The Five Effective Inventory Costing Methods in Your Business

What are inventory costing methods?

Inventory costing methods are used in businesses to track the cost of inventory. This is important for a number of reasons, including the following- - Managing inventory costs helps businesses to avoid over-stocking and under-stocking inventory which can lead to losing money. - Inventory costs help determine whether or not a business is profitable or not. - Inventory costs are also used in financial planning to help determine how much money will be needed in the future. These numbers also help with budgeting.

The benefits of inventory costing methods

Businesses that use inventory costing can be better prepared for business fluctuations, production changes and other unforeseen events. Inventory costing methods such as perpetual and perpetual equivalent allow businesses to know what the true cost of their products are and how they might fare in an economic downturn. Inventory costing helps businesses not only prepare but also predict future costs, which allows businesses to make more informed decisions.

Why businesses should use inventory costing methods?

Businesses should use inventory costing methods for the following reasons-

• It is capable of Inventory valuation
• Determines the cost of goods sold and the gross profit.
• Calculates net income and provides the most accurate inventory cost to deduct from taxable income.
• It aids in the planning of sales and manufacturing schedules.
• Gives you the ability to make more informed business decisions.

What are inventory costs?

Inventory exists in two states at the end of an accounting period- finished and unfinished. How do you calculate that investment?

Here's how businesses calculate their inventory costs-

Direct labor

Companies invest a lot of money in labour, whether it's for salaried or hourly employees. However, not all of that labour goes into creating the goods. As a result, only direct labour is considered when valuing inventories. This includes wages paid to those participating in product assembly, payroll taxes paid by the company, pension payments, and any insurance coverage provided by the company, such as medical, life, and workers' compensation.

Direct materials

Direct materials are any materials and supplies utilized in the manufacturing of a product. This comprises any supplies used or discarded during the procedure, as well as any damaged or useless goods. Any cost that fluctuates with each unit of manufacture is a direct cost, according to a good rule of thumb.

Factory overhead

Other than direct labor and direct materials, factory overhead covers all expenses spent during the manufacturing process. Salaries of personnel involved in inventory production but not making the products, such as production supervisors, quality assurance professionals, and materials managers, are examples. Rent, utilities, insurance, and equipment setup and maintenance are all included in factory overhead. It also includes the cost of small production tools that are completely expensed at the time of purchase, as well as the cost of depreciation for bigger equipment.

Freight in

This is the expense of delivering items to the company via transportation. If a corporation offers free or discounted shipping to its consumers and absorbs the corresponding costs, there is a matching freight-out cost.

Handling

This comprises all of the labor needed in picking merchandise, packing it for shipment, creating a shipping label, and loading the product onto a vehicle.

Import duties

Any imported materials or supplies used in the production of a company's goods may be subject to tariff. Items that are duty-free due to trade agreements or for other reasons are an exception.

5 effective inventory costing methods

Inventory costing is a crucial part of business. It helps to provide an accurate measure of the value of goods and services purchased and costs incurred for the production, distribution, sale, and maintenance. Inventory costs are often divided into variable and fixed components. Fixed costs include taxes, raw materials, utilities, salaries for personnel who work with inventory management, and depreciation. Variable costs are those that fluctuate with the level of inventory produced or sold during the period in question. The main variables used in inventory costing include cost per unit, total stock-out rate (TSOR), average time on hand (ATOH), working days lost (WDLS), and order processing cost (OPC).

If you're wondering how to calculate your inventory cost using different methods, keep reading to find out what they are.

1. The FIFO method

The first-in, first-out (FIFO) technique is the first method based on the principle that assets that are generated and acquired first are also sold or utilized first. FIFO assumes that the cost of goods sold (COGS) on an income statement includes assets with the oldest costs. When this happens, you need to match the company's existing inventory assets to those that were just purchased or produced.

This is the FIFO formula-

Cost of goods sold (COGS) = cost of oldest inventory x amount of inventory sold

2. The LIFO method

LIFO (last-in, first-out) is a way of recording newly created things as sold first. It reports the lower of older products as inventory and expenditures the cost of newer products purchased first as COGS.

This is the LIFO formula-

Cost of goods sold (COGS) = cost of most recent inventory x amount of inventory sold

3. The retail inventory method

The retail method, a process in which you estimate the worth of your ending inventory by factoring in the cost to retail price ratio, is a traditional inventory costing method.

This is the retail inventory formula-


Retail ratio = cost of beginning inventory + cost of inventory purchased/ retail value of beginning inventory + retail value of good purchase during the given period

4. The specific identification method

Here the actual cost of a product is attached to an identifiable unit of product using the specific identification method of inventory costing. When purchasing and selling huge inventory products, businesses find this strategy simple to use. Under this method, the business must identify each unit in inventory with a serial number or identification tag under the specific identification technique.

5. The weighted average method

Weighted-average or weighted average cost (WAC) is a method that determines the amount that goes into COGS and inventory through the use of a weighted average. Using this method involves dividing the cost of goods available by the number of units available.

This is the Weighted average formula-

WAC per unit = cost of goods available / units available

What is the best inventory costing method for your company?

Your cost accounting method is a critical decision, partly because switching from one approach to another is extremely difficult. All past years must be re-reported using the new procedure.

Here are a few points that will help you pick an inventory costing method that works best for you -

• For some firms, how you sell your inventory will have a significant impact on your cost accounting. Restaurants, supermarkets, and other industries that deal with perishables will undoubtedly choose FIFO. In such circumstances, the first things in are the first products out, and keeping inventory in this manner will help you maintain a realistic view of your inventory expenses.
• If you want to reduce your tax burden during an inflationary period, avoid using FIFO, which is the most precise approach and reports the highest income. The LIFO approach will reflect the lowest income, while the weighted average method and specific identification lie somewhere in the middle.
• FIFO or specific identification methods are both acceptable solutions if you wish to maintain an accurate track of your historical costs with revenue.
• You should utilize LIFO if you wish to compare revenue to current inventory count, which might be valuable during inflationary periods.