This guide on inventory cost accounting goes beyond simple costing to provide professionals everything they need to choose a method for financial reporting. We provide definitions, formulas, examples, expert advice and comparison charts to help you understand the concepts.

In this article:

What Is Inventory Costing?

Inventory costing, also called inventory cost accounting, is when companies assign costs to products. These costs also include incidental fees such as storage, administration and market fluctuation. Generally accepted accounting principles (GAAP) use standardized accounting rules to ensure companies do not overstate these costs.

Inventory costing is a part of inventory control technique. Proper inventory control within a supply chain helps reduce the total inventory costs and assists in determining how much product a company should carry. All this information helps companies decide the needed margins to assign to each product or product type.

Industry expert Steven J. Weil, Ph.D. and President at RMS Accounting discusses inventory costing and tracking inventory in the real world. He says,

“The best way to track shrinkage is still regular physical inventories, to check that what the system is saying is correct.”

“We typically want to cost the stock by departments. Setting similar margins in each department is easier to track. These similar margins show us when there is shrinkage and how much that product is bringing in (and what it could be bringing in).”

There are several approaches to cost accounting. These include:

  • Standard costing
  • Lean accounting
  • Activity-based
  • Resource consumption
  • Throughput
  • Marginal costing

Cost of Goods Sold vs. Inventory

In accounting, the difference in cost of goods sold (COGS) and inventory values are represented by where the accountant records them. Companies value inventory at its cost to them and as a part of their current assets. COGS represents the inventory costs of goods sold to customers.

Accountants record the ending inventory balance as a current asset on the balance sheet. When inventory increases, the assets on the balance sheet increase. When inventory decreases, the assets on the balance sheet also decrease. Accountants also record the change in inventory as a part of the COGS on the income statement.

Instead of showing a change in inventory as a COGS adjustment, accountants adjust some income statements to show the calculation of COGS as:

Beginning Inventory + Net Purchases = Goods Available for Sale - Ending Inventory

Companies generally report inventory value at their paid cost. However, a manufacturer would report inventory at the cost to produce the item, including the costs of raw materials, labor and overhead. Usually, inventory is a significant, if not the largest, asset reported on a company’s balance sheet.

Inventory Costing Methods

The method companies use to cost their inventory directly guides the income and inventory value they report on their financial statements. Each company chooses a systematic approach to calculating and reporting its inventory turnover, and regulators expect them to stick to that method every year.

There are four main methods to compute COGS and ending inventory for a period.

  • First In, First Out (FIFO):
    Companies sell the inventory first that they bought first.
  • Last In, First Out (LIFO):
    Companies sell the inventory first that they bought last.
  • Weighted Average Cost (WAC):
    Companies average the costs of inventory and how much they sell over the period.
  • Specific Identification:
    Not technically a cost-flow method but allowable under GAAP, this option often uses serial numbers to differentiate products and their inventory cost specifically.

GAAP covers FIFO, WAC and Specific Identification. GAAP does not cover LIFO, but it is mentioned above for comparison purposes.

To compare methods, consider the example of Jack’s Furniture and its bookcase sales. Regardless of which cost flow assumption the company uses, the balance sheet for the period starts the same. This journal shows the same beginning inventory, purchase and associated costs:

However, when a customer buys 60 units, the difference in these cost flow assumptions is clear. In FIFO, the ending inventory cost ends up higher to reflect the increase in prices. As a comparison, in LIFO, the ending inventory cost is lower as a reflection of the increasing prices of the bookcase. In the WAC example, the ending inventory cost is in the middle of LIFO and FIFO, showing that the price changed.

If these transactions were the only ones in this period and the sales were $12,000, the income statement and the balance sheet would look like the following:

As noted, specific identification is not technically a cost flow assumption, but it is a technique for costing inventory. In this case, the physical flow of inventory matches the method and is not reliant on timing for cost determination. The use of serial numbers or identification tags accommodate the use of this method and the identification of each item in inventory, capturing when the company bought the item and how much it paid.

