Maintaining a proportionate and cost-effective level of inventory is essential to every business. Having excessively high or low levels of stock can negatively affect business functions however, Inventory costs can be successfully managed through our Passport inventory control system.
The accounting method a company uses to determine the costs of inventory can directly impact their balance sheet, income statement and statement of cash flow. There are four inventory-costing methods that are widely used by both public and private companies, and typically your finance department will determine which method the inventory management system should use.
- First-In, First-Out (FIFO) – In warehousing, this describes the method of rotating inventory to use the oldest product first. For example, a bakery produces 200 loaves of bread on Monday at a cost of $1 each and 200 more on Tuesday at $1.25 each. FIFO costing states that if the bakery sold 200 loaves on Wednesday, the Cost of Goods Sold (COGS) is $1 per loaf because that was the cost of each of the first loaves into the inventory system. The $1.25 COGS loaves are still in inventory and would be queued up next to go.
- Last-In, First-Out (LIFO) – This method assumes that the last unit into the inventory system is the first sold. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period. This can lead to old or obsolete product which may need to be written off at some point.
- Average Cost – This method takes the weighted average of all units available in the inventory system and uses that average cost to determine the value of COGS and the remaining inventory. In the bakery example, the average cost of inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.
- Last/Simple Cost – This method is often used in R&D, warehouse and stockroom situations where costs are not necessarily the primary concern, raw material costs are stable, or when a simpler inventory cost is required due to the reduced complexity versus one of the other methods. In the bakery example, the COGS on Wednesday as well as the cost used to value inventory would simply be the most recent cost entered for the product which would be Tuesday’s $1.25.
If inflation were nonexistent, all four of the inventory control system valuation methods would produce the identical results. When prices are stable, the bakery would be able to produce all loaves at Monday’s costs and FIFO, LIFO, Average, and Last/Simple costing would give a cost of $1 per loaf to use for COGS and valuing inventory.
Unfortunately, the world is more complicated. Over the long term, and based on the industry, prices tend to rise or fall, which means the choice of inventory system accounting methods can affect valuations.
Whichever method you are tasked with, our Passport inventory system is one of the best inventory systems. Our built-in, customizable and exportable multiple-format reports allow for external calculations to be performed when needed.