Top 4 Inventory Costing Methods and How They Work
Working out the value of your inventory isn’t as simple as basic addition but it doesn’t have to be complicated either. The biggest challenge is choosing the right inventory costing methods for your business and when to use them.
In this article, you’ll learn about four important inventory costing methods, compare some real-world examples and understand the key factors in choosing the right inventory costing method for your e-commerce or retail business.
Table of Contents
- What is Inventory Costing?
- What’s the Difference Between Cost of Goods Sold (COGS) and Inventory?
- 4 Inventory Costing Methods -Real-World Scenario to Compare Inventory Costing Methods
- Choosing the Right Inventory Costing Method for Your E-commerce or Retail Business
- Match the Right Inventory Costing Method to the Right Inventory Optimization Software
What is Inventory Costing?
Inventory costing is also referred to as inventory accounting, inventory cost accounting and inventory valuation. The inventory costing method you choose can have a big impact on taxes as well as valuation.
As long as costs are rising, methods like FIFO (First-In, Last-Out) make your business look more profitable, which is a good sign for shareholders but inventory costing methods like LIFO (Last-In, First-Out) can reduce your tax burden as they make your business look less profitable.
What’s the Difference Between Cost of Goods Sold (COGS) and Inventory?
Before we get into the different inventory costing methods, it’s crucial to understand the difference between cost of goods sold and inventory.
COGS relates to any items you have sold and the costs that are associated with them. It includes things like direct labor costs, raw materials and freight costs directly related to producing the products that have been sold. It doesn’t include costs that are not directly related to the item, like storage costs, general administration or costs related to products that aren’t sold at the end of an accounting period.
Your inventory value relates to products that are not sold and that are sitting in your inventory at the beginning or end of a financial period. The ending inventory value of one period should always be equal to the beginning inventory value of the next period.
When you account for inventory costs during a financial period, you need to compare the value of goods in inventory to your COGS. The question is whether the COGS is attached to the earliest units purchased, the latest units purchased or if you use an average.
4 Inventory Costing Methods
The four inventory costing methods most e-commerce and retail businesses use are first-in, first-out (FIFO), last-in, first-out (LIFO), weighted average cost (WAC) and specific identification.
Three of the four methods are included in the generally accepted accounting principles (GAAP) — standardized rules put in place to make sure companies don’t overstate their costs. LIFO is the only one that isn’t included.
- First-In, First-Out (FIFO)
- Last-In, Last-Out (LIFO)
- Weighted Average Cost (WAC)
- Specific Identification
| Inventory Costing Method | Explanation | When to Use It | Financial Effects |
|---|---|---|---|
| FIFO (First-In, First-Out) | The first items purchased in a financial period are declared as the first items sold. COGS is taken from the oldest purchases. | In certain situations, like US based companies selling internationally, it’s the only option the IRS allows. Otherwise, FIFO results in the lowest COGS and the highest profit when supplier prices are rising. | With rising supplier costs because of inflation, FIFO provides a more accurate ending inventory value, the lowest COGS and the highest gross profit, which usually means higher taxes. |
| LIFO (Last-In, First-Out) | The most recent items purchased in a financial period are declared as the first items sold. COGS is taken from the most recent purchases. | With rising prices, LIFO results in the highest COGS and the lowest profit. You can use it for certain tax purposes because less income usually produces a lower tax bill. | When costs are rising, LIFO provides the lowest ending inventory value, the highest COGS and the lowest gross profit, which usually means lower taxes. |
| Weighted Average Cost (WAC) | The sum of all purchases and the beginning inventory is divided by the total units sold to calculate the average cost over a financial period. | Commonly used when inventory prices are almost identical for ease and when there’s a higher inventory turnover. | WAC results sit between FIFO and LIFO for ending inventory, COGS and gross profit. It provides an average cost across a particular financial period, which usually means your taxes will land between the FIFO and LIFO methods |
| Specific Identification | Each item is tracked individually and therefore has a unique COGS. | When a business has high-value, low-volume items like luxury cars, art or jewelry. | This is completely dependent on the specific goods sold and the acquisition costs for each item. |
First-In, First-Out (FIFO)
For each of the methods, we’re going to use Ariana’s Accessories as an example. Let’s look in more detail at a three-month account period from July to September using each of the inventory costing methods.
