Knowing which inventory costing method to choose can be a daunting decision for anyone running their own business. It’s easy to get stuck between understanding the differences and similarities of LIFO, WAC and FIFO when it comes to managing your inventory and finances. But if you don’t understand how each of these methods work, it could seriously unravel your supply chain management strategies – not something any entrepreneur ever intends on happening! In this blog post, we’ll take a deep-dive into each inventory costing method so that you can make an informed decision about the one that is best suited for your business needs.
What is LIFO?
The LIFO inventory method is a costing method that calculates the cost of goods sold (COGS) and ending inventory using the last-in, first-out (LIFO) principle. Under this principle, the most recently acquired goods are assumed to be the first ones sold. This results in a COGS that is based on the current market value of inventory, rather than its original cost.
Inventories are valued according to the LIFO principle, which is based on the idea that items should be resold at their original price. As a consequence, the oldest items are still considered ending Inventories.
According to LIFO, as the price of items rises, the newer and more costly things are consumed first, increasing the COGS overall and leaving the first-purchased, cheaper goods in Inventory.
Pros and Cons of LIFO
- Synchronizes current expenditures and revenue at any given time.
- LIFO is a straightforward approach. It requires a minimal amount of record keeping and does not require complex calculations or complex tracking of inventory movements.
- With LIFO, the costlier items are counted first, resulting in lower taxes for companies that have to pay corporate income tax.
- The most recent costs associated with an item are used for accounting purposes, which can better reflect current market conditions than using older costs associated with an item from months or years ago.
- Companies can also use LIFO to store items they suspect will become increasingly expensive over time while they wait to sell them; this allows them to charge customers higher prices while still making a profit.
- It can be difficult to accurately determine what the LIFO cost of an item should be, as companies use different methods for calculating costs.
- Some governments place restrictions on the use of LIFO when it comes to taxes, which may make it difficult for some companies to take advantage of possible tax savings.
- If prices go down instead of up over time, using LIFO can lead to losses rather than profits; this is especially true if a company has been storing items and selling them at higher costs under the assumption that prices will continue to increase in the future.
- In addition, since most methods of inventory tracking rely on first-in-first-out (FIFO) accounting, it can be difficult to track inventory accurately when using LIFO.
- Finally, if a company is considering selling or liquidating its assets, using LIFO may require them to pay higher taxes on the sale of those assets due to the increased cost associated with the use of LIFO.
What is WAC?
WAC (Weighted Average Cost) is one of the most commonly used inventory valuation methods. Under this method, the cost of an item in inventory is determined by averaging the cost of all items in inventory. The cost of each item is weighted according to its relative size in relation to the total quantity on hand.
The WAC inventory costing method is generally viewed as a compromise between LIFO, FIFO, and Inventory costing methods. This technique calculates COGS using the mean unit cost rather than the oldest or newest.
According to the WAC technique, inventory items are valued equally irrespective of when and how much they cost to acquire. The weighted mean cost per unit is determined by dividing the total price of the inventory system by the number of units.
Pros and Cons of WAC
Pros of WAC
- WAC takes into account all costs associated with a product, making it a great method for forecasting the total cost of inventory and budgeting accordingly.
- It provides an accurate representation of the average cost of purchasing in order to make informed pricing decisions.
- WAC is simple to calculate and easy to understand, making it accessible to those who may not have an extensive financial background or advanced understanding of accounting principles.
- It eliminates errors that can come from manually calculating individual costs for each purchase, such as miscalculations or discrepancies in price or quantity purchased.
- This method also helps to maintain consistent pricing throughout different purchases as long as the same cost structure is used.
Cons of WAC
- WAC does not take into account the timing of when a purchase was made, which could lead to outdated costs if the price of an item has changed since the original purchase.
- It can be difficult to accurately measure inventory levels when using WAC, as it does not account for any changes in demand or supply over time.
- There is no way to track individual cost components with this method, so it is impossible to identify areas where savings may be possible from bulk purchases or other discounts.
- It also relies heavily on historical data, which may not always reflect current market conditions and trends that could have an impact on pricing.
- WAC does not take into account any special discounts or promotions that may be available on certain items, which could lead to missed opportunities for savings.
- Finally, this method is not ideal for companies with a wide variety of inventory, as it can become difficult to accurately track all costs associated with each item.
Related: How Much Inventory Should I Have?
What is FIFO?
