Every business must develop a costing method that determines the cost for products sold. Accurately recording the cost of items is crucial to properly determine profit and make appropriate business decisions in the future. There is no one-size-fits-all solution for costing: as with all aspects of business, each company must assess their own needs as they relate to the industry and operation. Consider the following costing methods and their pros and cons in order to make the best decision.
First-in, first-out (FIFO) costing assumes that the first product in is also the first product sold. This means that the oldest items are those going off the shelf. This costing method is ideal for businesses with perishable goods, such as grocery and convenience stores.
Consider this example: a company purchases 10 loaves of bread for $0.20 each on Monday and 10 loaves for $0.30 each on Tuesday. It sells no bread on Monday, but sells five loaves Tuesday. Those five loaves are assigned a cost of $0.20, assuming that they're from the first batch. The more recent cost of $0.30 doesn't apply until the eleventh loaf sells.
FIFO costing is the most accurate method and one of the most widely used and accepted methods for costing. However, FIFO doesn't account well for periods of extremely high- or low-cost fluctuations. FIFO costing will also fall behind the latest trending prices, though it still provides an accurate representation of profits.
Last-in, first-out (LIFO) costing is essentially the opposite of FIFO costing. This method assumes that the last product purchased is also the first product sold. LIFO costing is only used in the United States and is actually banned by International Financial Reporting Standards because of its potential to distort financial statements.
Using the previous example, LIFO costing would assign the higher cost of $0.30 to the first five loaves of bread sold on Tuesday and only apply the lower $0.20 cost after reaching the eleventh sale. This typically reflects a smaller profit, which some companies may pursue to lower their tax obligations.
Weighted Average Cost
Weighted Average Cost (WAC) assigns an average cost to items. Using WAC costing in the bread example cited previously, all 20 loaves would be assigned an average cost of $0.25 regardless of when they were bought or sold. WAC costing is a simplified approach that gives no consideration to which items go out when.
This approach adjusts easily to price fluctuations, averaging out over time. However, WAC costing doesn't offer a detailed view into the costs and profits associated with each piece of merchandise. Since it relies on broad averages, WAC costing is impacted greatly by large price adjustments. This means that a sudden price increase can throw off all of the numbers rather than just those numbers recorded for particular sales.
Standard costing estimates the total expense associated with the product. This includes the item itself as well as the labor and manufacturing overhead. When a company uses standard costing, it replaces actual costs with expected costs in the accounting records. Standard costing is typically used by manufacturers rather than retailers. This method can help manufacturers identify problem areas in the manufacturing process by highlighting variances between the actual costs of goods when sold and the expected costs associated with the production of those goods.
Once a business has settled on the appropriate costing method, it's crucial to select costing software that accurately records and reflects financial information utilizing the chosen method. Having the appropriate software and systems in place makes it possible to aggregate and analyze data quickly and efficiently in order to access the right information for key business decisions.
Please contact Clients First Business Solutions for an evaluation of your current manufacturing and supply chain operations. We’ll work with you on a plan to implement Acumatica Cloud ERP, Dynamics 365 Business Central or Dynamics 365 Finance and Supply Chain Management to improve your bottom line.