With each inventory costing method example — except specific identification — you’ll notice that the sum of the cost of goods sold and the ending inventory is equal to the dollar amount from the net purchases ($160). The number of units sold is identical (25) but the COGS, ending inventory and gross profit all change.
-
Pros. It offers an accurate representation of your inventory and often mirrors the reality of what you physically sell. You’ll show higher gross profit and a lower ending inventory dollar value.
-
Cons. Hard to track different costs within the same stock keeping unit (SKU) when you purchase different batches.
Ariana’s Accessories FIFO example:
- Beginning inventory = $0
- Purchases July = 20 units * $4 each = $80
- Purchases August = 10 units * $5 each = $50
- Purchases September = 5 units * $6 each = $30
- Total number of units = 20 units + 10 units + 5 units = 35 units
- Net purchases (goods available for sale) = $80 + $50 + $30 = $160
- Cost of goods sold = $80 (20 units sold - July) + $25 (5 items sold - August) = $105
- Ending inventory = $25 (5 units remaining - August) + $30 (5 items remaining - September) = $55
As you can see, the COGS are attributed to the purchases made in July and August.
Let’s say the 25 units were sold at $12 each.
Total sales = 25 units * $12 = $300
To calculate the gross profit, subtract total COGS from total sales.
Gross profit = $300 - $105 = $195
Last-In, Last-Out (LIFO)
LIFO compares sales to the purchase price of the most recently bought inventory. It’s mainly used for tax purposes as it shows a lower gross profit.
- Pros. It shows a higher COGS, which can help to rein in tax liabilities
- Cons. It’s a complex system that isn’t allowed in most countries under GAAP.
Ariana’s Accessories LIFO example:
- Beginning inventory = $0
- Purchases July = 20 units * $4 each = $80
- Purchases August = 10 units * $5 each = $50
- Purchases September = 5 units * $6 each = $30
- Total number of units = 20 units + 10 units + 5 units = 35 units
- Net purchases (goods available for sale) = $80 + $50 + $30 = $160
- Cost of goods sold = $30 (5 units sold - September) + $50 (10 units sold - August) + $40 (10 units sold - July) = $120
- Ending inventory = $40 (10 units remaining - July) = $40
As you can see, the COGS are attributed to the purchases made in August and September.
Let’s say the 25 units were sold at $12 each.
Total sales = 25 units * $12 = $300
To calculate gross profit, subtract total COGS from total sales.
Gross profit = $300 - $120 = $180
Weighted Average Cost (WAC)
WAC, also called the average cost inventory method, divides the number of units bought by the total cost of goods available to sell in a financial period to find an average unit cost. It’s mainly used when inventory prices are almost identical and you don’t need to track specific costs.
- Pros. It’s much easier to track than specific costing as you don’t need to know which batch a unit was part of
- Cons. Can be less accurate if you regularly buy SKUs at varying prices
Ariana’s Accessories WAC example:
- Beginning inventory = $0
- Purchases July = 20 units * $4 each = $80
- Purchases August = 10 units * $5 each = $50
- Purchases September = 5 units * $6 each = $30
- Total number of units = 20 units + 10 units + 5 units = 35 units
- Net purchases (goods available for sale) = $80 + $50 + $30 = $160
- Average cost = $160 / 35 units = $4.5714285 (don’t round this number)
- Cost of goods sold = $4.5714285 * 25 units (total sold) = $114.29
- Ending inventory = $4.5714285 * 10 units = $45.71
As you can see, the COGS are attributed to the average of all the purchases made in the financial period.
Let’s say the 25 units were sold at $12 each.
Total sales = 25 units * $12 = $300
To calculate gross profit, subtract total COGS from total sales.
Gross profit = $300 - $114.29 = $185.71
Specific Identification
Specific identification works differently to the other inventory costing methods and technically isn’t a method in its own right. Instead of calculating your overall inventory costs, specific identification calculates every single piece of inventory. It’s useful for smaller businesses and companies that sell high value items like cars, art and jewelry.
