Using the right inventory costing methods is vital for any business. You need to know your gross profit margin and the inventory costing system used by your accountants to grow your retail firm. The company's inventory serves as both a high-cost and a key revenue generator.
It is important to balance costs and assets carefully. Therefore, understanding and improving the inventory costing methods in your accounting records is helpful. In this article, we'll walk you through how to value your inventory, different retail inventory methods, key inventory management techniques, and more.
What Is Inventory Costing?
Inventory costing, often known as inventory cost accounting, is the process through which businesses allot costs to items. These costs include extra expenses like storage, administration, and overall stock maintenance. Generally accepted accounting principles (GAAP) provide standardized accounting principles to prevent companies from exceeding their expenses.
Inventory costing methods are a part of inventory management. Good inventory management in a supply chain helps reduce inventory costs and determines the right product quality a firm should stock. Companies use various methods to reduce inventory costs to determine the necessary margins for each product or category.
How to Choose an Inventory Cost Accounting Method
There are 4 inventory costing methods for measuring inventory since each firm handles its stock differently. Asking yourself these questions can help you determine if your company costs inventory properly:
-
What city are you presently operating in? Where do you plan to do business going forward?
-
How much stock do you have? With a bigger inventory, techniques like individual identification will become more difficult.
-
Do you provide products with a shelf life, such as food or medicines? You should choose a strategy that prioritizes selling soon-to-expire goods first.
-
How often do your inventory's sourcing costs change? If you do not have constant expenses, a technique like a weighted average will not work for your business.
The Retail Inventory Method
The retail method determines the ending inventory balance for retail establishments by comparing the inventory cost to the items' cost. In essence, it chooses how much of an expenditure to acknowledge now vs later.
It is a more reliable approach when comparing the retail inventory method vs. the cost method. The retail technique assumes that your inventory has a constant markup throughout. Therefore, you subtract the markup from the total price of the product you're selling to determine your cost.
Specific Identification Method
According to the specific identification technique, a company must mark each unit of inventory with its price and keep that mark on file until the inventory is sold. After an inventory item has been sold, the unit cost is added to the cost of goods sold.
The specific identification process is time-consuming record keeping and is often restricted to inventories of expensive items such as cars, jewelry, and other things.
Weighted Average Inventory Costing or Average Cost Inventory Method
The weighted average inventory costing, commonly known as the average cost inventory method, is a GAAP-compliant methodology businesses use to value their company stock. This approach uses a weighted average to determine the per-unit cost, considering both the cost of goods sold and the inventory.
The weighted average cost method's formula is a per-unit computation. Divide the total cost of the merchandise up for grabs by the quantity of each inventory item to get the average cost method of inventory valuation.
WAC = COGS / Inventory (Sold)
The First in, First Out (FIFO) method
For companies with a large number of almost identical products, the exact identification may not be worth the effort. FIFO, or the first in, first out method, is preferable for such companies. In the FIFO method, it is believed that the sale of an item is made from the earliest available batch, which is mainly applicable when the prices of the purchased items vary.
Formula: To determine FIFO, multiply the cost of your oldest inventory by the quantity of that inventory sold.
Last in, First Out (LIFO) method
LIFO is the opposite of FIFO and is one of the most popular inventory costing methods. It considers the most recent purchases as the most recent sales. "LIFO" means to apply particular costs to individual goods or batches of products based on their real expenses, reducing your cost as you sell items and removing the latest items added from inventory first.
This approach only makes sense when it accurately reflects reality, in which the most recent products are sold first, and older products might remain on the market for a very long period.
Formula: Calculate the cost of your most recent inventory and multiply it by the quantity of goods sold.
The Weighted Average Method
Weighted average costing is an even simpler way that your accountant may utilize if the costs of the goods your company purchases don't fluctuate too much. When using the weighted average approach, all units of a particular stock holding are cost as a group.
All purchases are included in the cost pool, which is then split by the total number of units you own.
Retail Accounting: Inventory management Is key
No matter how carefully you've looked at your company's changing inventory costing methods periodic system and how knowledgeable your accountants are, you'll have problems keeping track of expenses correctly if your inventory management is a mess.
You must obtain clearer data and automated inventory systems for your logistics teams to act on by providing them with user-friendly technology to monitor, sell, receive, and manage inventory without mistakes. TranZact provides quick and easy stock recording and management solutions, like its inventory management software.
Simplify Inventory Costing Methods With TranZact
Inventory costing methods are essential for estimating inventory value and calculating the cost of goods sold. Businesses must carefully analyze their financial goals and inventory flow using FIFO, LIFO, or weighted average methods.
TranZact helps businesses make informed decisions that align with their profitability and reporting needs by streamlining their inventory methods with its automated inventory management software.
FAQs on Inventory Costing Methods
1. What are the three inventory costing methods?
Three inventory costing methods are:
- First In, First Out (FIFO),
- Last In, First Out (LIFO),
- Weighted Average Cost (WAC)
2. Which inventory cost accounting techniques are most widely used in businesses?
The FIFO (First-In, First-Out) inventory cost accounting method is often employed in enterprises.
3. What is the First-In, First-Out (FIFO) method?
First-In, First-Out (FIFO) is an inventory cost accounting technique that considers the acquisition and cost assignment sequence by assuming that the oldest inventory would be sold first.
4. How does the LIFO (Last-In, First-Out) approach compare to FIFO?
The LIFO (Last-In, First-Out) approach assumes that the most recently purchased inventory is sold first, whereas FIFO (First-In, First-Out) assumes the oldest inventory is sold first.
5. How is the cost of inventory determined using the weighted average method?
The weighted average approach divides the total cost of the items available for sale by the total number of units available for sale to get the average inventory cost.
6. How does profitability differ depending on the inventory cost accounting method?
The inventory cost accounting technique used may have an influence on the cost of goods sold, gross profit, and tax duties, which can have an impact on overall profitability.
