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  • Writer's pictureAlfredo Iorio

Inventory Costing Methods: What they do and how to choose them

Updated: Oct 20, 2023

Inventory costing is a method of accounting for the value of the goods a business holds in stock. Maintaining the correct Inventory Costing is critical for companies that trade physical products, such as retailers, manufacturers, and wholesalers.


In this post, we will learn the different types of inventory costing methods supported in Business Central, how these methods affect inventory valuation and COGS, and all you need to know about choosing the correct inventory costing method for your business or client.

Inventory Setup page in Business Central

Before we dive into inventory costing, companies can choose a default inventory costing method in Business Central. However, individual items can have different costing methods and be costed differently. The costing method set up on the item will override the default setup. Although Business Central supports multiple costing methods, the setup might not comply with local accounting standards. Please, check with your local tax authorities before applying different costing methods in a live system.


Inventory Costing Methods


There are five costing methods in Business Central:

  • First In, First Out (FIFO)

  • Last In, First Out (LIFO)

  • Average

  • Specific

  • Standard

Different Costing Methods result in different calculations of how inventory decreases after sales, increases following a purchase and if the actual or a budgeted cost is used in the calculation. Let's examine the four methods in detail.


FIFO

An item unit cost is the actual value of the receipt of the item. In the inventory valuation, Business Central assumes that the first items received in inventory are sold first.


Companies typically use this method where product costs are stable, for example, in consumer goods. In accounting, FIFO assumes that assets with the oldest costs are included in the cost of goods sold (COGS) first. The remaining inventory assets are matched to the most recently purchased or produced assets.


FIFO is a common costing method because it is easy to understand and because the cost application is based on the remaining quantity of the time ledger entry. When adjusted, the costs are carried forward according to the application quantity.

Item Ledger Entry of type Purchase fully invoiced. Action Applied Entries show sales applied to the purchase.
Item Ledger Entry of type Purchase fully invoiced. Action Applied Entries show sales applied to the purchase.
Applied entries of type Sale. COGS are revalued if the cost of the purchase receipt is adjusted
Applied entries of type Sale. COGS are revalued if the cost of the purchase receipt is adjusted

Revaluation journals can be backdated with FIFO. Only invoiced quantity can be revalued, and users can choose to reevaluate the entire inventory of an item or a specific item ledger entry (a purchase, transfer or production output).


Important: Existing entries are not reapplied to provide a correct FIFO cost flow if users backdate a stock adjustment. This means that the cost of goods sold (COGS) will be calculated using the value of the first inventory acquisitions, regardless of the backdated inventory decrease.


LIFO

An item unit cost is the actual value of the receipt of the item when using LIFO. In the inventory valuation, Business Central assumes that the last items received are sold first.


This method is disallowed in many regions as it does not comply with local tax authorities. With LIFO, the cost of the most recent products purchased is the first to be expensed, which means the lower cost of older products will be reported as inventory. The same FIFO rules about adjustments and revaluation apply to LIFO.


Average

An item's unit cost is calculated as the average unit cost at each point in time after purchase. The weighted average calculation is defined on the Inventory Setup page. I recommend using Item, Location and Variant and calculating costing periods in days.

Inventory Setup page in Business Central

For inventory valuation, the average method assumes that all inventories are sold simultaneously, and it is preferred by companies where product costs are unstable, and inventory is difficult to differentiate, like liquids or commodities sold by weight.


Unlike FIFO and LIFO methods, Average costing calculates inventory value and forwards costs based on the valuation date. This means that the inventory value is determined based on the costs recorded on or before the valuation date. Another significant difference with the Average method is that a backdated inventory increase or decrease recalculates the item cost, and all entries affected are updated.


Specific

An item's unit cost is the exact cost at which the particular unit was received. This method is used in the manufacturing or trade of easily identifiable items that have high unit costs and are tracked with serial numbers.


The Specific method requires item tracking on both inbound and outbound transactions. Because of item tracking, the cost application is fixed, which means the Cost of Goods Sold is calculated as the exact cost of the item when received.


