MGT Accounting

How to choose the right inventory costing method for your business

How to choose the right inventory costing method for your business

 Keep reading if last year you had:

  • difficulty matching the closing stock with the prices;
  • difficulty calculating how much you have spent on your current inventory;
  • difficulty in calculating how much you have spent on inventory that you’ve already sold; or
  • difficulty valuing your inventory.

 The most common issue raised by most entrepreneurs in manufacturing business is calculating the cost of raw materials held in the stores departments.

 What are raw materials?

These are materials or substances normally used in the primary production or manufacturing of goods. For instance, corn, grain, gasoline, lumber, forest resources, plastic, etc. Manufacturing companies take special steps to account for raw materials inventory. This includes three distinct inventory classifications on their balance sheet compared to just one for non-manufacturers.

All inventory, including raw materials inventory, should be valued at its comprehensive cost. This means its value includes shipping, storage, and preparation. The cost of the raw materials will be known from the purchase invoices, but closing stock may be made up of materials delivered at different times and at different prices. This makes it difficult to match the closing stock with the prices paid. Cost accountants have therefore developed three methods for placing a price on material issues from stores, and valuing the closing stock of raw materials.

 In this post, we’ll examine each method:

 1. FIFO (First in, First out)

This inventory valuation method assumes stock issued from stores is taken from the oldest stock held. Issues to production are, therefore, charged at the oldest prices, and the remaining stock is valued at the latest prices. This method assumes the first goods purchased are the first goods sold. In some companies, the first units bought must be the first units sold to avoid large losses from spoilage. Items such as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis.

FIFO simplifies your record-keeping process and lowers the probability of making mistakes in bookkeeping. In fact, FIFO is more popular as it’s allowed by the International Financial Reporting Standards (IFRS) and the General Accepted Accounting Principles (GAAP).

FIFO method example:

Let’s say a business bought vegetables on two separate occasions at two different prices during a month:

100 cabbage at R1

200 cabbage at R2

At the end of the month, the business had sold 50 cabbages.

With FIFO, we use the costing from our first transaction when we purchased 100 cabbages at R1 each.

So, after selling 50 cabbages this is what we get = (50 cabbages x R1 FIFO cost) = R50

As you can see, 50 cabbages from the first purchase are still left on the shelves, costed at R1 each, as well as the remaining 200 cabbages from the second purchase at R20 each, So:

Remaining inventory value = (50 cabbages x R1 cost) + (200 cabbages at R2 cost) = R450

 2. LIFO (Last in, First out)

This method assumes stock issued from stores is taken from most recent deliveries. The LIFO  method of inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods. Also, issues to production are, therefore, charged at the latest prices, and the stock remaining in the stores is valued at the older prices.

Companies who tend to use LIFO more commonly deal with items that aren’t at risk of spoilage. It also benefits you more if your products’ value increases over time. A few examples include oil, gas, wool and other raw materials.

 LIFO method example:

 The LIFO method would use the cost from the latest transaction when 200 shirts were purchased at R20 each.

 After selling 50 shirts = (50 shirts x R20 LIFO cost) = R1,000

 The 100 shirts that we bought in the first purchase are still left at R10 each. We also have 150 shirts from the second purchase at R20 each. So:

 Remaining inventory value = (100 shirts at R10 cost) + (150 shirts at R20 cost) = R4,000

 3. AVCO (Average Cost/Weighted Average)

This method charges an average price for issues to production. The total value of stock in the stores is divided by the total number of units in stock, giving an average cost per unit. The average cost is re-calculated each time a new delivery is received. Companies most often use the weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them.

 Weighted average cost example:

 Based on the example above, you have 300 (100+200) shirts, which you paid R5,000 for in total (R100 x 10 + R200 x R20).

 So, your weighted average cost would be the R5000 cost divided by the 300 shirts. This equals R16.67 per shirt.

 After selling 50 shirts = (50 shirts  x R16.67 average cost) = R833.50

 Remaining inventory value = (250 shirts remaining x 16.67 average cost) = R4,167.50

Which Would You Use?

In the end, your need and a variety of other factors determine which accounting and inventory method is best suited for you. Before you decide, take a step back and assess your company as a whole. Alternatively hire  MGT Accounting to help you.

After all, the right accounting and inventory system also depends on how you record your transactions.