Inventory Costing Methods: Types, Formula and Examples
What is inventory costing?
Inventory costing is essentially when you assign a cost to stock. Think about it this way: You’re giving a numerical value to your inventory. Inventory costing is also commonly referred to as inventory valuation.
But inventory costing goes deeper than that simple definition. First, let’s look at the concept of accounting to first understand the general principles. Then we’ll dive into accounting in inventory costing methods specifically as it relates to ecommerce and retail.
Cost accounting is when a business collects and analyzes data associated with cash flow and assets to determine how much a company possesses, represented as a monetary value even if not all of the assets are cash. In retail and ecommerce, cost accounting will almost certainly include the value of inventory.
Retailers use inventory costing to determine how much stock costs before a sale is made. This includes expenses like freight-in and production.
Inventory costing generally does NOT include expenses accrued after a sale is made. For example, future carrying, insurance, and interest costs are left out, as well as freight-out and other expenses related to fulfillment.
Businesses use this metric to calculate cost of goods sold (COGS) at the end of the year. The COGS is calculated with the following formula:
COGS = beginning inventory + purchases – ending inventory
Inventory costing comes into play when determining the beginning inventory (inventory at the start of an accounting period) and the ending inventory (inventory stock at year’s end) values for the COGS formula.
Inventory cost formula: How to calculate
The inventory cost formula is a multi-step process, and it requires a bit of working backwards from COGS and a few other formulas and metrics. The way to calculate inventory cost also depends on which method you use. There are four inventory costing methods:
- Specific identification
- First in, first out
- Last in, last out
- Weighted average
The Internal Revenue Service (IRS) also sets standards that U.S.-based businesses must adhere to, and there are guidelines set forth for other countries as well. These regulations may inform, and should influence, the inventory costing method you move forward with.
Example of inventory costing method
Before we dive into each of the inventory allocation methods, let’s first set the stage with an example:
You’re in the business of tote bags. You have a new line of zebra tote bags. For the first shipment, you ordered 1,000 units from your manufacturer for $5 each. You also had to pay $250 in shipping, which meant a $5,250 total investment — or $5.25 per tote bags. 500 units sold extremely quickly, so you ordered another 2,000 units for $5 each, and the shipping remained the same. This time the investment was $10,250 — or ~$5.13 per tote bag.
At the end of the period, you find yourself with 250 units left. How do you know much YOU paid for each of these totes, and what they should be valued at?
Types of inventory costing methods
The specific identification method of inventory costing is when each individual product is assigned an identification and unit cost. That amount is then applied to the accounting records when the item is sold.
The unit cost for each unit may vary with the specific identification method, as true COGS may fluctuate as production, shipping, and related costs often change over time.
As you might imagine, specific identification requires very diligent and detail-oriented record keeping — something that would be nearly impossible without inventory management software.
That’s why companies that sell fewer, but more expensive, products are most suited to this method: cars, fine jewelry, boats, artwork, etc.
In our tote example, each of the 3,000 units would have a unique identifier, along with the associated cost. You’d look at the sales data and determine exactly which 2,750 units sold, which order they came from, and how much it cost you. (You can see why this isn’t commonly used in high-volume sales.)
First in, first out (FIFO)
The first in, first out or FIFO inventory accounting method assumes that the first unit a business purchases for its inventory is also the first unit sold to a customer. Therefore, it associates the COGS with the oldest available stock. This may or may not be the way a retailer actually moves stock.
The U.S. Generally Accepted Accounting Principles (GAAP), (the accounting standard of the Securities and Exchange Commission (SEC)), and the International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB) both accept the FIFO method. This makes it a nice choice for brands selling internationally or considering overseas expansion.
Going back to our example, the first 1,000 totes that were purchased cost $5.25 each, whereas the most-recently purchased 2,000 units were $5.13 each. With FIFO, you’d assume that you sold ALL of those 1,000 totes from the first order, plus 1,750 from the second order. The 250 that remain come from the second order.
5.13 * 250 = 1,282.5
So the value of your stock would be $1,282.50.
Last in, first out (LIFO)
Last in, first out or LIFO is, predictably, the opposite of FIFO. Rather than assuming the oldest-sitting units are sold first, LIFO assumes that the most recently acquired items are the first to ship out.
Again, this may or may not reflect the actual flow stock. Companies that have perishable products, such as food or some cosmetics, would definitely NOT follow this system.
Bookkeeping can get a bit tricky with LIFO. Because the COGS are higher, it leads to lower profit margins, which also means lower income taxes. While the U.S.’s GAAP accepts LIFO, the IFRS does not consider LIFO an approved accounting method.
Example time: Instead of the 250 units left being from your second order, LIFO would allocate them to the first order. Those items had a unit cost of $5.25 (compared to the unit cost of $5.13).
5.25 * 250 = 1,312.5
The value of your stock would be $1,312.50.
The weighted average, or average cost inventory method, falls in the middle of FIFO and LIFO. Rather than using the oldest- or newest-recorded prices, this method takes an average unit cost to calculate COGS.
Again, let’s look at an example: Recall that you purchased 3,000 total units of zebra print totes packs. 1,000 of those had a unit cost of $5.25, whereas 2,000 cost $5.13. One-third of your stock had a unit price of $5.25, and two-thirds were $5.13. To calculate the weighted average, we’d do the following:
(5.25 * 1,000) + (5.13 * 2,000) / 3,000 = 5.17
The average unit cost is $5.17.
5.17 * 250 = 1,292.5
The value of your stock would be $1,292.50.
What are the types of inventory accounting methods?
The periodic inventory system and the perpetual inventory system are two common approaches to determining how much inventory you have on hand, and how much it costs.
Periodic inventory system
When it comes to inventory costing methods, the periodic system looks at the data periodically. In other words, rather than immediately updating your records when a sale is made or a shipment comes in, it will update this data over different time periods.
If you use the periodic inventory method, you’ll need to conduct physical counts to inform the system of how much stock you have.
Perpetual inventory system
The perpetual inventory system is a much more comprehensive way of keeping track of stock. Rather than periodic updates, data is updated continually and in real-time. This keeps a running record of your inventory, rather than periodic updates. The perpetual method also accounts for freight-in costs, which the periodic system does not.
Which inventory costing method is best?
The answer to which inventory costing method is best isn’t always straightforward. Just like customers have varied needs, brands have different needs.
The important takeaway here is to make sure you’re always within legal and tax compliance, both where your business is operating and where your customers are located. It’s always best to talk to an accredited tax professional about your specific situation so that your unique business needs are met.