Inventory Costing Methods: 3 Most Common for Your Business
Inventory costing methods are the systems used to calculate the cost of goods sold and ending inventory in a company’s financial statements. There are several methods, but the most common are FIFO, LIFO, and weighted average cost.
Each method has advantages and disadvantages, so choosing the one that will provide the most accurate results for your business is essential. In this article, we’ll look at the top three methods and discuss which might be best for your business.
But first, let’s explore what inventory costing methods are.
What Is Inventory Costing Method?
Inventory costing methods are used to determine the cost of goods sold (COGS) and inventory on hand. The main purpose of an inventory costing method is to match the costs of goods sold with the revenues from selling those goods. This helps businesses better understand their profitability and make more informed decisions about pricing, production, and inventory levels.
Businesses use different inventory costing methods depending on several factors, including accounting rules, tax implications, and business goals. Some businesses may even use multiple inventory costing methods for different types of inventory.
Regardless of your method, it’s important to be consistent so that your financial statements accurately reflect your business’s activity.
What Is FIFO?
The FIFO inventory costing method is an accounting method that assumes that the first items purchased are the first items sold. This method values the inventory on hand at the end of a period. The cost of goods sold is based on the cost of the oldest inventory. The ending inventory is valued at the cost of the most recent purchases.
FIFO stands for First In, First Out. It’s one of several methods businesses use to account for inventory and determine the cost of goods sold (COGS). When using this method, businesses assume that inventory on hand was purchased in chronological order, so the earliest products available are also assumed to be sold first.
The FIFO method is used in both periodic and perpetual inventory systems. In a periodic system, businesses only track inventory levels at the end of each accounting period. The ending inventory figure is then used to calculate COGS for the next period. In a perpetual inventory system, businesses constantly update their records to reflect sales or purchases made throughout the year.
There are several advantages of using the FIFO method:
- First, it’s easy to understand and implement.
- Second, it reflects real-world scenarios since most businesses sell their oldest products first.
- Finally, it generally results in lower income taxes since newer products are more expensive than older ones.
There are also some disadvantages to using FIFO:
- One drawback is that it may not always match the physical flow of inventory. For example, if a business has two products with the same cost but different shelf lives, the FIFO method would likely result in selling the older product first even if the newer product is physically on the shelves. This causes decision-makers to lose sight of what’s happening in their businesses.
- Additionally, businesses that use FIFO may be less inclined to invest in new inventory since they’ll want to sell off their older products first.
What Does FIFO Require?
FIFO requires that inventory be valued at the original cost of the first units purchased. This means that the most recent purchases are recorded as being the most expensive, regardless of whether or not this is actually the case. FIFO results in lower taxes due to the timing of when expenses are recognized.
FIFO requires that inventory be valued at the prices at which you first purchased them. This method assumes that the goods sold are those that were purchased first, and that newer purchases are still in inventory. This method is often used for perishable goods, since it more accurately reflects the actual cost of the goods sold. When using FIFO, businesses must keep careful records of all inventory purchases to ensure that the correct costs are assigned to the goods sold.
There are five things to keep in mind when using the FIFO method:
- Inventory needs to be physically tracked. This is because you need to know which units were purchased first to value them accordingly. This can be done through various methods such as barcoding, numbering, or other labeling systems.
- Accurate records must be kept. To use FIFO correctly, you must have accurate records of your inventory purchases. This includes the date of purchase, the quantity purchased, and the cost per unit.
- The method is best used for similar products. FIFO works best when valuing inventory that is relatively similar in nature. This is because this method can be difficult to track and value dissimilar products.
- Costs may not always be equal. Even though FIFO assumes that the first units purchased are the most expensive, this may not always be the case. Prices for inventory fluctuate over time, so it’s important to keep this in mind when using FIFO.
- Taxes can be impacted. As mentioned before, the timing of when expenses are recognized can impact taxes. This is because expenses are only recognized when inventory is sold. So, if you have much inventory sitting around for a while, your taxes may be lower than if you had just made recent purchases.
Overall, FIFO is a relatively straightforward method for valuing inventory. It requires accurate records and physical tracking of inventory, but can be used for similar products. Remember that costs may not always be equal and taxes can be impacted when using this method.
Why Use FIFO?
There are a few reasons businesses use FIFO when calculating the inventory cost. First, FIFO is generally thought to more accurately reflect the true cost of inventory. This is because the first units purchased are typically the first units sold, so they represent the oldest and possibly most expensive inventory on hand.
Second, FIFO helps businesses better manage their cash flow. Since inventory costs are constantly changing, using FIFO ensures that businesses only pay for the most recent inventory purchases. This helps businesses save money in the long run, as they won’t be stuck with outdated and overpriced inventory.
Finally, using FIFO helps businesses make more informed decisions about future inventory purchases. By knowing the cost of the most recent inventory, businesses can better estimate the cost of future purchases and make more informed decisions about their inventory management.
Overall, many reasons businesses choose to use FIFO when calculating inventory costs. While there are other inventories costing methods, FIFO is generally considered the most accurate and helpful in cash flow and decision making.
FIFO stands for First In, First Out. This method is often used in restaurants to ensure food is served fresh and hot. The principle is simple: the first dish that is prepared is also the first dish that is served. This way, customers always get the best possible product.
This system ensures that no customer has to wait too long for their food and guarantees they will receive a good meal. FIFO also prevents waste, as dishes sitting for too long are less likely to be ordered.
What Is LIFO?
