Inventory Cost Methods: Example And Advantage

Ngoc Lee
Inventory Cost Methods: Example And Advantage
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Inventory cost methods assist businesses in putting a monetary value on their most valuable asset. It is critical to comprehend what inventory is and how to calculate ending inventory. Inventories valuation methodologies assist firms in assigning valuations to inventory, gauging financial success, and identifying possibilities for growth. It is a critical inventory KPI for any company. Here's everything you need to know about the most prevalent inventory costing methods.

What are Costing Methods?

Specific costing methods must be used once the unit cost of inventory has been calculated using the preceding rationale. To put it another way, each unit of inventory will not have the same cost, hence an assumption must be made to keep a systematic approach to costing units on hand (and to units sold). 

Inventory Cost Methods Example And Advantage
 Inventory Cost Methods Example And Advantage (Source: Youtube)

Why Do We Use Inventory Costing Methods?

Inventory value has a direct and significant impact on a company's reported income, cash flow, and overall financial health. Inventory not only takes up a lot of room on the balance sheet, but it also speaks to a company's core ability when it moves smoothly. For instance, inventory days, sell-through rate, and inventory turnover ratio are all factors to consider. If you don't have an exact value given to your inventory, all of your inventory measurements are useless. This necessitates the application and knowledge of inventory costing procedures. You may easily sell your products on a DTC or online marketplace once you've gotten your costs under control and accounted for.

What is FIFO Method Definition?

The first-in-first-out strategy, sometimes known as FIFO inventory costing, posits that the products you buy first are also the goods you use and sell first. For businesses with perishable inventory or short demand cycles, the FIFO inventory method is used. This form of inventory is used by the majority of restaurants and bars.

FIFO Method Example: FIFO Method Step by Step

Let’s take one example of a Coffee Company:

  • Step 1: Assume BlueCart Coffee purchases 50 pounds of green coffee beans for $5 per pound on January 1, 2020.
  • Step 2: Assume they buy 50 pounds of green coffee beans for $6 per pound on March 1, 2020.
  • Step 3: Assume that 50 units have been sold. The ascribed cost of those 50 goods, using the FIFO technique, is $5 per pound. As a result, the COGS is $250.

Following that, the price of the items will increase to $6 per pound.

What is FIFO Method Formula? 

The COGS FIFO technique formula is as follows:

FIFO Method  = Cost of Oldest Inventory per Unit x Inventory Units Sold

If you're utilizing the FIFO approach to calculate COGS, you'll start by calculating the cost of your oldest inventory. Then multiply by the number of goods sold until you reach the total amount purchased at the oldest price. The rest of the inventory sold can then be multiplied by the new price. When you add them all up, you'll have a thorough picture of your COGS.

Pros and Cons of FIFO

Pros of FIFO

  • It's ideal for perishables. By using your products before they expire, you may save waste and shrinkage.
  • It generates a higher net income. You won't have large storage overhead costs if you sell the older products first. You won't have to deal with much depreciation because you'll sell the items before they lose too much value, maximizing bar profits.
  • It's in sync with your supply chain. When employing the FIFO method, it's easier to distinguish between on-hand and in-transit inventory levels. Every item is brought in and taken out in the same sequence. You now have a greater grasp of your inventory, which you may apply to your decision-making.
  • It is widely used. This may seem insignificant, but there's a reason practically every restaurant follows the same procedure. For the industry, FIFO is a no-brainer. Without a lot of training, you can always find accountants or finance people to work for your company.

Cons of FIFO

  • You have to pay more in taxes. In general, prices rise. This suggests that the things you bought first had the lowest price and will have a bigger profit margin when you sell them. You will also have a larger taxable income as a result of this. That is why many utilize LIFO to postpone paying taxes.
  • Your revenue and expenses aren't in sync. Revenue is estimated at current levels, but products sold are accounted for at outmoded pricing.
3 main inventory cost
3 main inventory cost

LIFO Method - LIFO Method Definition?

