Thursday, November 20, 2008

Inventory Costing

By Donna MacMillan

There are several ways to determine the value of your inventory and each type of valuation has benefits. The most common type used by small businesses is average cost or weighted average costing. This is based on the average cost of identical units. Using the total actual cost of all similar items available for sale divided by the number of units available for sale would result in a weighted average cost per unit. Multiplying the weighted average cost per unit times the number of units unsold gives you the value of your inventory.

First-In, First-Out Costing (FIFO) assumes that the first goods purchased are the first goods sold and therefore that the last goods purchased are the ones remaining in inventory. This system is used frequently because whenever the flow of inventory can be controlled it makes sense that the oldest items are sold first satisfying the accounting convention that inventory should be shown on the balance sheet at the most current cost possible. Also because this method has been used for such a long time, continued use assures consistency for income calculations comparability.

Last-In, First-Out Costing (LIFO) assumes that the most recent purchases are the first to be sold leaving the older items remaining in inventory. One argument for using this method is that it matches the most current cost of items purchased against the current sales revenue. Also when prices are rising net income calculated by this method is smaller than the amount determined from using other methods resulting in a smaller income tax. This would be reversed if pricing were falling.

One other, however uncommon, method is specific identification costing which requires that each item that is sold and each item remaining in inventory is separately identified in respect to it’s purchase cost. This method is not practical for most businesses. Only those businesses that sell items where the cost is relatively high, and sales volume is low and it is easy to identify the cost and sale price of each item separately would find this method useful.

When choosing a method consider the practical issues of how the valuation can be accomplished accurately and with the least amount of effort, and be sure to consult your tax preparer for tax return considerations.

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