What Is Inventory Costing And How To Do It?
Inventory or stock is one of the essential items for business. Inventory consists of all those items and materials bought to be resold. Inventory can be divided into three categories which are as below:
Raw Materials: Materials in raw forms that are required to be processed.
In-Progress Goods: These are the goods in the process of completion.
Fished Goods: Goods that are fully completed and readily available to be sold.
Product-oriented businesses should show special consideration for inventory management. Mainly businesses like manufacturers and retailers often have to deal with inventory-related matters.
As we know, inventory is a revenue-generating item treated as a business asset. In addition, inventory is a current asset, which means its period is shorter than one year, and it can be converted into cash. As inventory is a current asset, it is also used in calculating profit and loss and is also stated in a business's balance sheet.
It is an obligation and necessary for businesses to show the actual value of assets in their books and financial statements. According to financial practices, the value of an asset should not be overstated, and a business or a firm needs to ensure that the value of an asset stated in the financial statement should be close to real value.
We have inventory costing methods to ensure that a business or a firm reflects the real value of stock in financial statements. Inventory costing is the process of assigning a cost to inventory items or the whole inventory. There are four main types of inventory costing methods, but before we look into these, let's look at the cost linked with the inventory.
As we know, inventory is one of the essential current assets and the primary source of revenue generation for a business. Still, there is some cost related to it. So what is the cost related to or results in inventory management? Let's have a look at these costs and expenses.
Direct Material Cost
Direct Material consists of those physical goods that are bought by the business. These goods are expenses for the business as the business purchases them. These goods are used to produce finished goods. The cost incurred by a business in transforming raw materials into finished goods is called direct material cost.
Factory expenses consist of all the expenses incurred by a business due to the operational activities in the factory. These expenses are one of the major inventory-induced costs. Several expenses are included in the factory expenses.
Factory Labour Salary
Equipment Installations Expenses
Depreciation of the Factory's Machinery
Carriage or Freight Cost
Carriage In or Freight In is the cost incurred by a business as they bring the raw materials into the factory or warehouse. This is a transportation cost. It is also stated in retail or manufacturing businesses' profit and loss statements.
Various other costs are incurred when dealing with inventory. However, these costs are mainly incurred in picking, packaging, and shipment.
Three Inventory Costing Methods
As we know, there is special consideration put the inventory costing, which should highlight the real value in the business's financial statements. There are a few methods through which inventory costing can be done that could make the inventory costing method more transparent.
Mainly there is five inventory costing methods practiced by a business. Some comply with GAAP (Generally Accepted Accounting Principles), while others do not. We will look through each inventory costing method and tell you which is suitable for what type of business.
1. FIFO (First In, First Out)
This is one of the most commonly used inventory costing methods businesses use. The major reason why it is mostly preferred is that it complies with GAAP. In addition, the FIFO principle states that the inventory brought to business should be sold first. This principle sounds logical, too, as goods bought for resale are produced by a firm are the ones that should be dispatched first.
The calculation of FIFO is simple and can be done easily. An example is shown below:
Suppose a business Highbury Ltd bought 100 chairs worth $70 each in January. In February, they bought 200 chairs worth $75 each, and in March, they bought 150 chairs worth $80 each.
Throughout the year, 150 chairs are sold. Suppose the accountant of Highbury Ltd is calculating closing inventory and cost of goods sold using the FIFO method. In that case, he will do the following:
Closing Inventory (Unsold Goods): 150$75 + 150 $80 =$ 23,250
Cost of Goods Sold: 100$70 +50 75 =$10,750
Pros of Using FIFO
One of the most significant benefits of using FIFO is that it leads to higher profit valuation in the financial statements of a business. In addition, FIFO is also an easy-to-calculate and more practical inventory costing method.
Another advantage of using FIFO is that it complies with the inventory costing method permissible by GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards). The legitimacy of FIFO can't be questioned.
Cons of Using FIFO
One of the significant downsides of using FIFO is that it leads to higher profit valuation and more income on paper, which results in more taxation charges. As a firm earns more, it is bound to pay more in taxes.
Businesses that use FIFO
FIFO, as an inventory costing method, is mainly practiced in those related to the retail industry. Those businesses that have to put special consideration on expiry dates and businesses that deal with perishable items. These businesses include supermarkets and grocery retailers. Also, one thing essential to be mentioned here is that nearly 50% of the S&P 500 firms use FIFO as the primary inventory costing method, as per the report of Credit Suisse Group AG.
2. LIFO (Last In, First Out)
LIFO is one of the less commonly used inventory costing methods. Comparatively to FIFO. LIFO is less prevalent. The principle followed in this inventory costing method is that the latest additions are to be sold or shipped first. LIFO doesn't comply with GAAP, which is why most companies don't practice this inventory costing method.
