Top 5 Inventory Costing Methods With Examples

One of the most important indicators of a company’s financial performance is its inventory valuation. The irony is that inventory is one of the highest costs for a company while being the primary source of revenue too. 

Thus, a business owner should know how to properly calculate inventory costs using different inventory valuation methods. Here, we will delve deeper into the definition of inventory valuation, how it works, and the various costing methods.

What Are Inventory Costing Methods?

Inventory valuation is an accounting process that involves assigning a monetary value to a company’s inventory. Under inventory valuation, businesses calculate the value of any unsold goods at the time of preparing any financial statements. 

And the method by which a business calculates its unsold goods determines various financial indicators such as cost of goods sold (COGS), inventory turnover ratio, and gross income at the end of every financial period. It also gives you an understanding of how much more stock you need to purchase to maintain inventory levels for your organization.

How Does Inventory Costing Work?

Inventory costing or valuation is computed as the value of the remaining unsold goods at the end of a financial period. There are various types of inventory cost methods, including the retail inventory method, specific identification method, first in first out (FIFO), last in first out (LIFO), and the weighted average method. 

Some of the costs included as part of inventory valuation include direct labor, factory overhead, import duties, raw materials, and freight.

5 Inventory Costing Methods To Consider

Each organization uses different methods to calculate inventory costs, depending on factors such as taxation, profit margins, current market conditions, and financial goals.

We will now look at each of the inventory costing methods in detail.

1. The Retail Inventory Method

Under the retail inventory method, the ending balance of inventory is calculated by measuring the cost of goods relative to their price. Companies that use the retail inventory valuation method use the cost-to-retail ratio and determine how much expense to calculate for the current versus the next financial period.

Let us take an example to understand this better. Suppose the cost of goods sold at the beginning of the financial year is $50,000, and the retail value of the inventory is $75,000. Hence, the cost-to-retail ratio will be

COGS/Retail Value of Inventory

Or

50,000/75,000= 0.67 or 67%

Assuming that the estimated ending inventory at retail is $20,000, multiply the cost-to-retail ratio to arrive at the inventory value at the end of the financial period.

Thus, the inventory cost according to the retail inventory method will be

Cost-to-Retail X Estimated Ending Inventory Value

Or

0.67 X 20,000= $13,400

Pros

The retail inventory method is quite easy to use and is best for small businesses that don’t have strong inventory tracking systems and have a limited product range.

Cons

Since the retail inventory method tends to provide estimates of COGS and ending inventory, it may not always provide correct figures. Further, it is not suitable for enterprises that sell goods with fluctuating price levels.

2. The Specific Identification Method

Another method of inventory costing is the specific identification method. Here, companies assign a certain cost to every item in the inventory. It is ideal for businesses that have a diverse range of items to sell and a small inventory. 

Here is an example of the specific identification method to help you understand how it works. Let’s say you buy and sell used cars. Suppose you buy three cars in a month for $10,000, $12,000, and $8000, respectively. Thus, the total cost of inventory for the month will be $(10,000+12,000+8000)= $30,000.

If the first car is sold for $15,000, the inventory valuation according to the specific identification method will be $(30,000-15,000)= $15,000.

Pros

Ideal for small businesses, the specific identification method helps with easier inventory tracking, provides a more accurate profit and loss statement, and helps you identify the location, cost, and sale of every unit in your storehouse.

Cons

Given that the specific identification method involves assigning a unique price to every good, it can be time-consuming for large and growing businesses and those selling a diverse product range to keep a tab on inventory that is sold versus one that is unsold.

3. The First In, First Out Method (FIFO)

The first-in, first-out method, popularly known as the FIFO method, is an inventory valuation method that assumes that the items or goods that are purchased first are sold first. Thus, the inventory that is purchased first is recognized first while calculating the cost of unsold inventory at the end of a financial period.

