Inventory costing methods: a guide to higher profits

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For any business to be successful and lucrative, it’s crucial for ecommerce sellers to know how to effectively manage inventory – and a huge weight of this is down to how you manage the finances. 

Inventory costing methods is the approach that companies take when assigning costs to products, determining overall profitability and inventory control. 

But, with so many inventory valuation methods out there, how can you really know which one is the best and most profitable one for you? 

In this guide, we’ll be breaking down all you need to know about the familiar pricing methods, like FIFO and LIFO, and the impact they can have on your business. 

Why inventory costing methods matter 

Inventory costing methods is the umbrella that covers everything from financial statements, tax obligations, profit analysis, and decision-making process. 

The method that a company chooses to cost their inventory will directly affect the income they receive. This is also the method that regulators expect companies to stick with. 

So by carefully allocating inventory value, you’ll be able to:

Now that we know how impactful an efficient costing method can be, let’s explore the various ones and which one is perfect for you. 

Inventory costing methods and the impact on cost of goods sold (COGS)

There are four main methods that a company can choose to calculate and report inventory turnover, and evaluate the cost of Goods Sold (COGS). 

First In, First Out (FIFO)

The FIFO inventory costing method assumes that the first items purchased are the first ones sold. Essentially, the inventory on hand is the most recently acquired item. 

It’s one of the most commonly used costing methods for businesses because of how closely it matches the way inventory actually moves for most businesses. 

Plus, it’s beneficial for companies during inflationary periods since it leads to lower COGS with higher profits.

Here’s how:

In times of inflation, your first units in your inventory would have been purchased at the lowest price. So when you’re now selling these units, they’re being sold at today’s high market value – leading to a lower cost of goods sold and higher reportable income. 

Benefits of FIFO Costing Method:

Woman calculating inventory cost against sales

1. Accurate Matching of Costs and Revenue: FIFO closely aligns with the natural flow of inventory which ensures that the costs assigned to sold items are closer to their actual purchase costs. This means more accurate matching of costs and revenue, plus a reliable representation of your current inventory value.

2. Realistic COGS Calculation: By assigning the older, lower-cost inventory to COGS, FIFO can better reflect the current market value of inventory, especially in times of inflation. This can lead to higher reported profits, making it attractive for businesses seeking positive financial statements.

3. Reduced Risk of Obsolescence: Since the oldest inventory is sold first, it minimizes the chances of holding onto outdated or obsolete items in stock. This is particularly beneficial for businesses dealing with perishable goods as it ensures a faster turnover of inventory.

4. Enhanced Cash Flow: Lower-cost items results in higher reported profits, which can attract investors and lenders. Improved cash flow can facilitate growth opportunities, such as expanding product lines, investing in research and development, or acquiring new assets.

Cons of FIFO Costing Method:

1. Inaccurate Inventory Valuation: Although it’s great for businesses during inflation, FIFO can lead to an overstatement of the value of inventory on the balance sheet.  The older, lower-cost inventory remains on the books, while the replacement cost of new inventory is higher. This can inflate the reported value of inventory and mislead stakeholders.

2. Deferred Tax Benefits: From a tax point of view, FIFO isn’t as advantageous as other methods out there. FIFO’s lower COGS and higher reported profits also means higher income taxes and increased tax liabilities. We’d recommend speaking with tax professionals when considering tax obligations. 

3. Challenging in Periods of Declining Prices: While FIFO is beneficial during inflationary periods, it can be a harmful approach in deflationary environments. Older, higher-cost inventory for COGS can result in lower reported profits, impacting the financial health of the business. For businesses operating in industries with volatile prices, we’d advise evaluating how FIFO acts as economic conditions differ. 

4. Increased Holding Costs: FIFO can lead to higher holding costs for businesses with long-term or slow-moving inventory. Since the oldest items are sold first, the newer inventory may remain in stock for extended periods. This can result in higher storage costs, increased risk of inventory obsolescence, and potential write-offs.

While FIFO can be the most straightforward method to use for most businesses, it’s crucial to be mindful of the drawbacks and assess the specific needs of the industry your business operates when determining the method’s suitability for you. 

Last-In, First-Out (LIFO) Method

On the opposite side to FIFO is LIFO. This method assumes that the most recently purchased items are the first ones sold instead. 

The main advantage to using LIFO is that it matches the higher current costs with revenue during periods of inflation, leading to a few tax advantages. 

The LIFO (Last-In, First-Out) costing method has both benefits and drawbacks for businesses. Let’s examine them in more detail:

Benefits of LIFO Costing Method:

Colleagues using inventory costing methods to calculate profits

1. Current Cost Allocation: This method aligns with the idea that the cost of goods sold (COGS) should reflect current replacement costs. LIFO can provide a better representation of the cost of inventory when prices are rising or during inflationary periods.