LIFO is generally used during inflation when the cost of goods constantly rises. As the cost of goods rises, it becomes logical to appreciate the value of the cost of goods sold to show the actual value of profits earned.
The calculation for the LIFO method can be shown in an example below:
Suppose a business Spades Ltd. bought 100 tables at $80 in April. In May, they bought 120 tables for $90. And in June, they bought 130 tables for $110.
Throughout the year, 230 tables were sold. Therefore, if the accountant of Spades Ltd is calculating the cost of goods sold and closing the inventory using the LIFO method, the calculations would appear like this.
Closing Inventory (Unsold Goods): 120 $80= $9,600
Cost of Goods Sold: 230110=$25,300
Pros of Using LIFO
Any person would wonder why a business would use LIFO as this inventory costing method would reduce profits on paper. However, as LIFO understates the profit, this gives businesses a significant advantage, as there would be less or no profit businesses can enjoy tax breaks.
There is also another advantage a business could avail of using LIFO. At the time of recession and deflation, the cost of goods sold would decrease, resulting in higher profits; as the shareholders see higher profits during the deflation time, their firm reliability increases, resulting in more investments.
Cons of Using LIFO
The use of LIFO as an inventory costing method comes with three main disadvantages. The first is that LIFO is not by GAAP. As LIFO doesn't comply with GAAP, its legitimacy is often subject to question. Second, LIFO doesn't comply with IFRS (International Financial Reporting Standards).
The second disadvantage of using LIFO is as the profit needs to be more accurate in the Balance Sheet and other relevant financial statements, which leads to shareholders' dissatisfaction. As the profit appears less than expected, shareholder reliability in the firm's management decreases. As the shareholders are dissatisfied, this could result in a decrease in investments.
The third disadvantage a business could face using the LIFO method is that it is often complex to understand and calculate. As it is complex, this could result in time-consuming calculations of inventory.
Businesses that Use LIFO
LFIOs are practiced in renowned businesses such as automotive, petroleum-producing, and pharmaceutical-based companies. As per the report of Credit Suisse Group AG, LIFO is practiced by 15% of S&P 500 companies.
3. WAC (Weighted Average Cost)
Weighted Average Cost, or WAC, is the most different inventory costing method. This is a method that follows the principle of dividing the cost of goods available to each of the items available in the inventory. WAC states the same cost for each time of inventory unit rather than assigns the oldest or newest inventory cost used in FIFO and LIFO.
The calculation of WAC can be understood by seeing the example below:
Suppose a business names Knight Bridge Ltd bought 120 ladders at $150 in July. In August, they bought 150 ladders at $200, and in September, they bought 200 ladders at $250.
Throughout the year, 350 ladders were sold. Now, if the accountant of Knight Bridge Ltd is calculating the Weighted Average Cost, the calculation would appear as follows:
- Average Cost Per Unit: 120 $150 + 150 $200 + 200$250 470
- Average Cost per Unit: $208.5 per unit
- Closing Inventory: $208.5 per unit 120 = 25,020
Pros of Using WAC
One of the major benefits of using WAC is that the calculation process is fast. As there are no complex steps in the calculation, this speeds up the inventory calculation process. Besides this, the process of WAC is comparatively easier than LIFO and FIFO.
The visibility of real-time inventory valuation also enhances the usage of WAC. A quick overview of profits and the cost of goods sold could also be obtained using WAC as an inventory costing method.
Cons of Using WAC
One of the most significant disadvantages of using WAC is that the actual cost can't be assigned to the respective items. There are different costs for different items, so it is illogical to add certain costs to every item.
One of the major that a business could face using this inventory costing method is that if the number of purchased items in the inventory count is high, the calculation process could be time-consuming.
Businesses that use WAC
The businesses that use the WAC inventory costing mainly consist of manufacturing businesses. If we talk about specific industries in which WAC is practiced, then we have an agrarian business that most uses WAC.
We have gone through a detailed understanding of the most commonly used inventory methods. We hope that you have learned everything about inventory costing. What sort of inventory costing method you will use depends on several factors. These factors mainly include the industry your business operates in, what size of your business's scale of operations, how much inventory is purchased, and lastly, what economic period your business is operating.
No matter what sort of inventory costing method your business uses, to ensure that the calculations are accurate and error-free, you have to use the right tools. These right tools are accounting softwares that can help you gain accurate results for the financial calculation.
ZarMoney is one of the prime accounting software that can help businesses in any accounting calculation. Businesses worldwide use this accounting software for all their financial calculations, so why wouldn't you use it? Like other businesses, integrate ZarMoney into your financial management, and cut the need for expensive accountants.