The financial statements of a brand depend primarily on the inventory they have in stock. But how do you determine the actual cost of inventory?

Inventory costs often rank among a business’s highest expenses—for each dollar generated in revenue, most retailers maintain an average inventory value of $1.40.

This is particularly true for those in the retail and direct-to-consumer (DTC) sectors. It significantly impacts a business’s cost of goods sold (COGS), gross profit, and taxable income. 

To manage inventory better, business owners have a couple of options to consider when considering inventory costing. 

In this post, we’ll examine ten popular inventory costing methods and provide examples to help you choose the right one.

What is a costing method?

A costing method determines the cost of goods or services by assigning direct and indirect costs to production and inventory.

Inventory costing, also known as inventory valuation, assigns costs to the stock products.

Valuing inventory involves applying different cost-flow assumptions. These methods do not reflect the actual movement of items in your inventory. 

Instead, they distribute costs between the cost of goods sold and the ending inventory, enabling companies to ensure that they hold the right amount of inventory.

The below Reddit thread points out a common challenge in inventory costing: deciding whether to average costs or use the cost of the latest inventory purchases for year-end calculations.

Another Reddit user is a new entrepreneur seeking advice on valuing an inventory of sports cards acquired through mixed sourcing, like bulk buys, packs, and repacks.

Uncertainty about inventory valuation is common among businesses, but we’re here to simplify it. We’ll provide examples of different costing methods, guide you through their calculations, and help you find the most suitable option for your business.

Explained: The top seven inventory costing methods

Are you confident that your current inventory costing method is the best fit, or is it time for an update? 

Any inefficiencies or errors in accounting for inventory costs can have a domino effect, eventually impacting a business’s financial health. This makes understanding various inventory costing methods crucial.

Effective inventory management that tackles understocking and overstocking issues can result in a 10% cost savings.

Here are seven inventory costing methods to consider:

1. FIFO

FIFO (First-In, First-Out) is an inventory costing method where the oldest items are sold first. This method helps businesses efficiently manage inventory by ensuring that older stock is used or sold before newer stock. 

FIFO is particularly beneficial for businesses dealing with perishable goods or products with expiration dates.

Formula:
In FIFO, the cost of goods sold is calculated as:
COGS = Number of Units Sold × Cost per Unit of Oldest Inventory

Example:
A D2C company dealing in gourmet coffee has the following inventory at the start of the month:

• July Stock: 200 units at $12 each
• August Stock: 250 units at $15 each

Sales:
The company sold 220 units in September.

COGS Calculation using the FIFO method:

• July Stock: 200 units × $12 = $2,400
• August Stock: 20 units × $15 = $300

Total COGS = $2,400 + $300 = $2,700

Ending Inventory:

August Stock: 230 units at $15 each (250 units initially, minus 20 sold)
Value of Ending Inventory = 230 units × $15 = $3,450

2. LIFO

LIFO (Last-In, First-Out) is an inventory costing method where the most recent inventory items are sold first. 

Businesses often switch to the LIFO method during economic downturns or periods of rising prices, as it allows them to reduce taxable income by reflecting the higher, more recent costs in their cost of goods sold.

Formula:
In LIFO, the cost of goods sold is calculated as:
COGS = Number of Units Sold × Price of Most Recent Inventory

Example:
A D2C company dealing in home decor has the following inventory at the start of the month:

• July Stock: 150 units at $25 each
• August Stock: 180 units at $30 each

Sales:
Sold 210 units in September.

COGS Calculation using the LIFO method:

• August Stock: 180 units × $30 = $5,400 (all August stock sold)
• July Stock: 30 units × $25 = $750 (30 units from July stock sold)

Total COGS = $5,400 + $750 = $6,150

Ending Inventory:

July Stock: 120 units remaining (150 units initially - 30 units sold)
Value of Ending Inventory = 120 units × $25 = $3,000

3. Weighted average

Weighted average calculates a uniform cost per unit based on the total cost and total inventory quantity. This method helps businesses smooth out price fluctuations by averaging the cost of inventory purchased at different times.

Formula:
Weighted Average Cost Per Unit = Total Cost of Goods Available for Sale / Total Quantity of Units Available for Sale

Example:
A store buys 200 toys at $5 each and 300 at $7 each. If they sell 250 toys:

• Total cost = (200 × $5) + (300 × $7) = $1,000 + $2,100 = $3,100
• Total units = 200 + 300 = 500
• Weighted Average Cost Per Unit = $3,100 / 500 = $6.20
• COGS = 250 × $6.20 = $1,550

4. Actual costing

Actual costing is a method that records the exact cost of each inventory item. This model provides precise cost tracking and is ideal when inventory items have varying costs or highly accurate cost details are needed.

Example:
A high-end electronics store purchases 15 tablets at $300 each and 25 at $400 each. If the store sells 30 tablets:

• First 15 tablets at $300 each = 15 × $300 = $4,500
• Next 15 tablets at $400 each = 15 × $400 = $6,000

Total COGS = $4,500 + $6,000 = $10,500

5. Job costing

Job costing (also referred to as job order costing) is an inventory valuation method that accounts for the specific costs associated with producing each item or completing each project. 

This method is ideal for businesses in industries like construction, custom manufacturing, or professional services, where products or services are customized and each job has distinct costs.