Assume that your company sells smartphones. It purchased 100 units for $120 each, followed by an additional 150 units for $125 each. Later, the company sold 80 units for $200 each. Under the FIFO method, the COGS will be $9600 (80 X 120), or the cost of each smartphone would be $120. 

Thus, the value of the remaining inventory at the end of the financial period will be 

(20 X 120) + (150 X 125)= $2400 + $18,750= $21,150

Pros

The FIFO method is typically used by organizations that deal in perishable goods or those with a short shelf life. A key advantage of the FIFO method is that it helps report a higher net income owing to a lower COGS. Further, the FIFO method helps better reflect current market prices, ensuring that inventory is neither underpriced nor overpriced.

FIFO is also beneficial in terms of minimizing the tax liability of your business, particularly when prices are declining.

Cons

Since FIFO assumes that the goods purchased first are sold first, tracking prices from the beginning can be difficult and time-consuming. Moreover, with a higher net income, the tax will also be greater.

4. The Last In, First Out Method (LIFO)

As the name suggests, the last-in, first-out method assumes that the inventory bought last is sold first. Opposite of the FIFO principle, the LIFO method is typically not considered a good indicator of inventory valuation since it may understate the value of goods, resulting in a lower net profit and a higher COGS.

Let us take the examples of smartphones again to understand what LIFO is. Suppose your company bought 100 smartphones for $120 each and an additional 150 units for $125 each. Later, 80 units were sold for $200 each. Thus, the COGS, in this case, would be $20,000 (80 X 125) at a cost of $125 per unit.

To calculate the value of the unsold inventory, the calculator will be as follows:

(100 X 120) + (70 X 125)= $12,000 + $8750= $20,750

Pros

Since goods bought in the end are sold first, it results in higher COGS and in turn, lower profits. This helps firms save taxes. 

Businesses using LIFO adopt it in order to match revenue and current costs. This is beneficial for those in industries where price levels fluctuate often. Additionally, LIFO acts as a hedge against inflation since higher prices imply lower profit margins.

Cons

At present, the LIFO method has only been approved by the Generally Accepted Accounting Principles (GAAP) in the US, implying that businesses outside the US cannot use it to value inventory. Moreover, companies have found LIFO a complex method of inventory valuation.

5. The Weighted Average Method

Besides the methods discussed above, there is another inventory cost calculation method known as the weighted average method or the average cost inventory method.

Under the weighted average method, the inventory prices typically do not fluctuate, making it easier to assign a single value to every unit of a good. Here, you need to divide the cost of the goods that are sold and the cost of goods still on the shelf by the same price.

Let’s suppose that you have purchased 100 smartphones for $40,000. Hence, the per-unit cost of each smartphone will be 

40,000 / 100= $400

Assume that you sell 60 smartphones in a given financial period. Thus, the COGS will be

60 X 400= $24,000

So, the value of the ending or unsold inventory will be

40 X 400= $16,000

Pros

The weighted average cost method saves time and is easy to estimate since a single value is assigned to every unit of a good.

Cons

In companies where the price levels fluctuate quickly, the average costing method can lead to a mismatch between the book value and the market value of goods, resulting in either overvaluing or undervaluing inventory.

The Bottom Line

Companies use different methods to value inventory. However, which method is the best? There is no straightforward answer to this question.

Depending on factors such as future financial targets, taxation costs, specific product attributes, inventory management, and how orders are processed can determine which method of inventory valuation will be best suited to your business needs.

You can either hire a warehouse design consultant or adopt an inventory management software that can help make inventory costing more efficient and help you evaluate your company’s financial performance better.

Supriya Bajaj

Supriya is a highly skilled content writer with over 8 years of experience in the SaaS domain. She believes in curating engaging, informative, and SEO-friendly content to simplify highly technical concepts. With an expansive portfolio of long-format blogs, newsletters, whitepapers, and case studies, Supriya is dedicated to staying in touch with emerging SaaS trends to produce relevant and reliable content.