The LIFO technique, also known as the last-in-first-out approach, is a method of inventory costing that assumes a company's most recently bought goods have been sold first. That is, COGS and the cost of items available for sale are based on the most recent product valuation. The LIFO inventory approach is appropriate for businesses where goods prices fluctuate often. As a result, the newer, more expensive items get used first. This strategy is unlikely to be used in a bar or restaurant.

What is LIFO Method Formula? 

The COGS LIFO technique formula is as follows:

LIFO Method = Cost of Most Recent Inventory per Unit x Inventory Units Sold

Let's look at a LIFO method example to see how the LIFO method formula works.

LIFO Method Example

Consider the Coffee Company mentioned before. Let's utilize the same integers as in the last FIFO example:

  • They buy 50 pounds of green coffee beans for $5 per pound on January 1, 2020.
  • They buy 50 pounds of green coffee beans for $6 per pound on 1/3/2020.
  • Let's say 50 units were sold. The ascribed cost of them is $6 per unit using the LIFO approach. This results in a COGS of $300, which is $50 more than FIFO accounting. This reduces the Coffee Company's profit margins while simultaneously providing a tax advantage.

The LIFO reserve is the $50 difference. With the LIFO approach, it's the amount of taxable income that's delayed.

Pros and Cons of LIFO

Pros of LIFO

  • Non-perishable things work well in this container. These things can sit in warehouses for a long period because they don't lose value or expire. As a result, inventory carrying costs rise, as does inventory shrinkage. Customers may find newer things more appealing.
  • When prices are erratic, this is beneficial. If prices frequently fluctuate, it may be preferable to sell the newer things first. This can help you avoid losses and ensure that your things are returned.
  • You have a smaller tax burden. LIFO adherents sell their most recently purchased, and hence most expensive, products first. As a result, profits and taxable income are reduced.

Cons of LIFO

  • Certain organizations have prohibited or restricted its use. LIFO accounting is prohibited by the International Financial Reporting Standards (IFRS) due to its usage by unethical businesses to falsify reported figures. For the same reason, the GAAP restricts its use.
  • This results in a lesser income. Because products sold under LIFO have the greatest cost of goods sold, the business's profit margin and income are lower.

👉 Read More: LIFO – FIFO Inventory Cost Method: How To Calculate And Example

HIFO Method of Inventory Valuation: Highest In, First Out

The HIFO (highest in, first out) approach of inventory valuation posits that the merchandise with the greatest purchase cost is consumed or removed first. This has the costing connotation that COGS should be as high as possible. While keeping the ending inventory's value as low as possible. This can help to balance a company's books. The HIFO approach isn't often utilized for inventory appraisal. While it reduces taxable income for a short period of time, it isn't considered a best practice. There are two main reasons for this:

  • Because HIFO costing isn't recognized by GAAP, auditors may scrutinize a company that uses it exclusively.
  • Working capital is also reduced as inventory value decreases. When a company tries to borrow money using its assets as collateral, the chances of the loan being approved or the amount borrowed are reduced.

Weighted Average Cost Inventory Method

The weighted average cost inventory technique determines the cost of inventory items by dividing the total COGS by the total number of inventory items. It's also known as the weighted average inventory method or the average cost inventory method. 

WAC Method
WAC Method

Companies can gain an accurate assessment of the cost of items currently available for sale by multiplying the average cost per item by the ending inventory count. The same average cost per item can also be used to calculate COGS for the prior accounting period. Simply multiply it by the number of things sold within that fiscal period.

Example of the Weighted Average Inventory Method

Let’s consider the quarterly inventory ledger of the Coffee Company that we mentioned above.

Purchased On# of ItemsCost/UnitTotal Cost
Total975 $5287.50

Assume the Coffee Company sells 640 units during the quarter. The average cost of each unit is calculated by dividing the entire inventory value by the total number of units sold.

$5,287.50 / 975 = $5.42

The COGS is calculated by multiplying the average unit cost by the number of units sold:

$5.42 x 640 = $3,468.8

And the cost of products available for sale is calculated by multiplying the average unit cost by the ending inventory. That is the 335 units that were not sold.