Consider an art dealer that specializes in only one product type, handmade globes. An example of his inventory flow follows:

From this information and the information about which specific products the dealer sold over the period, he can calculate the following figures:

Ending inventory and COGS are based on what the dealer sold or did not sell from each specifically identified purchase or beginning inventory. Notice how he separated each purchase based on what he originally paid for them. He knows that customers purchase his handmade items based on which specific ones they prefer, not on the lot he bought them in. The gross profit is period retail sales minus the total spent originally for the specific goods he sold during the period.

Less mainstream methods not covered under GAAP include:

  • Highest In, First Out (HIFO): Companies sell the highest-cost inventory first.
  • Lowest In, First Out (LOFO): Companies sell the lowest-cost inventory first.
  • First Expired, First Out (FEFO): Companies sell the first-expiring inventory first.

Using the example from above of the bookcases at Jack’s Furniture, the journal starts the same.

The COGS and inventory balance once again change when customers buy 60 units under the HIFO and LOFO methods during a period. The HIFO example removes the highest cost inventory first, leaving less value in stock, and the LOFO example removes the lowest cost inventory first, leaving a higher value in stock.

For the income statement and the balance sheet for $12,000 worth of sales, HIFO and LOFO would compare as the following:

In FEFO, expiration dates drive the sales. For example, if a retailer began with and purchased a total of 80 units and sold 40 units with two different expiration dates, it would look like the following:

The items in stock after the sale have a later expiration date. The company exhausts the stock with the earliest expiration date first.

Inventory Valuation Adjustments and Estimates

GAAP allows adjustments in inventory valuation when it has an uncertain future, such as when it may become obsolete. Methods for these adjustments include:

  • Lower of Cost or Market (LCM):
    Companies record the lowest cost, either the purchase price or the price at market, of their inventory.
  • Net Realizable Value (NRV):
    Companies record the estimated selling price, less the cost of their sale or disposal.

Finally, some methods estimate the cost value of the ending inventory:

  • Retail Inventory Method:
    Companies calculate the cost of inventory in stock based on the relationship to their retail price.
  • Gross Profit Method:
    Companies calculate their inventory amount and COGS utilizing a ratio to sales.

Weighted Average Inventory Costing or Average Cost Inventory Method

The weighted average inventory costing method, also called the average cost inventory method, is one of the GAAP-compliant approaches companies use to value their business stock. This method calculates the per-unit cost using a weighted average for the cost of goods sold and the inventory.

The formula for the weighted average cost method is a per unit calculation. Divide the total cost of goods available for sale by the units available for each inventory item.

WAC = COGS / Inventory (Sold)

For example, Trax is a small business that purchases and sells snowboards. For November, the following shows its purchases and sales:

The ending inventory is the total units available minus the total units sold during the period. In this example, the ending inventory = (200 + 200 + 150 + 300 + 300 + 400) - (100 + 75 + 200 + 300 + 300) = 1550 units purchased - 975 units sold = 575 units remaining.

Calculate the weighted average cost for the snowboards by using the following chart that shows the number of units purchased, the cost for each unit on the date purchased and the total cost paid for the purchase on that day.

The weighted average unit cost based on the chart above for Trax in November was $384,250/1550 = $247.90 per unit.

The cost of goods sold (COGS) valuation is the number of units sold multiplied by the weighted average cost.

COGS = 975 x $247.90 = $241,702.50

The ending inventory valuation is the 575 units remaining multiplied by the weighted average cost.

Inventory = 575 x $247.90 = $142,542.50

Together, the COGS and the inventory valuations add up to the actual total cost available for sale.

Actual Total Cost Available For Sale = $241,702.50 + $142,542.50 = $384,250

Inventory Cost Flow Assumptions

An inventory cost flow assumption is the method accountants use to remove their company’s inventory costs and report them as cost of goods sold for accounting valuation. Examples of these assumptions include FIFO, LIFO and WAC.

The cost flow assumptions do not necessarily represent the actual physical flow of goods. They are merely the costs assigned to the company’s inventory units. The main inventory costing methods that are GAAP-compliant are FIFO and WAC. LIFO is also included below for comparison purposes:

Compare these methods using the Trax sales and purchases of snowboards for January and February:

In January, Trax bought 500 snowboards at $250 each = $125,000. In February, Trax bought 400 snowboards at $275 each = $110,000.

For the accounting period January-February, Trax had 900 snowboards in stock and sold 200 snowboards.