Standard

An item's unit cost is defined based on an estimate. When the actual cost differs from the specific cost, a variance is posted to either an inventory or a dedicated cost of goods sold in the general ledger.


The Standard costing method is used in discreet manufacturing to better account for the cost of materials and overhead. This method requires more maintenance as the cost is typically updated periodically.


Examples

In this example, we purchase the same item and register the purchases on the same day at a different cost. The tables below show how the item cost and the cost of goods sold vary depending on the costing method.


FIFO:

​Date

Transaction Type

Quantity

Cost Amount

01/01/2023

Increase (Purchase)

1

£10.00

01/01/2023

Increase (Purchase)

1

£20.00

01/01/2023

Increase (Purchase)

1

£30.00

02/01/2023

Decrease (Sale)

-1

-£10.00

03/01/2023

Decrease (Sale)

-1

-£20.00

04/01/2023

Decrease (Sale)

-1

-£30.00

LIFO:

​Date

Transaction Type

Quantity

Cost Amount

01/01/2023

Increase (Purchase)

1

£10.00

01/01/2023

Increase (Purchase)

1

£20.00

01/01/2023

Increase (Purchase)

1

£30.00

02/01/2023

Decrease (Sale)

-1

-£30.00

03/01/2023

Decrease (Sale)

-1

-£20.00

04/01/2023

Decrease (Sale)

-1

-£10.00

AVERAGE

Date

Transaction Type

Quantity

Cost Amount

01/01/2023

Increase (Purchase)

1

£10.00

01/01/2023

Increase (Purchase)

1

£20.00

01/01/2023

Increase (Purchase)

1

£30.00

02/01/2023

Decrease (Sale)

-1

-£20.00

03/01/2023

Decrease (Sale)

-1

-£20.00

04/01/2023

Decrease (Sale)

-1

-£20.00

SPECIFIC

Here we introduce a serial number to the item purchased. Note how the decrease (sale) transaction on date 04/01/2023 shows a cost of -£20.00 because the item with Serial Number 002 was purchased at that cost.

Date

Transaction Type

Quantity

Cost Amount

Serial No.

01/01/2023

Increase

1

£10.00

001

01/01/2023

Increase

1

£20.00

002

01/01/2023

Increase

1

£30.00

003

02/01/2023

Decrease

-1

£10.00

001

03/01/2023

Decrease

-1

£30.00

003

04/01/2023

Decrease

-1

£20.00

002

STANDARD

In this example, we transact the same item but assign a standard cost of £15.00. The purchase cost becomes irrelevant for inventory costing purposes.

Date

Transaction Type

Quantity

Cost Amount

01/01/2023

Increase (Purchase)

1

£15.00

01/01/2023

Increase (Purchase)

1

£15.00

01/01/2023

Increase (Purchase)

1

£15.00

02/01/2023

Decrease (Sale)

-1

-£15.00

03/01/2023

Decrease (Sale)

-1

-£15.00

04/01/2023

Decrease (Sale)

-1

-£15.00

Purchase Variance: How to account for the difference between Standard cost and cost to pay to the vendor

In the example below, the item purchased has a standard cost of £15.00. What happens when the vendor of this item increases the price? Business Central register the difference between an item's standard cost and purchase price as a Purchase Variance. This variance is typically accounted for as a cost of material and can be set up on the General Posting Setup page.

General Posting Setup page in Business Central

Closing Thoughts

Inventory costing is an accounting method used to determine the value of a business's stock. It is essential for companies that deal with physical products, such as retailers, manufacturers, and wholesalers. Business Central supports five different inventory costing methods: First In, First Out (FIFO), Last In, First Out (LIFO), Average, Specific, and Standard. Each method has its unique characteristics and is suitable for different types of businesses. It is essential to check with your local tax authorities before applying different costing methods in a live system, as the setup might not comply with local accounting standards.


Regards

Alfredo Iorio


 

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