Formula:
Cost of Job = Direct Materials + Direct Labor + Overhead Applied to the Job

Example:
A construction company tracks the costs for a specific project as follows:

• Direct materials: $15,000
• Direct labor: $10,000
• Overhead: $5,000

Total cost of the project = $15,000 + $10,000 + $5,000 = $30,000

6. Standard costing

Standard costing involves setting fixed costs for materials, labor, and overhead before production begins. This method substitutes expected costs for actual costs in the accounting records, allowing businesses to measure performance against predetermined standards.

Formula:
Cost Variance = Actual Cost - Standard Cost

Example:
An electronics manufacturer sets standard costs as follows:

• Materials: $10
• Labor: $6
• Overhead: $4

If actual costs are:

• Materials: $11
• Labor: $7
• Overhead: $5

Calculations:

• Total standard cost per unit = $10 + $6 + $4 = $20
• Total actual cost per unit = $11 + $7 + $5 = $23
• Cost variance = $23 - $20 = $3 unfavorable

7. Direct costing

Direct costing assigns costs directly related to producing a specific product or service provision, such as materials and labor costs. It includes all costs directly tied to a cost object (like a product, project, or service).

Formula:
Direct Cost Per Unit = Direct Materials + Direct Labor

Example:
A clothing manufacturer has the following direct costs:

• Direct materials: $100
• Direct labor: $50

Direct cost per unit = $100 + $50 = $150

If they sell 60 units:

Cost of Goods Sold (COGS) = 60 × $150 = $9,000

Tips for picking the right inventory valuation method for your business needs

Implementing the right inventory costing method depends on many factors, such as the type of business you run, the nature of your inventory and production processes, your human resources, and the level of historical cost data you hold. 

There are exceptions, but according to GoodDay’s internal data—most brands operate using FIFO, LIFO, or Weighted Average Costing. 

The choice of method can impact everything from tax liabilities to cash flow and profit margins.

Here are seven considerations to guide your decision:

1. Understand your industry dynamics

Different industries have unique inventory needs. For example, perishable goods businesses benefit from FIFO because they must first sell older inventory. 

On the flip side, manufacturing sectors might lean towards the weighted average. Understanding these dynamics will help you align the costing method with industry standards and practices.

2. Evaluate cash flow impact

LIFO may reduce taxable income in times of rising prices by matching the latest, higher costs against current revenues—potentially benefiting cash flow. However, it can also lead to outdated inventory valuations on financial statements. Consider how each inventory costing method affects your cash flow and tax obligations.

3. Consider inventory turnover rates

A good inventory turnover ratio in most industries is between 4 and 8. High turnover rates often favor FIFO, ensuring that older stock is used first, reducing the risk of obsolescence. For businesses with slower turnover, weighted average or actual costing might provide a more accurate reflection of inventory costs.

4. Analyze financial reporting needs

Accurate financial reporting is essential for decision-making. FIFO provides a clear picture of inventory costs and aligns with the physical flow of goods. 

At the same time, LIFO may be advantageous for tax purposes but can obscure the actual cost of inventory. Choose a method that aligns with your reporting needs and compliance requirements.

5. Assess the complexity and administrative costs

Methods like job—and activity-based costing can be complex to implement and maintain. Evaluate the administrative burden for each process and the costs to ensure they align with your company’s resources and capabilities.

6. Review the impact on profit margins

Different costing methods affect reported profit margins. FIFO typically results in higher reported profits during inflationary periods due to the lower cost of older inventory. LIFO, on the other hand, might show lower profits but could benefit cash flow. Assess how each method affects your financial statements and profit reporting.

7. Align with business strategy

Your chosen method should support your overall business strategy. For instance, if your plan involves maintaining competitive pricing and managing inventory efficiently, FIFO or weighted average may be more suitable. 

Manage inventory costs effectively with GoodDay

Selecting the proper inventory costing method is a pivotal decision that can significantly impact your business’s financial health and operational efficiency. 

By understanding your industry dynamics, evaluating cash flow implications, and aligning with your business strategy—you can choose a method that supports your goals and provides accurate financial reporting.

GoodDay offers a comprehensive platform for managing your inventory costs more precisely, enabling easy and accurate FIFO-level inventory costing. 

As a reinvented ERP retail operating system built natively into Shopify, GoodDay streamlines inventory management for businesses globally, offering enhanced visibility and actionable insights. 

Book a demo today to see how GoodDay can centralize your inventory management and support your costing strategy.

FAQs

Here's a set of questions that we get asked often from our customers and the retail community in general.

1. How to treat inventory accounting?

Inventory accounting involves tracking and valuing inventory to determine the cost of goods sold and ending inventory. To assign costs to inventory, use an appropriate costing method—such as FIFO, LIFO, or weighted average. Ensure accurate inventory purchases, sales, and usage records to maintain financial clarity.

2. Which is the best inventory costing method for small businesses?

The best inventory costing method for small businesses often depends on the nature of the inventory and business goals. FIFO is the most popular method because it is simple and aligns with the physical flow of goods. The weighted average is also a good choice because it is consistent in cost allocation. Evaluate your specific needs and industry practices to select the most suitable method.

3. How can inventory costing affect my financial statements?

Inventory costing impacts your financial statements by influencing the reported cost of goods sold, gross profit, and taxable income. Different methods can lead to varying financial results. For example, FIFO can show higher profits in inflationary periods, while LIFO may reduce taxable income but can also lead to outdated inventory valuations.

4. What should you consider when deciding on an inventory costing strategy?

When choosing an inventory costing method, consider factors such as industry standards, cash flow impact, inventory turnover rates, and financial reporting needs. Also, evaluate each method’s complexity and administrative costs to ensure it aligns with your business’s resources and strategy.