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Inventory costing methods

inventory costing methods

Which are the most used inventory costing methods? Which inventory costing method is supported in ERP/MRP software solution? Should you use FIFO, LIFO, Average or Specific costing method in your ERP?

In practice, after you sell anything from your inventory, the cost of goods sold must be included in the period the sale has been made.

There are four main types of inventory costing methods:
1. Weighted average method
2. FIFO (First In First Out)
3. LIFO (Last In First Out)
4. Specific identification

In one of our previous blogs, we explained the differences between Weighted average and FIFO costing methods: https://blog.erpag.com/2019/01/fifo-vs-weighted-average-inventory.html
In this blog, we will go over each method.

Weighted average method

This is the most commonly used costing method. With this method, the average cost is assigned to each inventory piece when it’s sold throughout the year.

The average cost is calculated after each purchase with the next formula:
Average cost (purchase price) = Old inventory value + landing cost / Old inventory quantity + landing cost
Where the inventory value = purchase price + landing cost

The average cost contains your purchase price plus the shipping, handling, etc. (landing cost)

Susan has a bike store. She uses the weighted average method to run her inventory costs. If she purchases a bike on the 1st of March for $70, with $10 shipping, her average purchase price for the bike will be $80. On 9th of March, she purchases a bike from a different supplier for $50 and $10 shipping, her stock price will now be $70.
Purchase cost balance = $80 + $60 = $140, divided by 2 pcs = $70

weighted average inventory cost method

Upon making the sale, the $70 cost will be assigned to the bike:

weighted average costing method

As the inventory purchase price changes over time, so will the stock price (average purchase price). 
ERPAG uses a perpetual inventory costing method in inventory transactions, which means that it updates the stock price (weighted average price) after each purchase.
FIFO (First In First Out)
The FIFO method means that the inventory that is first physically acquired will be charged to expenses account. Therefore, for this reason, the inventory items that were first bought they are sold first as well, and the remaining stock items at the end of the period are those that were last purchased or manufactured.
The FIFO inventory method is actually based on the physical flow of inputs or inventories without taking into account the price of these inventories and whether these inventories will be consumed in that order.
Karen also has a bike store, and she purchased 4 bikes on Monday at $70 each, and she purchased 2 bikes on Tuesday at $75 each (Jesus Karen, always buy in bulk when you find a great deal!). Mike comes in and purchases a bike. Even though he bought a bike that Karen paid $75, she will assign the cost of $70, because she is calculating her inventory costing by FIFO method. Her inventory stock amount will be $360.
FIFO costing method
The result that will arise by applying this method, expressed through the amount of expense and inventory at the end of the period, depends on whether or not the cost of inventories increases.
If it is assumed that it’s a sale of finished products, the effects of applying the FIFO method will affect the amount of cost sold and the value of the inventory that will be in stock at the end of the period.
LIFO (Last In First Out)
The LIFO inventory method means that the last purchased inventory item is sold first, and the remaining stock items at the end of the period are those items that were first purchased or manufactured.
Same as with the FIFO method, the LIFO inventory method is based on the physical flow, the input, ie the inventory, regardless of the price level of these inventories and regardless of whether the inventories are actually consumed in that order.
In this case, Karen will sell to Mike the bike that she purchased for $75.
The result that will occur by applying the LIFO method expressed through the level of costs or expense and inventory at the end of the period, will depend on whether the cost of inventories increases or decreases.
Specific identification
This method is used when you can track individual items of your inventory. Whether it’s through the serial number, or a barcode, or a QR tag. If you can distinguish each item in your inventory, you can track the cost of each and one of them through an accounting system, or even a simple XLS table. The point of the specific identification method is to track the cost of each item sold.
If Susan shifts to this costing method and purchases bikes in June for $65, and for $70 in July and puts QR codes on each one of them. Upon each sale, she will be able to identify the cost of the sold bike.
This sounds like the best option to track the cost of your inventory, but it’s also very time-consuming method, and it’s more suitable for items of high-value. And since Susan & Karen are super busy bike-shop owners, they need to rely on FIFO or weighted average, or, at the last spot – LIFO costing 
method, if they want the procurement, inventory stocking, sales, and cost assignment to be done asap.
ERPAG as one of the ERP and MRP business software solutions offers Weighted average and FIFO as inventory costing methods. Due to opinion collision, we incorporated the 2 most used costing methods, and we give you a full ability to choose by which method you will run the warehouse. Once you assign it to your warehouse and start creating documents, we are stripping down that ability from you and tying your hands and you won’t be able to change the costing method anymore. So make a wise choice. At least, with ERPAG, you have such a possibility.

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