A Summarized Guide to Inventory Costing Methodologies

For manufacturing companies, few things are as important as inventory costing. The method chosen has a direct impact on not only the bottom line, but also provides insight into operations and operational efficiencies. Among the countless inventory valuation methodologies permitted by Generally Accepted Accounting Principles (GAAP), there are several that are worth focusing on: Weighted Average Costing (WAC), First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and standard costing. Although these methods are calculated similarly under both periodic and perpetual systems, there are key timing differences in a periodic system that can impact results. Let’s break down each approach, looking at how they function, their key advantages, and the industries that rely on them. For clarity, this article focuses on companies using a perpetual inventory system.

Weighted Average Costing (WAC)

The Weighted Average Cost (WAC) costing method is one of the most used costing methods for companies that have fast turnover and are purchasing inventory on a regular basis. The method divides the costs of goods available for sale by the number of units available for sale. Manufacturers will typically use this approach when their inventory contains items that are blended and difficult to assign specific costs to individual units. Below is a list of key takeaways from this inventory approach:

• WAC offers the most simplified record-keeping for businesses, yielding operational efficiencies.
• It provides “price smoothing” from a financial reporting perspective. Price hikes or drops are spread across all inventory items, which leads to less volatile reporting. The drawback to this lies in the difficulty of providing a precise internal cost analysis for a respective item. Given that all costs are lumped together, cost managers will have a difficult time following costs from the point of production through the point of sale to their customers.
• WAC is favorable for manufacturers in the food and beverage industry, agricultural sector, as well as the pharmaceutical industry. However, it is also suitable for any manufacturer with considerable order volume.

First-In, First-Out (FIFO)

The First-In, First-Out (FIFO) asset management and valuation method assumes that the first items added to inventory are sold, used, or disposed of first, leaving any newly purchased inventory on the balance sheet. FIFO provides businesses with several notable benefits:

• FIFO provides the most accurate “real-time” picture of costs and profitability. The most recent purchases are what is being reflected on a company’s balance sheet, which is likely directly correlated to the current economic conditions.
• This is the favorable approach for any manufacturer that operates with perishables or products with inherently short shelf lives.
• It provides an opportunity to protect a company’s bottom line during inflationary periods, as the cost of goods sold (COGS) remains lower by expensing the older, less expensive inventory first.

Last-In, First-Out (LIFO)

Last-In, First-Out (LIFO) operates under the assumption that a company’s most recent inventory purchases are sold first, leaving the COGS of the most recent inventory to match against current revenue amounts. This is opposite to the FIFO approach listed above. This inventory management method is ideal for manufacturers handling products with long shelf lives, such as non-perishables or machinery, that face annual inflationary pressures and typically have high unit costs. Below are several additional points of LIFO to consider:

• This is the most tax advantageous approach for companies operating in inflationary environments. The higher COGS reduces bottom line profitability. This is the main reason why LIFO is used by select manufacturers.
• LIFO can impact a company’s balance sheet by undervaluing inventory in comparison to current market conditions, making it difficult for outside parties to accurately assess the company’s financial health.

Standard Costing

Standard costing is a system that sets predetermined costs for direct materials, labor, and manufacturing overhead. These costs are determined by management through detailed analysis and serve as benchmarks to compare against actual expenses incurred throughout the year. The difference between the actual cost and standard cost is recorded as a favorable (costs lower than benchmarked) or unfavorable (costs higher benchmarked) variance, which is analyzed to assess production efficiency and control expenses. Some reasons manufacturers choose this approach include:

• This approach is instrumental for budgeting and planning within any manufacturing organization. It is one of the most informative methods for any inventory team.
• It’s a streamlined accounting process, as the organization does not have to track every inventory item at cost.
• As mentioned in a previous article, while this approach brings valuable information, it is time-consuming and often does not reflect real-time fluctuations, depending on the frequency of the predetermined standard. In recent years, determining a reasonable standard has been particularly challenging due to a period of high inflation, which led to more frequent adjustments.
• Standard costing is likely suited for a large-scale manufacturer with predictable production costs and workflows.

Considerations

Each approach detailed above provides a different benefit to any given manufacturer regarding financial reporting, tax obligations, or internal planning. Weighted average costing offers simplistic inventory cost management and is commonly used by many new manufacturers. FIFO offers a company financial reporting that reflects their industry’s current market conditions and is often the choice of a manufacturer dealing with perishable goods. LIFO offers an approach for any manufacturer operating in an inflationary environment looking to minimize their tax liability. Finally, standard costing will provide a focus on cost control and overall planning for any organization, and usage is heavily concentrated on large manufacturing organizations. All four of the listed methodologies offer distinct benefits, making it important for management to assess which option aligns best with the strategic direction of their company.

Please reach out to a member of our Manufacturing & Distribution team for more information on the topic outlined above. For more information regarding our Manufacturing & Distribution experience, visit our Manufacturing & Distribution industry page.

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