2. Tax Advantages: LIFO can offer significant tax benefits, especially when prices are increasing. Since LIFO assigns the most recent, higher-cost items to COGS, it leads to a larger deduction for COGS, thus lower taxable income and reduced tax liabilities.

3. Reflects Cost of Replacement: LIFO closely reflects the current market conditions by valuing COGS with the most recent and, typically, higher-priced inventory. This gives businesses a clearer understanding of the cost of replacing sold items, allowing for better pricing decisions and strategic planning.

Drawbacks of LIFO Costing Method:

1. Inaccurate Inventory Valuation: The older, lower-cost inventory remains on the books, while the replacement cost of new inventory is higher. This can lead to an understatement of assets and potentially distort financial ratios.

2. Reduced Profitability Reporting: LIFO generally results in higher COGS and lower reported profits compared to other costing methods such as FIFO (First-In, First-Out). This can impact the perceived profitability of a business, potentially affecting investor perceptions and the ability to secure financing.

3. Challenging in Inflationary Environments: While LIFO has its benefits during inflation, it can become challenging during periods of deflation or stable prices. Using recent, higher-cost inventory for COGS can lead to lower reported profits, affecting financial performance reports and the ability to attract future investment.

4. Inventory Holding Risks: LIFO can increase the risk of holding older, potentially outdated inventory on the balance sheet. The lower-cost inventory may not reflect the current market value, potentially leading to higher carrying costs, inventory obsolescence, and write-offs.

5. International Accounting Differences: It’s important to note that some countries may not allow or have restrictions on the use of LIFO for financial reporting purposes. This can present challenges for multinational businesses that operate in jurisdictions with different accounting standards and regulations.

The LIFO costing method offers benefits such as current cost allocation, potential tax advantages, and visibility of replacement costs. However, it’s important for businesses to be mindful of potential drawbacks, including inaccurate inventory valuation, reduced profitability reporting, and the challenges in both stable or deflationary environments. 

Weighted Average Method

The weighted average costing method is a healthy inbetween of LIFO and FIFO. It calculates the average cost of all units available for sale during a certain period and assigns it to both inventory on hand and COGS. 

Being able to calculate inventory turnover can help smoothen out any fluctuations in cost which is a huge pls point for your business in the long run. 

Pros of Weighted Average Costing Method 

Woman presenting costings and sales data

1. Ease of Use: This method is relatively straightforward and easy to implement. By simply calculating the average cost of all units available for sale during a specific period, it makes it largely accessible for most businesses. 

2. Smoothing Out Cost Fluctuations: It helps smooth out fluctuations in the cost of inventory as it takes into account the costs of all units purchased, regardless of when they were acquired. This is great for businesses working in industries with volatile or unpredictable costs, as it reduces the impact of significant price fluctuations on the cost of goods sold (COGS).

3. Accurate and Consistent Cost Allocation: The method allocates costs to both inventory on hand and COGS based on the average cost per unit, providing a fair representation of the average cost of inventory at any given time.

4. Great for Periodic Inventory Systems: The weighted average method is particularly suitable for businesses that use periodic inventory systems. In periodic systems, the physical count of inventory is performed at specific intervals, and the average cost can be easily calculated based on the total cost of goods available divided by the total quantity. 

Cons of weighted average method:

1. Blurred Cost Visibility: The weighted average method does not differentiate between older and newer inventory units. This can lead to blurred cost visibility and make it challenging to analyze and manage inventory on specific purchases.

2. Doesn’t Align with Specific Inventory Flow: Unlike the FIFO (First-In, First-Out) or LIFO (Last-In, First-Out) methods, the weighted average method does not correspond to a specific physical flow of inventory. This can be a disadvantage for businesses that require precise tracking of inventory movement or have unique inventory turnover characteristics.

3. Poor Reflection of Current Inventory Costs: It also fails to accurately represent the current cost of inventory during periods of significant price fluctuations. It calculates the average unit cost based on historical purchases, which may not reflect the most recent market prices. 

4. Distorted Margins in Inflationary / Deflationary Period:  If costs are rising, the average cost per unit may be lower than the most recent purchase costs. This can result in higher reported gross profit margins, potentially misleading stakeholders about the true profitability of the business.

While the weighted average costing method offers simplicity and a reduction in cost fluctuations, it does have some drawbacks including blurred cost visibility and inaccuracy in current costs. It’s key to consider whether your company’s dynamics would be best suited to this type of costing method. 

A step by step guide on choose the right inventory costing method for you

Small business owner doing inventory checks

Choosing the right inventory costing method means looking into a variety of factors. Here’s a step-by-step guide to help you make an informed decision:

Understand your business / industry: 

Start by evaluating the nature of your business, industry dynamics, and the characteristics of your inventory. 

Factors such as product perishability (like in restaurants), technological obsolescence, inventory turnover rate, pricing strategies, and market volatility must be considered.

It’s also good to note that different industries may have specific requirements or regulations that influence the choice of inventory cost approach.