The FIFO inventory method is a valuation method used to determine the cost of goods sold and the ending inventory for a company. Under this method, the first items purchased are considered the first items sold, and the costs of these items are used to calculate the cost of goods sold and the ending inventory. This method is often used in businesses that sell products that have a short shelf life, such as food or pharmaceuticals.
Consequently, the restaurant's remaining Inventory is made up of the most recent acquisitions and is recorded at the item's current cost. The most popular approach for pricing restaurant inventory is based on this computation since it captures the regular flow of goods in a restaurant and is precise, dependable, and simple to carry out.
Pros and Cons of FIFO
Pros of FIFO
- It is a simple and easy method to use, as it follows the “first in, first out” principle.
- It results in fewer errors since there is no need for complex calculations or tracking procedures.
- It helps maximize profits by selling the oldest inventory items first, resulting in lower storage costs since there are less items that must be held in inventory over time.
- It reduces stock-outs since older items can be quickly identified and sold before newer ones arrive.
- This system ensures that customers receive their orders promptly and on time since older items are always shipped first.
- The FIFO method also helps companies comply with legal regulations because it guarantees that all items have been properly tested and meet safety standards.
Cons of FIFO
- It can lead to higher costs since the oldest inventory items tend to be more expensive due to inflation or obsolescence.
- This system does not take into account customer demand for certain products, which could result in slower sales of certain items if their popularity decreases over time.
- FIFO also requires more effort in tracking inventory movements and updates as new items are added or removed from storage facilities.
- The “first in, first out” principle can cause problems when dealing with perishable goods such as food or beverages since they need to be handled and sold in a timely manner to remain fresh and safe for consumption.
- It can also create a situation where outdated items have to be discarded or sold at lower prices, resulting in financial losses for the company.
- Lastly, FIFO can limit a company’s ability to take advantage of price fluctuations as older inventory items will often not benefit from changes in market conditions.
Related: What is Work in Process Inventory (WIP)?
Tips To Choose The Proper Inventory Costing Method For Your Business
1. Analyze Your Business Model
Before you choose an inventory costing method, take the time to analyze your business model and determine which method will best suit your needs. Consider the types of goods that you sell, the size of your inventory, and how often it changes, as well as the volume of sales and frequency of new orders.
2. Assess Risk Level
The inventory costing method you choose should be based on how much risk you are willing to assume about pricing accuracy. If there is a greater potential for errors in calculating costs when using one method over another, then choosing a more accurate method such as FIFO or LIFO may be beneficial for reducing risks associated with pricing mistakes.
3. Understand Tax Implications
Different inventory costing methods can have different tax implications, so it is important to understand which method will work best for you from a tax standpoint. For instance, under FIFO, the cost of goods sold is calculated using the oldest items in inventory first; whereas with LIFO, the cost of goods sold is calculated using the newest items in inventory first.
4. Consider Your Accounting System
If your accounting system doesn’t support both FIFO and LIFO methods, then you may need to choose one or the other depending on what software you are using. Be sure to research all relevant options to ensure that whatever inventory costing method you choose is compatible with your existing system.
5. Keep Up With Industry Standards
Depending on the type of business you are in, certain inventory costing methods may be considered industry standards. For example, if your company is in the retail industry, FIFO should likely be used to accurately reflect inventory costs and ensure pricing accuracy.
6. Seek Expert Advice
If you’re still unsure about which inventory costing method is right for your business, there are several professionals available who can provide advice and guidance. Talk to an accountant, bookkeeper, or financial advisor to get their opinion before making a final decision.
7. Test Before Deciding
Once you have narrowed down your choice of inventory costing methods, it's recommended that you test them out in your accounting system before making a final decision. This will ensure that everything runs smoothly and that you can accurately calculate costs in the long run.
As we can see, each inventory costing method comes with its own advantages and drawbacks so it is highly important to choose the one that fits your business needs. We hope this blog was helpful in arming you with the right tools and knowledge when it comes to choosing the ideal inventory costing method for your businesses’ operations. As 3PL managers, make sure that you equip yourselves with a comprehensive understanding of all these methods in order to ensure that your supply chain is well-guided – for only then can you truly expand and accelerate your business progress! Now go ahead and use what we have understood here to choose an inventory costing method today! And if you'd like extra help from an advanced 3PL software, don't forget to check out Your new all-in-one 3PL management. We build the tools 3PLs use to not only compare supplier quotes but also track performance through analytics, automate manual processes via scalable solutions, enhance customer service experiences, manage billing automatically - all while helping increase profits!
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