Inventory: Understanding Costing Methods
Monitoring your inventory life cycle has an impact on your general ledger, making it important to understand how costing methods affect your profits and losses. Cost accounting may seem confusing, but it doesn’t have to be if you understand the different methods of valuing your cost of goods. Let me break down the four typical costing methods that most businesses use:
FIFO – First In, First Out
LIFO – Last In, First Out
Average costing
Standard costing
Let’s talk first about FIFO (First In, First Out). In FIFO, the earliest purchase price is assigned to inventory items when they are sold.
Let’s say we own a nursery, and we purchase 12 willow trees at $12.00 each on Thursday. We then purchase 12 additional willow trees at $10.00 each on Friday. The total value of our 24 willow trees in inventory is now $264.00 ((12 x $12.00) + (12 x $10.00).
On Saturday, we sell 2 willow trees to a customer. Using FIFO, these 2 trees would be valued at $12.00 each because that was the earliest purchase price. So, the Cost of Goods Sold for this sale is $24.00, and now the value of our 22 willow trees in inventory is $240.00 ($264.00 - $24.00).
Companies providing goods with a limited lifespan will use the FIFO costing method because you would want to sell the oldest goods in your inventory first.
FIFO - First In, First Out
Next, we will look at the LIFO (Last In, First Out) costing method. In LIFO, the most recent purchase price is assigned to inventory items when they are sold.
Using the same example from above, if we were using the LIFO costing method, the 2 trees we sold on Saturday would be valued at $10.00 each because that was the most recent purchase price. So, the Cost of Goods Sold for this sale is $20.00, and now the value of our 22 willow trees in inventory is $244.00 ($264.00 - $20.00).
Companies using the LIFO method may require large inventories to have in stock and give you a more accurate P&L report, particularly during inflationary economic periods.
LIFO - Last In, First Out
Now, let’s take a look at the Average Costing method. When using Average Costing, the average purchase price of the inventory in stock is assigned to inventory items when they are sold.
In keeping with the same example, when we sell the 2 willow trees on Saturday, they would be valued at $11.00 using the Average costing method ($264.00 / 24 trees). So, the Cost of Goods Sold for this sale is $22.00, and now the value of our 22 willow trees in inventory is $242.00 ($264.00 - $22.00).
The average costing method is the most widely used method for valuing inventory because it is the simplest to calculate and is not sensitive to market fluctuations.
Average Costing Method
Lastly, we will talk about Standard Costing. When using Standard Costing, a defined standard cost is assigned when purchasing and selling the inventory, and any variations in the actual purchase price are journaled as purchase price variances.
Our example from above looks slightly different with Standard Costing than with the other methods. Let’s assume that the standard cost of the willow tree is set to $11.50. If we purchase 12 willow trees at $12.00 each on Thursday and then 12 additional willow trees at $10.00 each on Friday, the total value of our 24 willow trees in inventory is $276.00 ($11.50 x 24 trees). This is because the trees are added to inventory at the Standard cost regardless of the purchase price, and the difference is classified as a purchase price variance.
We can calculate the purchase price variance to post for the Willow trees as follows:
Thursday (12 x $12.00) – (12 x $11.50) = $144 - $138 = $6.00 PPV
Friday (12 x $10.00) – (12 x $11.50) = $120 - $138 = ($18.00) PPV
When we sell 2 willow trees on Saturday, using the Standard Costing method, the trees would be valued at $11.50 because that is the defined standard cost. So, the Cost of Goods Sold for this sale is $23.00, and now the value of our 22 willow trees in inventory is $253.00 ($276.00 - $23.00).
The Standard costing method is best when you need to set a baseline, which is especially useful in setting target costs to compare them with actual costs; this is typically used in manufacturing.
Standard Costing Method
