What Is Inventory Costing and Its Effect on Financials?

Inventory costing is a fundamental accounting practice for businesses that sell goods. It involves assigning a monetary value to products a company holds for sale, whether raw materials, work-in-progress, or finished goods. This process directly influences how a company’s financial performance and position are presented. Properly valuing inventory provides a clear picture of a business’s assets and the cost of goods sold, impacting reported profits. Accurate inventory costing is crucial for reliable financial reporting, tax calculations, and informed decision-making.

What Makes Up Inventory Cost

The cost of inventory encompasses more than just the price a business pays for its goods. It includes all expenditures necessary to bring the inventory to its current location and condition, making it ready for sale. These costs are broadly categorized into direct and indirect costs.

Direct costs are those directly traceable to the production or acquisition of inventory. This includes the purchase price of raw materials or finished goods, freight-in, direct labor, and direct materials.

Indirect costs, often referred to as manufacturing overhead, are also included if necessary to convert raw materials into finished goods. These can include expenses such as factory rent, utilities for the production facility, and depreciation of manufacturing equipment.

Common Inventory Costing Methods

Businesses employ different methods to assign costs to inventory and the goods they sell. These methods—primarily First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average Cost—are assumptions about the flow of costs, not necessarily the physical flow of goods. The chosen method impacts both the reported cost of goods sold (COGS) and the value of remaining inventory.

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. This means the costs assigned to COGS are those of the oldest inventory, while the costs of the most recently acquired items remain in ending inventory. This method often aligns with the actual physical flow of inventory for perishable goods or products with expiration dates.

The Last-In, First-Out (LIFO) method operates on the assumption that the most recently purchased or produced goods are the first ones sold. Consequently, LIFO assigns the costs of the newest inventory to COGS, leaving the costs of the older inventory in the ending inventory balance. LIFO can lead to a higher COGS during periods of rising prices, which may result in lower reported taxable income. While LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP), it is not allowed under International Financial Reporting Standards (IFRS).

The Weighted-Average Cost method calculates an average cost for all goods available for sale during a period. This average cost is then applied to both the units sold (COGS) and the units remaining in inventory. This method tends to smooth out price fluctuations and is often used when inventory items are indistinguishable from one another. The weighted-average method is permissible under both GAAP and IFRS.

How Inventory Costing Affects Financials

The choice of inventory costing method significantly impacts a company’s financial statements, specifically the income statement and the balance sheet. Different methods can lead to varying reported profits and asset values, especially during periods of price changes.

On the income statement, the inventory costing method directly influences the Cost of Goods Sold (COGS). A higher COGS results in a lower gross profit and net income. Conversely, a lower COGS leads to a higher gross profit and net income. For example, in an inflationary environment where costs are rising, FIFO typically results in a lower COGS and higher net income because it expenses older, cheaper inventory first. In contrast, LIFO results in a higher COGS and lower net income during inflation because it expenses newer, more expensive inventory first.

The ending inventory value, presented as a current asset on the balance sheet, is also directly affected. Under FIFO during inflation, the ending inventory will be valued at more recent, higher costs, reflecting a higher asset value. Conversely, LIFO will value ending inventory at older, lower costs, resulting in a lower asset value on the balance sheet. The weighted-average method provides an inventory value that falls between FIFO and LIFO during inflationary periods. These differences can also have implications for income tax expense; LIFO, by showing lower profits in inflationary times, can lead to lower taxable income and thus reduced tax liabilities.

Adjusting Inventory Value

Beyond the initial costing method, businesses must sometimes adjust the reported value of their inventory to ensure it accurately reflects its true economic worth. This is primarily governed by rules designed to prevent overstating inventory value.

Under U.S. GAAP, companies generally apply the “Lower of Cost or Market” (LCM) rule. This principle dictates that inventory must be valued at either its historical cost or its current market value, whichever is lower. “Market” in this context typically refers to the inventory’s replacement cost. If the market value falls below the historical cost, the inventory must be “written down” to the lower market value. This write-down reduces the reported value of inventory on the balance sheet and is recognized as an expense on the income statement, often increasing the cost of goods sold, which in turn reduces net income.

International Financial Reporting Standards (IFRS) use a similar concept called “Lower of Cost and Net Realizable Value” (LCNRV). Net realizable value (NRV) is the estimated selling price less costs to complete and sell. If the NRV of inventory falls below its cost, a write-down is required to adjust the inventory to this lower value.