Inventory Costing Methods

There are several different ways that a company can compute the cost of holding a good in stock

. Inventories are the collection of items that a company physically holds for later sale or the collection of items that a company physically holds for later manufacture. Three of the methods that are used to calculate the value of a company's inventory and its cost of goods sold (COGS) are approved by GAAP (generally accepted accounting principles). The three methods that are supported by GAAP to calculate inventory cost and the COGS are the FIFO method (first in, first out), the LIFO method (last in, first out), and the weighted average method. In order to calculate a company's inventory value, you must know which inventory costing method they are using.

The first GAAP approved method that companies can use to calculate the value of their inventory and their COGS is called the weighted average method. In this method, both the inventory and the COGS are based on the cost of all of the units that the company purchased throughout the period. The order in which the inventory was purchased is not important. At the end of the period, the company takes all of the purchases made, adds them up, and calculates the average. This average is what they value their inventory at. If a company bought 5 items on 9/1 for $5 each and 5 items on 9/15 for $6 each, and they sold 7 items on 9/30, they would value each item sold at $5.50 each because they are using the weighted average method. The result of this inventory costing would put their COGS at $38.50

The second GAAP approved method that companies can use to calculate the value of their inventory and their COGS is called the first in, first out (FIFO) method. In this method, the oldest items in the company's inventory are sold first. They use the price at which the oldest item in their inventory cost them to calculate their COGS. If the company bought an item on 9/1 for $5 and on 9/15 for $6, and they sold a product on the 30th, they would sell the one that they bought on the 1st and use that $5 for their COGS. If the company bought 5 items on 9/1 for $5 and 5 items on 9/15 for $6 and sold 7 items on 9/30, they would use the first 5 items purchased on 9/1 along with 2 purchased on 9/15 for a total cost of $37. This is because they are using the FIFO method and they sell off the oldest items in their inventory.

The third and final GAAP approved method that companies can use to calculate the value of their inventory and their COGS is called the last in, first out (LIFO) method. In this method, the newest items in the company's inventory are sold first. They use the price at which the newest item in their inventory cost them to calculate their COGS. For example, if the company was to buy an item on 9/1 for $5 and they bought another one of those items on 9/15 for $6, and they sold an item on 9/30, they would sell the item that cost them $6 since they are using the LIFO method. Also, if the company bought 5 items on 9/1 for $5 and 5 items on 9/15 for $6, and they sold 7 items on 9/30, they would use 5 items from the 9/15 purchase and 2 items from the 9/1 purchase for a total cost of $40.

As you can see, with three identical situations, the company would have three different COGS depending on which inventory costing method they used. If they used weighted average, their COGS would be $38.50. If they used FIFO, their COGS would be $37. If they used LIFO, their COGS would be $40. Different inventory costing methods are best based on how the economy is going and whether the cost of whatever product the company is buying is going up or down. If the prices of the items that the company is buying are going up, they should use FIFO, if the prices of the items that the company is buying are going down, they should use LIFO for the lowest COGS.

Inventory Costing Methods

By: Mark Mcguinn

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