason.
- Leads to lower income. Since products sold under LIFO have the highest cost of goods sold, the profit margin and income for the business is lower.
Now let's look at FIFO and LIFO's lesser-known sibling, HIFO.
HIFO Method of Inventory Valuation: Highest In, First Out
Highest in, first out (HIFO method of inventory valuation) assumes that the inventory with the highest purchase cost is used or taken out of stock first. The costing implication of this is that COGS is as high as possible, while the valuation of the ending inventory is as low as possible. That can smooth a company’s balance sheet.
The HIFO method of inventory valuation is rather different, specific, and isn’t commonly used. While it works to decrease taxable income for a period of time, it’s generally not seen as a best practice.
Why not? Two primary reasons:
It’s not recognized by the GAAP, so a business using solely HIFO costing can come under scrutiny from auditors. And working capital reduces with lower inventory value. If a business is attempting to leverage their assets for a loan, this decreases the chances of loan approval or loan amount.
Weighted Average Cost Inventory Method
The weighted average cost inventory method is assigning costs to inventory items based on the total COGS divided by the total number of inventory items. It’s also known as the average cost inventory method or weighted average inventory system.
By multiplying the average cost per item by the ending inventory count, companies get an accurate estimate of the cost of goods currently available for sale.
And that same average cost per item can be used to determine the previous accounting period’s COGS, too. Just multiply it by the number of items sold in that accounting period.
Weighted Average Inventory Method: Specific Example
Let’s consider the quarterly inventory ledger of BlueCart Coffee Company.
Let’s also say BlueCart Coffee Company sold 540 units throughout the quarter.
The average cost of each unit is the total inventory value divided by the total number of units sold.
$4,287.50 / 775 = $5.53
The COGS is that average unit cost multiplied by the number of units sold:
$5.53 x 540 = $2,986.2
And the cost of goods available for sale is that average unit cost multiplied by the ending inventory. Which is the 235 units that didn’t sell.
$5.53 x 235 = $1,299.55
The weighted average inventory costing method is beautiful in its simplicity.
Average Cost Inventory Method Benefits
The average cost method is widely considered the easiest, least-expensive inventory costing system. The weighted average inventory method particularly benefits high-volume companies or companies without much variation among their stock. It relieves companies of the need to spend bunches of time and effort tracking individual items and item types. The benefit of doing so pales in comparison to the time saved using weighted average inventory costing.
Inventory Replacement Cost Method
Another way to understand inventory is that inventory’s replacement cost. The inventory replacement cost method assigns value based on the amount your business will spend to replace inventory units after sale.
This, of course, means that the value assigned changes over time depending on supplier pricing at the time of replacement. Along with the size of your order, since replacement cost may go down with an MOQ (what does MOQ mean?) and bulk shipping discounts.
What’s important to note is that the replacement cost should be lower than market value. That’s because market value is a prediction, while replacement cost is actual money spent and now tied up in inventory.
The other option, as we’ve mentioned, is market price. That brings us to the GAAP’s lower of cost or market rule.
Lower of Cost or Market Rule
What Is the Lower of Cost or Market Rule?
The lower of cost or market method or rule assigns value to inventory at either the price it cost to acquire the inventory or the inventory’s current market value.
When Is the Lower of Cost or Market Rule for Inventory Used?
The value of inventory shifts over time. Sometimes the market's appreciation of inventory is less than the cost paid to acquire it, and the business experiences a loss.
When that happens, companies can use the lower of cost or market method to record the loss. That’s why businesses with obsolete inventories favor the lower of cost or market rule.
Lower of cost or market is typically for long-held inventory. And the lower of cost or market rule is under the GAAP framework.
Lower of Cost or Market Example
Here’s how the lower of cost or market method works. Let’s imagine again BlueCart Coffee Company. Here’s their ledger:
Notice that the Excelsa coffee beans have a lower market value per unit than the cost acquired for. That’s a loss.
GAAP allows for companies that experience situations like this to record the inventory value at the market value (the lower of the two). Doing so protects businesses from large fluctuations in price.
Imagine if BlueCart Coffee Company had to record $3,600 worth of coffee at the acquired price, $8,100. That discrepancy that would impact the health of their balance sheet big time.
Is There a Lower of Cost or Market Formula?
No, there isn’t a lower of cost or market formula. The lower of cost or market rule is a specific method of accounting, not a calculation, necessarily. It helps businesses lower their recorded losses in a GAAP-sanctioned method.
Frequently Asked Questions About Inventory Costing Methods
Here are some common questions about inventory costing methods.
What are the 4 Inventory Cost Methods?
The four inventory cost methods and types of inventory valuation include the following:
- HIFO method of inventory valuation
- FIFO inventory costing method
- Weighted average cost method
- LIFO method of inventory costing
What are the 5 Types of Inventory?
The five types of inventory include:
- Finished goods inventory
- Raw material inventory
- MRO inventory
- Work In Progress inventory
- Decoupling inventory
What is the 80 20 Rule in Inventory?
The 80/20 rule states that 80% of outcomes come from 20% of efforts, consumers, or other units of measurement. According to the rule when it comes to inventory, businesses can expect to make 80% of their profits from 20% of their inventory.
Why Use Inventory Costing Methods?
The value of a company’s inventory directly and substantially impacts their reported income, cash flow, and general financial health.
Not only does inventory take up a lot of space on the balance sheet, but the smooth movement of inventory speaks to a company’s fundamental competence. Things like inventory days, sell through rate, and inventory turnover ratio, for example. You'll need the inventory turnover formula to calculate turnover.
All the inventory metrics in the world don’t mean a thing if you don’t have an accurate value assigned to your inventory. And that requires use and mastery of inventory costing methods.
Once you've got your costs under control and accounted for, you can start selling your products on a DTC or online marketplace with ease.