If your business sells physical products, that warehouse of boxes or those shelves of stock aren’t just waiting for a customer—they’re one of your biggest financial assets. But figuring out what that inventory is actually worth is a lot more complex than just tallying up what you paid for it. The process, known as inventory costing, is all about assigning a dollar value to your unsold goods. And while it might sound like some dusty, back-office accounting task, the method you choose has a massive, direct impact on your company’s profits, its tax bill, and even the big strategic moves you make.
What is Inventory Costing and Why is it Crucial?
At its core, inventory costing is the accounting framework used to figure out the value of everything you haven’t sold yet. This number is non-negotiable for getting your financial reporting right, and it directly shapes the two most important financial statements your business has.
First, on the balance sheet, the value of your ending inventory shows up as a current asset. Getting this right is critical because it influences metrics like working capital and the current ratio—the very numbers lenders and investors scrutinize to decide if your business is financially stable in the short term.
Second, over on the income statement, how you cost your inventory defines your Cost of Goods Sold (COGS). COGS is simply the direct cost of the products you sold during a period. The math is straightforward:
Beginning Inventory + What You Bought – What’s Left Over = COGS.
The cost inventory method you pick determines how money moves from being an asset (inventory) to an expense (COGS). A higher COGS means lower reported profits. A lower COGS makes your profits look healthier. You can see how this becomes a pretty significant decision.
The Core Inventory Costing Methods Explained
There are a few universally accepted ways to handle this, and picking one isn’t just about preference; it’s a strategic decision that needs to sync up with how your business actually operates and what you’re trying to achieve financially. Let’s break down the four main inventory cost methods used around the world.
First-in, First-out (FIFO) Method
The FIFO method runs on a simple, logical assumption: the first things you buy are the first things you sell. This makes perfect sense and often matches the real-world flow of goods, especially for businesses dealing with things that can expire or become outdated, like food or electronics. You want to sell the oldest milk first, right?
Let’s run through a quick example. Imagine this is your company’s monthly activity:
- Beginning Inventory: 10 units @ $10 each
- Purchase 1: 20 units @ $12 each
- Purchase 2: 15 units @ $14 each
- Units sold: 30 units
With FIFO, those 30 units sold are the first 10 you had, plus the 20 you bought next.
- COGS Calculation: (10 units x $10) + (20 units x $12) = $100 + $240 = $340
- Ending Inventory Calculation: You’re left with the 15 newest units. 15 units x $14 = $210
FIFO’s main draw is that it’s intuitive and easy to follow. When prices are rising (think: inflation), FIFO gives you a lower COGS, which in turn leads to a higher net income. That looks great to investors, but there’s a catch: it also means a higher tax bill. It can also create a slight distortion by matching old, cheaper costs against today’s higher sales prices.
Last-in, First-out (LIFO) Method
Now, let’s flip that idea on its head. The LIFO method assumes the last things you bought are the first ones you sell. This almost never matches how physical goods actually move, but it’s a powerful tool for financial reporting.
Using the same numbers as before:
- Beginning Inventory: 10 units @ $10 each
- Purchase 1: 20 units @ $12 each
- Purchase 2: 15 units @ $14 each
- Units sold: 30 units
Under LIFO, the 30 units you sold are considered the newest ones you have.
- COGS Calculation: (15 units x $14) + (15 units x $12) = $210 + $180 = $390
- Ending Inventory Calculation: What’s left are the oldest units. (5 units x $12) + (10 units x $10) = $60 + $100 = $160
So why do this? During inflationary periods, LIFO provides a much better matching of your most recent costs against your current revenue, giving a more realistic snapshot of your profitability right now. This results in a higher COGS, lower reported profits, and—here’s the main attraction—a lower tax liability. The big problem? LIFO is banned under International Financial Reporting Standards (IFRS), so it’s not an option for most of the world. It can also leave your balance sheet looking strange with ancient, outdated inventory values.
Weighted-Average Cost (WAC) Method
If FIFO and LIFO feel too extreme, the Weighted-Average Cost (WAC) method is your middle-of-the-road solution. It smooths everything out by calculating one average cost for all your identical items in stock and then applies that average to both what you sold and what you have left.
The formula is pretty simple: Total Cost of Everything Available / Total Number of Units Available
Let’s plug in our numbers:
- Total Cost Available: (10 x $10) + (20 x $12) + (15 x $14) = $550
- Total Units Available: 10 + 20 + 15 = 45 units
- Weighted-Average Cost per Unit: $550 / 45 units = $12.22
From there, the math is easy:
- COGS Calculation: 30 units sold x $12.22 = $366.60
- Ending Inventory Calculation: 15 units remaining x $12.22 = $183.30
The appeal of WAC is its sheer simplicity, especially for businesses where it’s nearly impossible to track specific batches of products. It irons out any wild swings in reported income. The downside is that the numbers you get for COGS and inventory value are a blend; they don’t reflect the actual cost of any single item, which can mask the impact of recent price spikes or drops.
