Every business must develop a costing method that determines the cost for products sold. Accurately recording the cost of items is crucial to properly determine profit and make appropriate business decisions in the future. There is no one-size-fits-all solution for costing: as with all aspects of business, each company must assess their own needs as they relate to the industry and operation. Consider the following costing methods and their pros and cons in order to make the best decision.
First-In, First-Out
First-in, first-out (FIFO) costing assumes that the first product in is also the first product sold. This means that the oldest items are those going off the shelf first. This costing method is ideal for businesses with perishable goods, such as grocery and convenience stores.
Consider this example: a company purchases 10 loaves of bread for $0.20 each on Monday and 10 loaves for $0.30 each on Tuesday. It sells no bread on Monday, but sells five loaves Tuesday. Those five loaves are assigned a cost of $0.20, assuming that they're from the first batch. The more recent cost of $0.30 doesn't apply until the eleventh loaf sells.
FIFO costing is the most accurate and one of the most widely used and accepted methods for costing. However, FIFO doesn't account well for periods of extremely high- or low-cost fluctuations. FIFO costing will also fall behind the latest trending prices, though it still provides an accurate representation of profits.
Last-In, First-Out
Last-in, first-out (LIFO) costing is essentially the opposite of FIFO costing. This method assumes that the last product purchased is the first product sold. LIFO costing is only used in the United States and is actually banned by International Financial Reporting Standards because of its potential to distort financial statements.
Using the previous example, LIFO costing would assign the higher cost of $0.30 to the first five loaves of bread sold on Tuesday and only apply the lower $0.20 cost after reaching the eleventh sale. This typically reflects a smaller profit, which some companies may pursue to lower their tax obligations.
Weighted Average Cost
Weighted Average Cost (WAC) assigns an average cost to items. Using WAC costing in the bread example cited previously, all 20 loaves would be assigned an average cost of $0.25 regardless of when they were bought or sold. WAC costing is a simplified approach that gives no consideration to which items go out when.
This approach adjusts easily to price fluctuations, averaging out over time. However, WAC costing doesn't offer a detailed view into the costs and profits associated with each piece of merchandise. Since it relies on broad averages, WAC costing is impacted greatly by large price adjustments. This means that a sudden price increase can throw off all of the numbers rather than just those numbers recorded for particular sales.
Standard Costing
Standard costing estimates the total expense associated with the product. This includes the item itself as well as the labor and manufacturing overhead. When a company uses standard costing, it replaces actual costs with expected costs in the accounting records. Standard costing is typically used by manufacturers rather than retailers. This method can help manufacturers identify problem areas in the manufacturing process by highlighting variances between the actual costs of goods when sold and the expected costs associated with the production of those goods.
Once a business has settled on the appropriate costing method, it's crucial to select costing software that accurately records and reflects financial information utilizing the chosen method. Having the appropriate software and systems in place makes it possible to aggregate and analyze data quickly and efficiently in order to access the right information for key business decisions.
Please contact Clients First Business Solutions for an evaluation of your current manufacturing and supply chain operations. We’ll work with you on a plan to implement Acumatica Cloud ERP, Dynamics 365 Business Central, or Dynamics 365 Finance and Supply Chain Management to improve your bottom line.
FAQs
While there are other inventories costing methods, FIFO is generally considered the most accurate and helpful in cash flow and decision making.
What is the best costing method? ›
For long-term pricing, you must have a good handle on overhead costs. Therefore, job costing, standard costing, or activity-based costing costing will yield more accurate results than direct costing for long-term pricing decisions.
What is the ideal costing method? ›
Firstly, the costing system must suit the organization. Some points to be taken into consideration are the size of the organization, the nature of the business, conditions of the economy etc. The ideal costing system must provide information that is necessary for decision making by the management.
Which costing method is more accurate? ›
FIFO costing is the most accurate and one of the most widely used and accepted methods for costing. However, FIFO doesn't account well for periods of extremely high- or low-cost fluctuations. FIFO costing will also fall behind the latest trending prices, though it still provides an accurate representation of profits.
What is the most accurate inventory costing method? ›
FIFO usually provides a more accurate valuation of leftover inventory, since the value of unsold inventory is closer to the purchase price. The LIFO method, however, does not always provide an accurate valuation of ending inventory since older goods tend to be stored repeatedly as inventory.
What is the easiest costing method? ›
Direct costing is a quick and easy costing method aimed at cost calculation for making decisions on production and sales planning.
What are the 4 costing methods? ›
The 4 inventory costing methods for effective stock valuation.
- The first in, first out method (FIFO)
- The last in, first out method (LIFO)
- The specific identification method.
- The weighted average method.
Answer: The most common costing methods are process costing, job costing, direct costing, and Throughput costing. Each of these approaches can be used in various production and decision-making situations.
Which costing method is best for the service industry? ›
A job costing method is employed in service industries such as advertising companies, accounting firms, etc. Activity Based Costing (ABC) can be used to assign overheads or indirect costs. There are two steps in ABC.
Which costing method produces the highest operating income? ›
The absorption method produces the highest operating income because under the absorption method fixed manufacturing cost is charged only for the number of units sold.
Implement the first in, first out (FIFO) method
If you've ever stocked shelves at a grocery store, you're probably already familiar with FIFO. The FIFO method assumes that you will sell all of the oldest stock in your inventory first, before your new stock.
What are two methods of accounting? ›
The two main accounting methods are cash accounting and accrual accounting. Cash accounting records revenues and expenses when they are received and paid. Accrual accounting records revenues and expenses when they occur. Generally accepted accounting principles (GAAP) requires accrual accounting.
What is the average cost method? ›
What Is Average Cost Method? Average cost method assigns a cost to inventory items based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. Average cost method is also known as weighted-average method.
Is job costing or process costing more accurate? ›
Job costing allows for more accurate cost tracking and helps businesses determine the profitability of each job. Process costing allows businesses to determine the cost per unit of each product and helps them make decisions about pricing and production levels.
What is the most accurate source of cost data? ›
To obtain accurate and reliable cost data, it is advisable to consult a variety of sources including professional estimators, contractors, suppliers, industry publications, and online databases.
Which method produces the more accurate cost assignment? ›
Activity-based costing is a more accurate method, because it assigns overhead based on the activities that drive the overhead costs.
Why is variable costing more accurate? ›
Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead costs. Variable costing can provide a clearer picture of per-unit cost and inventory value because it excludes the fixed overhead cost.
