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Small Business Center

5 Inventory Costing Methods to Consider When Valuing Your Stock

October 20, 2021

By Francesca Nicasio, Vend
https://www.vendhq.com

How much have you spent on your current inventory? How much did you spend on inventory that you’ve already sold? These are some of the most critical things retailers should be asking, and believe it or not, there is no one “right” answer to these questions because of the various inventory costing methods out there. Check out the different ways for valuing retail stock below and see which one is right for your business.

The retail method

The traditional way of handling accounting is known as the retail method, a process in which you estimate the value of your ending inventory by factoring in the cost-to-retail price ratio. Former website Accounting Explained illustrated it like this:

  1. Add the retail value of your beginning inventory and retail value of products purchased to determine the retail value of the merchandise available for sale.
  2. Deduct your total sales during that period from the retail value of merchandise available for sale.
  3. Calculate the cost-to-retail price ratio using the formula: (A+B)/(C+D), where: A is the cost of beginning inventory; B is the cost of inventory purchased, including incidental costs, such as freight-in; C is the retail value of beginning inventory; and D is the retail value of goods purchased during the period.
  4. Multiply the number resulting from Step 2 and the cost-to-retail ratio from Step 3 to obtain an  estimated cost of ending inventory.

The retail method involves a surprising amount of estimation about your inventory, so it’s not always the most accurate way to calculate your costs. Fortunately, with the advent of inventory management systems, it’s now much easier to figure out what inventory you actually have. As a result, most retailers now use more modern inventory costing methods like FIFO, LIFO and weighted average.

Let’s talk about how to use each of these methods and which businesses they work best for.

Specific identification method

The specific identification method is perhaps the most straightforward way to calculate inventory costs. When using this method, you attach the exact cost of creating an item to that same item. The specific identification method requires being able to follow a particular product exactly through its time with your business by using serial numbers or otherwise tagging the item. Because of this, specific identification is best used for luxury retailers selling such unique and expensive items as jewelry or cars.

Here’s how the specific identification method looks numerically, using a jeweler as an example:

T.S. Jeweler’s has at the beginning of the year:

1 diamond necklace at $200
1 emerald necklace at $700
1 bracelet at $100
1 pair of earrings at $150
1 gold ring at $350
1 diamond ring at $500
Total inventory cost: $2,000

At the end of the year, T.S. Jeweler’s has sold the diamond necklace, the bracelet, and the diamond ring, and it has added to its collection a sapphire ring at $200. The result looks like this:

1 diamond necklace @ $200 (SOLD)
1 emerald necklace @ $700
1 bracelet @ $100 (SOLD)
1 pair of earrings @ $150
1 gold ring @$350
1 diamond ring @ $500 (SOLD)
1 sapphire ring @ $200
Total ending inventory cost: $1,400

To figure out your profit, you’d just subtract that ending inventory cost from the amount sold. Let’s say that the jewelry sold totaled $5,000 in sales and the total ending inventory cost is $1,400. That would make T.S. Jeweler’s annual profit $3,600.

You can see the limitations here. You need to be able to track every single item, which makes the process time consuming. If you mass-produce items, you may find that there are better ways of cost accounting for you.

Please note that while the specific identification method is the most logically straightforward process, it is not necessarily the most accurate. That’s because the specific identification method can allow for some manipulation of the numbers when there are identical products at different costs. Because each of the items is the same to the customer, the retailer may choose to sell — or report selling — the item with a higher cost in order to lower paper profit.

FIFO

FIFO stands for “first in, first out,” which accurately describes the method. It assumes that the first purchased goods are also the ones that are sold first. Therefore, your remaining stock would be valued at the most recently incurred costs. As a result, the costs listed on your balance sheet should be quite close to their value in the current marketplace.

Let’s say you’re a grocer. On Monday, you acquired five oranges for $0.10 each. On Tuesday, another five oranges cost you $0.20. And on Wednesday, you got a final five for $0.25 each. On Thursday, you sell 10 oranges. Given that oranges go bad, you assume that customers are buying Monday’s oranges first and so on. Let’s do the math using the FIFO method to figure out your remaining inventory costs on Thursday, as well as what your paper profit would be.

Day 1: purchased 5 oranges at $0.10 each
Day 2: purchased 5 oranges at $0.20 each
Day 3: purchased 5 oranges at $0.25 each
Day 4: sold 10 oranges at $1 each

With the FIFO method, you assume those 10 sold oranges are five from the first day and five from the second day, so you sold $1.50 worth of inventory, while bringing in $10 in sales, resulting in $8.50 in profit. Your remaining inventory is all worth $0.25 each, so you have $1.25 in oranges left to sell.

FIFO is the most popular method internationally and makes sense for the way many businesses run. It is also the most precise method, as it does not allow for any manipulation of the numbers.

