How to Calculate the Cost of Inventory

The cost of inventory represents the total expenditures a business incurs to acquire or produce goods intended for sale. Accurate calculation of this cost is fundamental to financial management. It directly impacts a company’s financial statements, notably the balance sheet where inventory is listed as an asset, and the income statement through the cost of goods sold.

Accurate inventory costing is essential for determining profitability and making informed operational decisions. It influences pricing strategies, inventory management, and market competitiveness. Precise inventory valuation is also required for tax reporting.

Understanding What Constitutes Inventory Cost

The comprehensive cost of inventory includes all expenditures incurred to bring goods to their current location and condition, ready for sale. For businesses that purchase finished goods for resale, the primary component is the purchase price paid to the supplier. This initial cost forms the foundation of the inventory’s value.

Beyond the purchase price, other direct costs for purchased inventory include freight-in (transportation), import duties, taxes, and handling charges. Tariffs on overseas imports, for instance, become part of the inventory cost.

For businesses that manufacture their own inventory, the cost structure is more complex, encompassing three main categories. Direct materials are the raw goods that become an integral part of the finished product, such as the wood used to build furniture. Direct labor represents wages paid to employees directly involved in production, such as assembly line workers.

Manufacturing overhead includes all indirect production costs, such as factory rent, utilities, equipment depreciation, and indirect labor like supervisor salaries. These costs are accumulated and allocated to produced units.

Identifying Costs Not Included in Inventory

Certain costs, though related to business operations, are excluded from inventory cost and expensed when incurred. This prevents overstating inventory assets and ensures proper matching of expenses with revenues.

Selling costs, such as sales commissions, advertising, and freight-out (delivery to customers), are expensed when incurred, not capitalized into inventory.

General and administrative costs, like office salaries, supplies, and corporate overhead, are not included in inventory valuation. These overhead costs of running the business are considered period expenses.

Costs from abnormal waste or production inefficiencies, such as wasted materials, idle capacity, or labor due to spoilage or breakdowns, are excluded from inventory. These non-value-adding costs are expensed immediately. Interest costs incurred on borrowed funds are generally treated as period expenses and are not capitalized into inventory.

Common Inventory Costing Methods

Businesses employ various methods to assign costs to inventory, especially when identical items are purchased or produced at different prices over time. These methods are based on assumptions about the flow of goods, not necessarily the physical movement of specific items. The choice of method can significantly impact a company’s reported financial results, particularly the cost of goods sold and the value of ending inventory.

One widely used method is First-In, First-Out (FIFO). This method assumes the first units purchased or produced are the first ones sold. It aligns with the physical flow of many goods, like perishables, where older inventory sells first. Under FIFO, the oldest inventory cost is assigned to goods sold.

Last-In, First-Out (LIFO) assumes the last units purchased or produced are the first sold. While often not reflecting physical flow, LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP) but generally prohibited under International Financial Reporting Standards (IFRS). With LIFO, the most recent inventory cost is expensed first.

The Weighted-Average Cost Method calculates an average cost for all goods available for sale. This average cost applies to both ending inventory and units sold. It smooths price fluctuations by combining all purchase and beginning inventory costs, providing a uniform cost per unit useful for homogenous products.

Applying Inventory Costing Methods

Understanding how to apply each inventory costing method is crucial for accurate financial reporting. Consider a business with the following inventory data: Beginning Inventory of 100 units at $10. Purchases include 200 units at $12 and 150 units at $13. If 300 units were sold, we can calculate the cost of goods sold and ending inventory under each method.

Under the First-In, First-Out (FIFO) method, we assume the earliest purchased units are sold first. The 300 units sold would consist of the 100 units from beginning inventory at $10 each, totaling $1,000. The remaining 200 units needed to fulfill the sales would come from the first purchase of 200 units at $12 each, totaling $2,400. Therefore, the total cost of goods sold under FIFO is $1,000 plus $2,400, equaling $3,400. The ending inventory of 150 units would then consist of the most recent purchases, specifically the 150 units at $13 each, valued at $1,950.

Using the Last-In, First-Out (LIFO) method, the assumption is that the most recently acquired units are sold first. To account for the 300 units sold, we would first assign the 150 units from the latest purchase at $13 each, amounting to $1,950. Next, we would take the remaining 150 units needed from the prior purchase of 200 units at $12 each, totaling $1,800. The total cost of goods sold under LIFO would be $1,950 plus $1,800, resulting in $3,750. The ending inventory of 150 units would then be composed of the oldest units, specifically 100 units from beginning inventory at $10 each ($1,000) and 50 units from the 200-unit purchase at $12 each ($600), for a total ending inventory value of $1,600.

For the Weighted-Average Cost Method, first determine the total cost and units available. In our example, 100 units at $10 ($1,000), 200 units at $12 ($2,400), and 150 units at $13 ($1,950) sum to a total cost of $5,350 for 450 units. The average cost per unit is $5,350 divided by 450 units, which is approximately $11.89 per unit. The cost of goods sold for 300 units would then be 300 multiplied by $11.89, resulting in $3,567. The ending inventory of 150 units would be 150 multiplied by $11.89, equating to $1,783.50, demonstrating how the choice of costing method directly impacts both the expense reported on the income statement and the asset value on the balance sheet.