Everything You Need to Know About Inventory Costing
In order for a materials handling, order fulfillment, or manufacturing operation to be successful over the long term, it is crucial that they have a firm understanding of the cost of goods sold for their business.
This is one of the most important financial KPIs that a business needs to prioritize tracking, for a number of reasons: Because inventory is often one of the largest assets that an operation maintains, the cost of goods sold is an essential piece of both financial reporting as well as the tax process.
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But even more critically, the metric can be used to determine a trend that speaks to the overall health of a supply chain: If inventory costs are continuously rising, what does that mean for the health of your operation? Are there ways that you can lower cost of goods sold by finding a cheaper supplier, or by bringing production in house, or some other solution?
How does inventory costing work?
Inventory costing is the process of assigning value to inventory, and thus to the cost of goods sold. Though all inventory costing involves assigning a value to goods sold, there are a number of common costing methods, including:
- First In First Out (FIFO)
- Last In Last Out (LIFO)
- Average Cost/weighted average
Which inventory costing method a particular business chooses to use will be based on the specifics of the operation itself, as well as the nature of the inventory. Below, we discuss each of these costing strategies in more detail.
1. First in First Out (FIFO)
An operation following a First-in, First-out inventory costing methodology operates under the assumption that the cost of inventory on-hand at any given time should represent the the cost of the inventory that has been most recently purchased. This means that when inventory is sold, the oldest costs (the cost of goods for the oldest inventory) are associated to the sale.
First-in, First-Out inventory costing is the method most-attuned to true buying cycles, where the oldest inventory is typically the first inventory to be sold. This is especially important for goods that expire or become out of date quickly, such as food, pharmaceuticals, and other perishable goods.
2. Last In First Out (LIFO)
An operation following a Last-in, First-out inventory costing methodology works in the exact opposite way from first-in, first-out. With LIFO, when a sale is made, the most recent inventory costs are associated with that sale.
LIFO may seem like an odd method of inventory costing for many operations, since it is not tied to the typical buying cycle. And, indeed, it is less practical than FIFO in most cases. But there are certain types of operations and products where LIFO makes sense: Operations where LIFO actually does mirror the buying cycle.
An example of this might be a supplier of wood chips. In many operations like this, wood chips are stored in large piles. It is difficult to rotate these types of products like you might other goods. When new wood chips are created or delivered, they are added to the top of the pile, and the older wood chips are on the inside of the pile.
When an order is placed, workers would take wood chips from the outside of the pile and work in. By associating the purchase with the newest inventory costs rather than the oldest, this allows inventory costing to more closely match the flow of inventory.
3. Average Cost/Weighted Average
An operation using the average cost inventory costing methodology would assign costs to inventory sold by calculating an average of all costs of buying inventory. Each piece of inventory is then assigned this average cost, instead of costs tied to the time of purchase or the age of product.
By its nature, to be accurate, the average cost/weighted average for the cost of goods sold must be recalculated each time product is sold or added to inventory. This is often done automatically by an operation’s inventory management system.
Most of the operations using the average cost methodology sell or distribute non-perishable goods, often in a non-sequential manner. It is often the case in these operations that new stock is intermingled with older stock, making it difficult to differentiate between the two.
The Bottom Line
Ultimately, the inventory costing strategy that you choose to implement in your operation will depend on a number of key factors involving how your operation and industry work, how inventory is handled, how orders are processed, and the specific characteristics of your product itself.
A skilled systems integrator or warehouse design consultant, once they understand the specifics of your operation, can help you determine which inventory costing strategy is right for you and implement systems and technologies that compliment this and other needs to help your operation become as efficient as possible.