The LIFO inventory costing method is an inventory valuation technique that assumes that the most recent items added to inventory are the first items sold. The acronym “LIFO” stands for last-in, first-out.
Using the LIFO costing method, the cost of goods sold is based on the costs of the most recently acquired inventory items, while the ending inventory value is based on the cost of the oldest inventory items.
The LIFO method is often used in times of inflationary conditions, because it generally results in a lower taxable income than other methods, such as FIFO (first-in, first-out) or weighted average. In contrast, during periods of deflationary conditions, LIFO generally results in a higher taxable income.
Under LIFO, the last inventory items acquired are assumed to be the first ones sold. The cost of goods sold is, therefore, based on the most recent prices paid for inventory items. The ending inventory balance is based on the oldest prices paid for inventory items.
LIFO can be applied to either a periodic or perpetual inventory system. In a periodic system, LIFO calculations are only made at the end of an accounting period, while in a perpetual system, they are made continuously.
The main advantage of using the LIFO costing method is that it more accurately reflects current costs in calculating the cost of goods sold than other methods. This is especially true in times of inflation when the prices of inventory items are constantly rising.
The main disadvantage of LIFO is that it results in large swings in the value of ending inventory from one period to the next. This makes financial statements more difficult to interpret and creates tax implications.
Under International Financial Reporting Standards (IFRS), LIFO is banned, though it is permitted in the United States, where Generally Accepted Accounting Principles (GAAP) are used.
Should Restaurants Use LIFO?
LIFO, or Last In First Out, is a popular inventory management technique in which the most recently stocked items are sold first. Many restaurants choose to use LIFO because it helps to ensure that perishable items are used before they go bad. Additionally, LIFO helps to minimize shrinkage (i.e., food waste) by selling older items before they have a chance to expire.
There are, however few key reasons why the LIFO inventory costing method may not be ideal for restaurants:
- LIFO leads to higher costs of goods sold (COGS). This is because the most recent and expensive items are typically the ones that are sold first. This eats into profits and makes it difficult to maintain margins.
- LIFO creates issues with menu planning. This is because restaurant menus are often seasonal and change frequently. If the most recent items in inventory are the ones that are being used, it can be hard to plan ahead and ensure that older, less expensive items are still available when they’re needed.
- LIFO leads to waste. This is because older items that have been in inventory for a long time are more likely to go bad before they’re sold. This creates significant food waste and costs the restaurant money.
Ultimately, whether or not to use LIFO is a decision each restaurant must make based on its unique needs and circumstances. There is no right or wrong answer, but it is important to weigh the pros and cons carefully before deciding.
Weighted Average Cost
The weighted average cost is a method of inventory valuation that uses the average unit cost of inventory items rather than the oldest or newest cost. This method assigns the same valuation to all inventory items, regardless of when they were purchased. To calculate the weighted average cost, the total cost of inventory items is divided by the number of units on hand.
This method is generally considered a middle ground between FIFO and LIFO. WAC may be a good choice for businesses that want to simplify their inventory costing methods or for businesses with high inventory turnover rates where it would not be easy to track individual unit costs.
When using the weighted average cost, businesses should know that their COGS will fluctuate as prices change over time. This may need to be taken into account when pricing products or services. Businesses should also keep track of their inventory levels to adjust the weighted average cost per unit as needed.
How to Calculate Weighted Average Cost
The weighted average cost (WAC) measures the average cost of all the units in inventory, taking into account the different costs at which those units were acquired. The total cost of sitting inventory is divided by the number of units to get WAC.
To calculate WAC, start by adding the total cost of all the units in your inventory. This includes the purchase price, shipping costs, and other associated costs. Then, divide that total by the number of units in your inventory. This will give you your weighted average cost per unit.
Next, divide the total cost by the number of units to arrive at the weighted average cost per unit.
For example, if a company has 100 units of inventory with a total cost of $5,000, the WAC would be $5,000 / 100, or $50 per unit.
WAC = ( Total Cost of Sitting Inventory ) / (Number of Units)
Businesses use weighted average cost when they don’t have enough information to value their inventory using a more precise method such as first-in, first-out (FIFO) or last-in, first-out (LIFO). WAC is also often used for tax purposes, resulting in a lower taxable income than other methods.
The weighted average cost can be a helpful tool for businesses to track inventory costs, but it’s important to remember that it is only an estimate. In some cases, using a more precise valuation method may be necessary.
You can use WAC to compare the cost of different inventory types or see how your costs have changed over time. If you have a large number of units in inventory, you may want to calculate WAC for each type of unit separately. This will give you a more accurate picture of your overall costs.
Frequently Asked Questions About Restaurant Inventory Costing Methods
Inventory costing methods are important considerations when it comes time to tag your inventory officially. Below, we’ll answer some of the most frequently asked questions about restaurant inventory costing methods.
What Is the Best Inventory Costing Method?
When choosing an inventory costing method, businesses should consider factors such as the type of products they sell, their production processes, and their financial goals. Each inventory costing method has its own advantages and disadvantages, so choosing the one that best suits the business’s needs is essential.
What are the 4 Inventory Costing Methods?
The four main methods for valuing inventories are:
- First-in, first-out (FIFO)
- Last-in, first-out (LIFO)
- Weighted average cost
- Specific identification
Do Restaurants Use Perpetual Inventory System?
Since restaurants have to keep track of their inventory regularly, they often use a perpetual inventory system. This system allows businesses to have an up-to-date inventory record, which is essential for companies that maintain a certain stock level.