How to Calculate the Cost of Inventory

Calculating the cost of inventory is a fundamental accounting practice for businesses that sell goods. This process determines the monetary value of items a company holds for sale, directly impacting financial statements. Understanding inventory cost is essential for determining profitability and asset valuation, influencing pricing strategies and financial accuracy.

Understanding Inventory Cost Components

The total cost of inventory includes all expenses incurred to bring goods to their current location and condition, ready for sale. These components vary depending on whether a business is a merchandiser or a manufacturer.

For merchandising businesses, inventory cost includes direct acquisition expenses. This encompasses the purchase price from suppliers, freight-in (shipping expenses to transport inventory), and any import duties or taxes directly related to acquiring the goods.

Manufacturing businesses have a more complex inventory cost structure, involving three primary components. Direct materials are raw materials that become an integral part of the finished product, such as lumber or flour. Direct labor includes wages paid to workers directly involved in production, like assembly line workers. Manufacturing overhead comprises all indirect production costs not directly traceable to a specific product, such as factory rent, utilities, equipment depreciation, and indirect labor.

Certain expenses are excluded from inventory cost because they do not directly contribute to bringing inventory to its present location and condition. Selling expenses, such as marketing costs, sales commissions, and freight-out, are treated as expenses when incurred. Administrative expenses, including office salaries and general overhead not related to production, are also excluded. Additionally, abnormal amounts of wasted materials, labor, or other production costs are expensed rather than included in inventory.

Inventory Costing Methods

Businesses use different methods to assign costs to inventory, especially when identical items are purchased at varying prices. These methods determine how much cost is recognized as Cost of Goods Sold (COGS) and how much remains in ending inventory. The chosen method directly impacts a company’s reported profit and asset valuation.

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. This approach aligns with the physical flow of many businesses. To calculate COGS using FIFO, the costs of the oldest inventory units are matched against the units sold. For instance, if a business bought 100 units at $10 each, then 100 units at $12 each, and sold 150 units, COGS would be calculated by taking the first 100 units at $10 ($1,000) and the next 50 units from the $12 batch ($600), totaling $1,600. The remaining 50 units from the $12 batch would be ending inventory, valued at $600.

Conversely, the Last-In, First-Out (LIFO) method assumes that the most recently purchased or produced goods are the first ones sold. This method is based on a cost flow assumption rather than a physical flow. To calculate COGS under LIFO, the costs of the most recent inventory units are expensed first. Using the same example: 100 units at $10 each, then 100 units at $12 each, and 150 units sold. Under LIFO, COGS would be calculated by taking the 100 units from the most recent batch at $12 ($1,200) and the remaining 50 units from the oldest batch at $10 ($500), totaling $1,700. The ending inventory would consist of the remaining 50 units from the $10 batch, valued at $500.

The Weighted-Average method calculates the average cost of all goods available for sale and applies that average to both units sold and remaining inventory. This method smooths out price fluctuations. To determine the weighted-average cost per unit, the total cost of goods available for sale is divided by the total number of units available. Continuing the example: 100 units at $10 ($1,000) and 100 units at $12 ($1,200) means 200 units are available at a total cost of $2,200. The weighted-average cost per unit is $2,200 / 200 units = $11. If 150 units are sold, COGS would be 150 units $11 = $1,650, and the ending inventory of 50 units would be valued at 50 units $11 = $550.

Inventory Systems and Their Impact

The chosen inventory system dictates how and when costing methods are applied, affecting the timing of cost recognition. The two primary systems are perpetual and periodic, each having distinct procedural differences in tracking inventory and determining cost of goods sold.

The perpetual inventory system continuously updates inventory records with each purchase and sale. This real-time tracking provides an immediate balance of inventory on hand and the cost of goods sold after every transaction. When an item is sold, the system automatically debits the Cost of Goods Sold account and credits the Inventory account for the item’s cost. For example, if a business uses FIFO under a perpetual system, the cost assigned to a sale is the oldest unit’s cost. If using LIFO, the most recently acquired unit’s cost is used. The weighted-average method under a perpetual system involves calculating a new moving average cost after each purchase, applied to subsequent sales until the next purchase.

In contrast, the periodic inventory system updates inventory records and calculates the cost of goods sold only at specific intervals, such as at the end of an accounting period. This system does not maintain a continuous record of inventory movements. Instead, businesses rely on a physical count of inventory at period-end to determine the ending inventory balance. COGS is then calculated using a formula: Beginning Inventory + Purchases – Ending Inventory. For instance, under a periodic system, FIFO, LIFO, and weighted-average methods are applied to the total goods available for sale during the entire period, based on the physical count of ending inventory, with COGS and ending inventory calculations happening in a batch process at period-end, rather than transaction by transaction.