Specific Identification Method
The Specific Identification method is the most precise but also the most demanding. It does exactly what the name implies: you track the exact cost of every single, individual item from the moment you buy it to the moment you sell it.
This is only realistic for businesses selling unique, high-value goods. Think of an art gallery selling one-of-a-kind paintings, a dealership selling cars with specific VINs, or a jeweler selling distinct pieces. When the dealer sells that specific car, the COGS is the exact price they paid for that specific car.
The advantage is obvious: a perfect matching of cost to revenue, which gives you the most accurate profit figure on a per-sale basis. The disadvantage is that it’s completely impractical for anyone selling large quantities of similar items. It also opens the door to a bit of “creative accounting,” where management could strategically choose to sell a higher or lower-cost item to nudge the period’s profit number in a desired direction.
How to Choose the Right Method for Your Business
Picking the “best” from these methods of inventory costing isn’t about finding a single right answer—it’s about finding the right fit for your specific situation. You need to weigh a few key factors.
- What are you actually selling? The nature of your inventory often points you to an answer. If you’re selling perishable goods or tech that quickly becomes obsolete, the physical flow matches FIFO perfectly. But if you’re dealing in homogenous commodities like gravel or oil, where one batch mixes with the next, the WAC method just makes more sense.
- What’s the economy doing? In times of high inflation, LIFO (if you can use it) is a powerful tax-saving tool because it matches your highest costs against revenue. When prices are falling, FIFO actually delivers a similar tax benefit.
- What do the regulators say? This is a big one. LIFO is allowed under U.S. GAAP, but it’s a firm no-go under IFRS, the standard used in Europe and much of the rest of the world. For many international companies, the choice is effectively between FIFO and WAC.
- What are your financial goals? Your strategy matters. If your primary goal is to maximize reported net income to look good for investors or secure a loan, FIFO is your friend during inflation. If your top priority is to minimize your tax bill, LIFO is the more effective choice (where allowed).
Advanced Concepts and System Considerations
Once you’ve wrapped your head around the basics, there are a couple of related concepts that determine how these methods are actually applied in the real world.
Perpetual vs. Periodic Inventory Systems
Your choice of inventory system dictates how and when you apply these costing methods.
- A perpetual inventory system is like your bank account: it’s updated in real-time. Every time you buy or sell something, the system logs the change instantly, giving you a constantly current view of your inventory levels and COGS.
- A periodic inventory system is more like checking your wallet at the end of the night. You don’t track every transaction. Instead, you do a physical count at the end of the month or quarter to see what’s left and calculate your COGS for the entire period in one go.
This difference is especially important for the WAC method. A perpetual system calculates a new “moving” average cost after every single purchase, while a periodic system calculates just one average for the whole period.
Lower of Cost or Net Realizable Value (LCNRV)
Accounting has a fundamental rule of thumb: don’t pretend your assets are worth more than they actually are. The Lower of Cost or Net Realizable Value (LCNRV) rule is how this principle applies to inventory.
Net Realizable Value (NRV) is just a fancy term for what you could realistically sell an item for today, minus any costs to finish it, sell it, and ship it.
At the end of every accounting period, you have to do a reality check. Compare the cost of your inventory (what you have on your books using FIFO, WAC, etc.) with its NRV. If the NRV is lower—meaning your products have lost value due to damage, obsolescence, or market changes—you must write down the inventory’s value to that lower number. This write-down hits your income statement as a loss, ensuring your balance sheet isn’t overstating the true value of what you have on your shelves.
The Strategic Impact of Your Inventory Costing Choice
Ultimately, how you cost inventory is much more than a box-ticking exercise for your accountant. It’s a strategic decision that sends ripples through your entire business.
The cost inventory method you choose directly influences your pricing decisions, because your COGS is the floor upon which you build your profit margins. It shapes your profitability analysis, too; switching from FIFO to LIFO could completely change how you view the performance of a product line. That, in turn, might change which products you promote and which you decide to drop. It even impacts supply chain management, as the financial results of holding older inventory can influence your purchasing strategy and turnover goals. When you understand these connections, you can use your inventory costing method not just for compliance, but as a sharp tool for smarter financial management.
Inventory costing isn’t just about compliance, it’s a strategic lever. With Intuendi, you can connect costing, forecasting, and decision-making in one platform.