LIFO

LIFO is the opposite of FIFO and stands for “last in, first out.” In this case, rather than assume you’re selling your first acquired products first, you assume you’re selling your most recently acquired products first. To clarify what this looks like, let’s imagine you’re the same grocer with the same oranges as above; only this time, we’ll use the LIFO method to determine inventory costs and profit.

Day 1: purchased 5 oranges at $0.10 each
Day 2: purchased 5 oranges at $0.20 each
Day 3: purchased 5 oranges at $0.25 each
Day 4: sold 10 oranges at $1 each

This time, we assume that the oranges you sold were the 10 from Days 2 and 3. That means for the $10 you made in sales, you had to spend $2.25, resulting in a profit of $7.75. Your five remaining oranges are from Day 1, leaving you with $0.50 worth of oranges to sell.

You can see what a difference LIFO makes in the final result. Even though you had all the same variables, you end up with a smaller profit. Why would anyone use LIFO if it results in them making a smaller profit? The main reason is that with a smaller profit, businesses tend to have to pay less in taxes. That’s also the reason LIFO is barred by International Financial Reporting Standards. A secondary reason you would want to show a smaller profit is that during times of inflation, LIFO can give you a good idea of how your profits are comparing to rising current costs.

Beyond tax purposes, though, LIFO can serve some businesses’ needs well. Certain companies may actually set their stock up in a way that the products that come in last really do go out first. An example that jumps to my mind is a mulch wholesaler. Mulch, whether bagged or loose, typically gets thrown into a big pile. When a sale of mulch is made, the retailer doesn’t dig to the bottom of the pile to fish up the older mulch. It just sells the mulch right from the top.

As a note: When you use LIFO for cost accounting, you must also use it for financial reporting.

Weighted average

The final mainstream cost accounting method is the weighted average method. It is sometimes known as the rolling-average method. As the name implies, you take the average of the costs you’ve faced when acquiring a set of items. As you add new products to your inventory, you’ll adjust your average cost. Let’s go back to the grocer example:

Day 1: purchased 5 oranges at $0.10 each
Day 2: purchased 5 oranges at $0.20 each
Day 3: purchased 5 oranges at $0.25 each
Average cost of 15 oranges: $0.18 each
Day 4: sold 10 oranges at $1 each

This time, we’ll take the cost of the sold oranges to be $1.80, leaving your profits at $9.20 and your remaining inventory costs at $0.80.

Now, say you add a 4th day of oranges at $0.21, this is how the math changes under the weighted average:

Day 1: purchased 5 oranges at $0.10 each
Day 2: purchased 5 oranges at $0.20 each
Day 3: purchased 5 oranges at $0.25 each
Day 4: purchased 5 oranges at $0.21 each
Average cost of 20 oranges: $0.19
Day 4: sold 10 at $1 each

Now, the cost of the same sold oranges as before is $1.90, so your profits become $9.10. Your new remaining inventory cost is $1.90.

The weighted average method should be used when all of your products are so identical to each other that the cost differential is negligible. A good example is a gas station. Every time the gas station restocks the gasoline, the new gasoline becomes mixed with the old gasoline. Chances are, customers really are buying a little old gas and a little new gas.

Please note that, of the methods listed in this article, the weighted average method is the only one the IRS is picky about. In order to file your taxes under the weighted average method, you must recalculate the average every time you add inventory or on a monthly basis and must meet one of the following criteria:

  • Your ending inventory cost must not vary by more than 1% from what the FIFO method would determine its cost to be, or
  • Your complete inventory must turn over a minimum of four times a year.

How to choose the right inventory costing method for your business

Choosing your method of cost accounting is a crucial decision, largely because once you start using a method, it’s very difficult to switch to another. You’ll have to re-report all the previous years using the new method. So how do you choose the right one?

1. For some businesses, the way you sell your inventory will clearly determine your cost accounting. Restaurants, grocers and other businesses working with perishables will obviously want to use FIFO. The first products in really are the first products out in that situation, and taking inventory like that will help you keep a realistic view of your inventory costs.

2. If you’re looking to lower your tax burden during a time of inflation, don’t go with FIFO, as it is the most precise method and reports the highest income. LIFO will report the lowest income, while specific identification and the weighted average method both fall in between.

3. If you want to keep precise track of your historical costs compared with revenue, FIFO or the specific identification methods are both good options.

4. If you’d rather compare revenue with the current costs of goods, which can be useful during times of inflation, you’ll want to use LIFO.

Wrap-up

Ultimately, you should talk to your accountant about your business needs to be certain you’re choosing the right method for your business, especially if there is no obvious method for your business.

This article was originally published at https://www.vendhq.com/blog/inventory-costing-methods.

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