4 Popular Inventory Costing Methods for Small Businesses

The method you use to value your inventory and how you look at costing can significantly impact your small business. This is why inventory costing methods are so crucial to small businesses. 

In this article, we’ll look at some of the most popular inventory costing methods (also called inventory valuation methods) and how they impact your business.

Inventory costing methods for pricing your products

Before diving into inventory costing methods, it’s important to distinguish between price and cost. Although this might seem obvious, it is possible to miscalculate total costs and lose money on a sale in the frenzy of running your business.

Price refers to the dollar amount charged to your customer. Cost is the amount your business pays for your inventory.

However, inventory valuation is not necessarily just what you pay for the goods. As a general rule of thumb, inventory should include all costs that are “ordinary and necessary” to put the goods “in place” and “in condition” for resale.

This means when considering your pricing, you’ll also want to include all the other “little” things that add up, such as:

• Shipping charges
• Packaging
• Customs and duty fees

Some merchants call these costs “non-vendor costs,” which means they do not include them in the wholesale purchase price. In most inventory control software, you can add these non-vendor costs to any purchase order as a dollar amount or as a percentage.

What are the most popular inventory costing methods?

Which inventory costing method is right for you will vary from business to business. Generally speaking, you would choose between one of the following four inventory valuation methods. 

Weighted average cost

One of the most common inventory costing methods is weighted average cost. With this inventory valuation method, your inventory cost is re-calculated every time you make an inventory purchase. To accomplish this, you take the total cost of the items purchased divided by the number of items in stock. With this inventory valuation method, your inventory cost is essentially re-calculated every time you make an inventory purchase.

You would then use this number as your cost of ending inventory and the cost of goods sold for your accounting purposes.

One thing to keep in mind, however, is that you can only use moving average cost with a perpetual inventory tracking system that keeps up-to-date records of inventory balances. You can accomplish this easily by using inventory software like inFlow. Alternatively, you could use spreadsheets to get by if you don’t have software. However, we should warn you things will quickly become unmanageable as you scale.  

Manual or standard cost

You can also keep track of your inventory costs by manually assigning the cost to your items. However, this is the most tedious way and not necessarily the most accurate, especially if your vendor prices change on a regular basis. Of all the inventory costing methods mentioned in this article, this one is easily the lowest effort but also the most unreliable. 

FIFO costing

FIFO costing stands for First-In, First-Out. This inventory costing method means you record the oldest inventory items as sold first. Therefore, your oldest purchasing costs will be used to calculate your profit.

Inventory management software like inFlow will allow you to set your inventory valuation method to FIFO to calculate inventory costing.

LIFO costing

As you may have guessed, LIFO costing stands for Last-In, First-Out. This inventory valuation method means you use the cost of your most recent inventory purchases to calculate your profit.

Many US firms would use LIFO since it typically over-values their inventory and reduces the income tax they have to pay. However, the International Financial Reporting Standards (IFRS) have banned the use of LIFO, so many companies have turned back to FIFO. It’s also interesting to note that LIFO is only ever used in the US.

Examples of Inventory costing methods

To illustrate these inventory costing methods better, let’s look at an example.

Let’s say you made two separate purchases of 100 basketballs at $10 each and 200 basketballs at $20 each. Let’s also say at the end of your accounting period, you sold 50 basketballs. Now let’s use the various inventory valuation methods to calculate our cost of goods sold (COGS) and ending inventory value. 

Example: weighted average cost

You’ll first need to calculate your average unit cost to determine your COGS and ending inventory using the weighted average cost valuation method. 

In total, you have 300 (100+200) basketballs. You also paid $5,000 for all of them ($100 x 10 plus $200 x $20).

So your weighted average cost would be the $5000 cost divided by the 300 basketballs. This is equal to $16.67 per basketball.

Now let’s look at what your COGS would look like for this example as well as the ending inventory value after selling 50 basketballs.

COGS: (50 basketballs x $16.67 average cost) = $833.50

Remaining inventory: (250 basketballs left x 16.67 average cost) = $4,167.50

Example: FIFO

If we were to use FIFO for our inventory costing method, we would use the cost from our first transaction when we purchased 100 basketballs at $10 each. Below you can see what your COGS would be as well as the ending inventory value.

COGS: (50 basketballs x $10 FIFO cost) = $500

Remaining inventory: (50 basketballs x $10) + (200 basketballs x $20) = $4,500.

Remember, when you use the FIFO inventory valuation method, you need to separately calculate all the inventory transactions with different costs rather than using an average.

Example: LIFO

With LIFO cost, we’ll use the cost from the latest transaction when we purchased 200 basketballs at $20.

With this inventory valuation method, you end up with a COGS and ending inventory value that looks like the following after selling 50 basketball. 

COGS: (50 basketballs x $20 LIFO cost) = $1,000

Remaining inventory: (100 basketballs x $10) + (150 basketballs x $20) = $4,000.

Since we’re selling the last basketballs that we received first we would subtract our 50 basketballs from the $20 per basketball transaction (our last transaction). 

Comparing the inventory costing methods

To quickly recap, let’s compare the numbers from the above examples.

Weighted average costing: 

• COGS = $833.50 
• Remaining inventory = $4167.50

FIFO costing:

• COGS = $500
• Remaining inventory = $4,500

LIFO costing:

• COGS = $1,000
• Remaining inventory = $4,000

You can see above how using the LIFO method produces the highest costs of goods sold, which means you’ll have less profit to pay tax on. Remember, you typically can’t use the LIFO method in alot of countries. The CRA or IRS, if they audit you, may make you re-do all the accounting using FIFO or one of the other inventory valuation methods. In addition to the extra work you’ll also be responsible for paying a steep penalty for using LIFO. 

How to price your products appropriately

Once you’ve decided between the inventory valuation methods, you can use the information you’ve gathered to choose how to price your products accordingly. There are a few methods that businesses use to do this:

Price multiplier method

The most common is simply to “double” your cost. Many businesses use a multiplier formula that multiplies costs by 2 or 3.

Competitive market rates

It’s also very common to price your products based on what your competitors charge. You should always examine the market prices and your competition but don’t follow this method exclusively when you do the costing. (For example, if your competitors charge a lower price than your cost, you’ll lose money.)

To be competitive, you may want to offer a lower price than your competition, but don’t go too low, or consumers might wonder why your price is so low.

Too many numbers with inventory costing methods?

When you’re dealing with so many numbers, it can get really confusing quickly. That’s why many small businesses rely on an inventory system such as inFlow to do all their costing calculations for you. You can run reports at the end of your reporting period to give to your accountant. Better yet, you could use inFlow’s integration with QuickBooks Online or Xero to make things even more accessible. 

Interested? Try inFlow today for free and see for yourself whether or not it’s a great fit for your small business!