$5.42 x 335 = $1,815.7

inventory cost
inventory cost

Pros and cons of Weighted Average Cost Inventory Medthod

Pros of Weighted Average Cost Inventory Method

  • The simplest and least expensive method of inventory costing.
  • Beneficial to high-volume businesses or businesses with little fluctuation in their items.
  • Saving businesses time and effort by eliminating the need to track specific items and item kinds. The time saved by employing weighted average inventory costs outweighs the advantage of doing so.

Cons of Weighted Average Cost Inventory Method

The Weighted Average Cost Inventory Method has a disadvantage known as the "smoothing" effect. This effect can potentially distort the actual cost of goods sold and the value of ending inventory, especially in a volatile pricing environment. Under the Weighted Average Cost method, the cost of goods sold and the value of ending inventory are calculated by averaging the costs of all units in stock, regardless of when they were purchased. While this method can provide a relatively stable and predictable cost flow, it may not accurately reflect the current market prices of the goods. This smoothing effect can distort financial ratios, mislead stakeholders, and potentially violate the principle of matching expenses with revenues. As a response to this disadvantage, some companies may opt for more specific inventory costing methods, such as First-In, First-Out (FIFO) or Last-In, First-Out (LIFO), to better align with the actual flow of costs and market prices.

Inventory Replacement Cost Method

The replacement cost of inventory is another approach to value it. The inventory replacement cost technique sets a value based on how much your company will spend to replace that inventory item once it has been sold. This, of course, means that the value allocated changes over time, based on the pricing of the provider at the time of replacement. Along with the quantity of your order, the cost of replacement may be reduced with a MOQ and bulk shipping savings. It is critical to emphasize that the replacement cost should be less than the market value. This is because market value is a forecast, whereas replacement cost is actual money spent that is now locked up in inventory. The other alternative, as previously said, is the market price. This gets us to the lower cost or market criterion in GAAP.

Lower of Cost or Market Rule

What Is the Lower of Cost or Market Rule?

The lower cost or market method or rule provides value to inventory based on the lower acquisition cost or the inventory's current market worth.

Lower of cost or market method
Lower of cost or market method (Source: Investopedia)

When Is the Lower Cost or Market Rule for Inventory Used?

Inventory value fluctuates over time. When the market value of inventory is less than the cost of acquisition, the business suffers a loss. When this occurs, businesses can record the loss using the lowest cost or market. As a result, companies with outmoded inventory prefer the lowest cost or market rule. Long-held inventory often has a lower cost or market value. And the lowest cost or market rule is governed by GAAP.

Lower of Cost or Market Example

Here's how the lower-cost technique works. Consider the Coffee Company once more. Here's what they've got:

Coffee TypeCurrent InventoryUnit CostTotal Inventory CostMarket Value per UnitLower of Cost or Market

It's worth noting that the Excelsa coffee beans have a lower market value per unit than the price at which they were purchased. That's a setback. Companies in this situation are permitted by GAAP to record the inventory value at market value (the lower of the two). As a result, businesses are protected from severe price swings. Consider what would happen if that Coffee Company had to register $2,800 in coffee at the acquired price of $6,300. That disparity would have a significant influence on their balance sheet's soundness.

Is There a Lower Cost or Market Formula?

No, there is no such thing as a lower cost or market formula. The lower cost or market rule is a method of accounting, not necessarily a computation. It assists firms in reducing their recorded losses in a GAAP-compliant manner. You may have guessed by now that inventory management may be as easy or as complex as you want it to be. One thing is certain: it can provide you with a critical picture of your company's health. It might assist to challenge your preconceptions about the strength of your sales by highlighting the cost of products sold and the time it takes to shift various types of stock.

Ngoc LeeNgoc Lee is an Content Creator Manager at EFEX. She wields her long-term expertise in Logistics and Supply Chain, harnessing her top-notch writing and research skills to bring incredibly valuable content. Whether you're a small startup or a well-established enterprise, Ngoc Lee is here to equip you with the essential knowledge of e-commerce, fulfillment, and all things business-related.