Analyze cost flow patterns

Examine the flow of inventory in your business. Identify whether your inventory follows a specific pattern, such as first-in, first-out (FIFO) or last-in, first-out (LIFO), or if it is more of a mixed flow.

Understanding the cost flow patterns can help you align appropriate inventory costing methods with your inventory management practices.

Assess financial reporting needs

Consider the impact of each inventory cost accounting method on your financial statements. 

How does each costing method affect your balance sheet and income statement? Determine if there are specific reporting requirements from stakeholders, investors, lenders, or regulatory bodies that should be taken into account.

Evaluate tax implications

Understand the tax consequences associated with inventory costing methods in your jurisdiction. Remember, different methods can have varying effects on taxable income, tax liabilities, and cash flow. 

We’d advise consulting with tax professionals in your decision-making process to assess the tax pros and cons of each method and seeing which one aligns with your tax planning objectives.

Consider industry standards and regulations

Be aware of any industry-specific standards or regulations that impact inventory costing. 

Some industries, such as pharmaceuticals or food products, may have specific requirements for cost allocation and inventory valuation. It’s vital to ensure that your chosen method complies with industry standards and meets regulatory obligations.

Assess practicality and system compatibility

Evaluate the practicality and compatibility of each inventory valuation method with your existing systems, software, and processes. 

Consider the availability of historical data, the ease of implementation, and the ability to generate accurate and reliable reports and assess whether your current inventory management system supports the chosen method and if any adjustments or upgrades are required.

Consider the long-term viability and scalability of the chosen average cost inventory method. Assess its suitability for your business growth plans, expansion into new markets or product lines, and evolving inventory management needs. Choose a method that can accommodate changes in your business without significant disruptions or the need for frequent method changes.

Remember that the choice of inventory costing method is not set in stone and can be changed if your business circumstances or regulatory requirements evolve.

It’s good to regularly review and reassess your inventory cost method to ensure it remains aligned with your objectives and helps provide accurate and meaningful financial information. Interested in trialling Linnworks inventory software? Take a free interactive tour or book a more in-depth product demo to learn more.

FAQs on inventory costing methods

Warehouse worker calculating inventory costs

Q: What are the different inventory costing methods?

A: There are four primary inventory costing methods used in businesses: First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Weighted Average Cost, and Specific Identification. 

Q. How does your choice of inventory costing approach impact taxes? 

Different inventory costing methods can result in varying values for the cost of goods sold (COGS) and ending inventory. This, in turn, affects the business’s taxable income and liabilities. 

For example, the LIFO method, which assumes that the most recently purchased items are sold first, can lead to a higher COGS, resulting in lower taxable income. Businesses using LIFO may be able to lower their taxable income and reduce tax liabilities, particularly in times of rising prices.

It’s important to note that businesses should consult with tax advisors or accountants to ensure compliance and make informed decisions regarding the most suitable method for them. 

Q. What is the best inventory costing method? 

FIFO is often preferred in industries where the costs of goods tend to increase over time, such as in inflationary environments. This is because it helps accurately valuing ending inventory at current market prices, giving a better representation of the business’s financial position.

FIFO can also result in lower taxable income during periods of rising prices, as older, lower-cost inventory is matched with current sales.

Q.What is the difference between perpetual and periodic inventory systems?

The perpetual inventory system offers real-time updates, keeping you constantly informed about your stock levels. On the other hand, the periodic inventory system involves periodic physical counts to determine inventory quantity and value.

The choice between the two depends on things like sales volume, inventory complexity, and your business’s need for real-time visibility. 

Q. Which inventory costing methods are best for inflation?

When it comes to inflation, one of the most common inventory costing methods is: the LIFO method. When prices are on the rise, you’ll want your inventory valuation to reflect the current market conditions. LIFO, short for Last-In, First-Out, is able to do this as the cost of goods sold (COGS) matches the cost of the latest inventory purchases. 

Q. How does inventory cost affect profitability?

Your weighted average cost method directly impacts profitability. Different methods, like FIFO and LIFO, affect the cost of goods sold (COGS) and, subsequently, gross profit, ultimately influencing overall profitability.

For example, in inflationary periods, the LIFO method can result in higher COGS due to matching recent, potentially higher-cost inventory with sales. This may lower gross profit and overall profitability.

Choosing the right inventory costing method involves considering industry norms, accounting regulations, and business objectives.

Q. What are GAAP inventory cost methods?

GAAP, or Generally Accepted Accounting Principles, provides a framework for financial reporting. For inventory valuation, GAAP offers a set of inventory cost methods that businesses can choose from. These methods, including FIFO, LIFO and WAC, ensure consistency and accuracy in recording inventory on financial statements.

By following GAAP inventory cost methods, businesses can easily present their financial statements with accurate and reliable information, providing stakeholders with a clear understanding of their inventory valuation practices.