- Pros. Extremely accurate and specific
- Cons. Almost impossible to implement with larger quantities
For this example, let’s go to the more exclusive part of Ariana’s Accessories, which we haven’t yet mentioned:
Ariana’s Accessories - The exclusive store
- Individual unit cost
- Diamond ring = $2,000
- Pearl necklace = $1,000
- Ruby bracelet = $3,000
- Items sold
- Diamond ring = $5,000
- Ruby bracelet = $7,000
- Total COGS (diamond ring + ruby bracelet)
- $2,000 + $3,000 = $5,000
- Ending inventory (pearl necklace)
- $1,000
- Total sales = $12,000
Gross profit = $12,000 - $5,000 = $7,000
Real-World Scenario to Compare Inventory Costing Methods
Let’s see the different inventory costing methods for Ariana’s Accessories in one table so you can see how the COGS, ending inventory and gross profit compares. We’re not including specific identification in this example.
| Inventory Costing Method | Cost of Goods Available for Sale | Cost of Goods Sold (COGS) | Ending Inventory | Gross Profit |
|---|---|---|---|---|
| FIFO | $160.00 | $105.00 | $55.00 | $195.00 |
| LIFO | $160.00 | $120.00 | $40.00 | $180.00 |
| WAC | $160.00 | $114.29 | $45.71 | $185.71 |
Choosing the Right Inventory Costing Method for Your E-commerce or Retail Business
The right inventory costing method for your e-commerce or retail business depends on a number of factors. Let’s review them:
What type of inventory do you have?
If you’re a small business that only sells a few items or a bigger business that sells high-value products in low quantities, specific identification makes sense. Otherwise, you can rule it out. If you sell products with consistently fluctuating purchase prices, WAC won’t be the best method for you, but FIFO and LIFO could both work.
💡Pro Tip: Take advantage of Singuli’s detailed Reporting & Analytics to create a forecast that meets the strategic needs of your business.
Profit and loss
If you’re looking for investment or you want to show off as a profitable business, LIFO is not the best method. Your gross profit is not as high as it would be with FIFO or WAC, which will make your business seem less attractive
📌Get Started: Understand what’s working and turn your performance marketing into a category level forecast with Singuli’s Performance Marketing.
Sales locations
If you’re based in the US but you sell internationally, you have to use FIFO, which at least makes the decision making process easier.
💡Pro Tip: Use Singuli’s real-time, channel-aware forecasting to maximize sales in every location.
Taxes
Many countries don’t accept LIFO as an accounting method anymore but for those who do, it can sometimes be worth considering to lower your tax burden.
📌Get Started: Be ready for anything. Access any metric with Singuli’s query panel for customer reports so you can quickly adjust to sudden changes.
Match the Right Inventory Costing Method to the Right Inventory Optimization Software
You know the four most important inventory costing methods, from FIFO to LIFO, to WAC, to specific identification, so now it’s time to choose the best method for your business and to optimize your inventory. With the right inventory optimization software (like Singuli), you can make sure that whatever inventory costing method you choose, you’ll always have up-to-date, relevant reports and accurate forecasts.
Forecast demand, issue and track POs, re-order on autopilot, and step up your reporting game across multiple channels and locations. Get in touch to see how Singuli can help you optimize your inventory.
Inventory Costing Methods FAQ
What are the 4 Inventory Costing Methods?
The four inventory costing methods are:
- FIFO (First-In, First-Out)
- LIFO (Last-In, Last-Out)
- WAC (Weighted Average Cost)
- Specific Identification
What is the Best Inventory Costing Method?
The best inventory costing method depends on your business but the most popular is FIFO (first-in, first-out), as it usually provides the most accurate view of COGS (cost of goods sold) and gross profit.
Which Inventory Cost Method is Acceptable for GAAP?
First-In, First-Out (FIFO), Last-In, First Out (LIFO) and Weighted Average Cost (Wac) are all acceptable inventory costing methods for GAAP in the US. Having said that, you are not permitted to use LIFO if you’re based in the US and sell products abroad.
Forecast demand, issue and track POs, reorder on autopilot, and step up your reporting game across multiple channels and locations. Get in touch to see how Singuli can help you optimize your inventory.