Inventory costing methods: Your guide to higher profits
In the world of ecommerce, managing your inventory is crucial to maintaining profitability. One key factor that can significantly impact your bottom line is how you calculate the cost of that inventory.
Inventory costing methods are the means used to value the goods you have in stock, and this can determine not only how much profit you make but also how you handle cash flow, pricing, and financial reporting.
With multiple sales channels and fluctuating inventory levels, ecommerce sellers need to understand inventory costing methods to keep their businesses financially healthy and competitive.
In this article, we’ll explore what the main inventory costing methods are, their advantages, and their potential impact on the bottom line of your business. Let’s get going!
What is inventory costing?
Inventory costing is the process of determining the value of your inventory at any given time. This is essential for tracking expenses, setting prices, and ultimately determining your profit margins. For ecommerce businesses, it plays a vital role in understanding how much they spend on acquiring and maintaining stock, and how much they can expect to earn once that stock is sold. Accurate inventory costing helps businesses avoid overpricing or underpricing their products, keeping their operations profitable and their cash flow steady.
In ecommerce, where businesses often juggle multiple sales channels, inventory costing has a direct impact on financial reporting. It influences how assets and liabilities are represented on balance sheets and affects tax obligations.
According to Hamed Ali, Plant Manager for S. I. L. Group, , “the cost of goods sold for the period is based on the value of the inventory at the beginning of the period. So the accuracy of the inventory valuation affects the accuracy of the cost of goods sold, which in turn affects the gross profit reported for the period.”
Different costing methods can also impact how you report profits, affecting the timing of your tax liabilities. Moreover, inventory costing can help ecommerce sellers make informed decisions about stock levels, pricing strategies, and when to replenish goods, making it a critical part of an efficient supply chain strategy.
What are the main inventory costing methods?
The main inventory costing methods are designed to value stock in different ways, depending on how goods move through a business. These include First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Weighted Average Cost (WAC), and Specific Identification. Each of these methods has its own advantages and disadvantages, and choosing the right one depends largely on the type of business and the products being sold.
For ecommerce businesses, it’s important to understand that each method impacts profitability, tax liabilities, and cash flow differently. Some methods like FIFO may be ideal for businesses selling perishable goods. Others, like LIFO, could provide tax benefits during inflation. The choice of method can also affect pricing strategies, stock valuation, and financial performance. It makes it crucial to choose the method that best suits your business model.
FIFO – First-In, First-Out
The First-In, First-Out (FIFO) method assumes that the first items placed in inventory are the first to be sold. This means the oldest stock is sold first. The remaining inventory is made up of the most recently purchased items. FIFO is commonly used by businesses dealing with perishable goods, as it ensures products don’t sit for too long and expire. In ecommerce, FIFO helps businesses manage their inventory efficiently by keeping older items moving while maintaining an accurate reflection of current stock costs.
Advantages of using FIFO
One of the primary advantages of FIFO is its ability to provide accurate inventory tracking. Because you are selling the oldest items first, the cost of goods sold reflects the real price you paid for those items, which aligns better with current market prices. This method is especially beneficial for businesses that deal with perishable goods like food or fashion, as it reduces the risk of products becoming outdated or obsolete. Additionally, FIFO tends to provide a clearer picture of inventory value.
How FIFO can lead to higher profits
FIFO reduces the risk of obsolete stock, which can eat into profit margins if left unsold. By prioritizing the sale of older items, businesses can avoid discounting products that are no longer in demand. Additionally, FIFO often aligns with inflationary trends, as the cost of goods sold is based on older, lower costs, while the remaining inventory reflects higher current costs. This can result in higher profit margins since the revenue from sales is compared against lower-cost goods, improving overall profitability.
LIFO – Last-In, First-Out
Last-In, First-Out (LIFO) is an inventory costing method where the most recently purchased items are sold first. Unlike FIFO, LIFO assumes that the latest inventory added to stock is sold first, leaving the oldest stock on hand. This method is rarely used for businesses dealing with perishable goods. However, it can be beneficial for those selling non-perishable or durable items where inventory turnover is slower. In ecommerce, LIFO can offer certain financial benefits, particularly when prices are rising, but it comes with its own set of challenges.
What are the advantages of using LIFO for inventory costing?
LIFO can be advantageous in periods of inflation because it allows businesses to reduce their tax liability. By selling the most recently purchased, higher-cost inventory first, the cost of goods sold increases, reducing reported profits and, in turn, lowering taxable income. This method can be especially useful for businesses dealing in durable goods or those that don’t face frequent price changes in their inventory. LIFO can also help businesses that focus on maximizing short-term gains and prefer to reduce taxable profits in the current period.
How does LIFO impact profits?
LIFO’s primary benefit is in how it impacts a business’s short-term profitability and tax obligations. By selling more expensive, recently acquired inventory first, the profit margins may appear lower on paper. It can reduce the company’s immediate tax liability. However, this method may not be beneficial in the long term if older inventory becomes obsolete or unsellable. It can lead to potential write-offs or inventory waste. For businesses focused on immediate financial benefits, LIFO can provide an advantage, but it may not align with long-term profitability strategies.
Weighted Average Cost (WAC)
The Weighted Average Cost (WAC) method calculates the cost of inventory by averaging the cost of all items available for sale during a specific period. Instead of tracking individual items, WAC takes the total cost of goods available and divides it by the number of units in stock. This method creates a uniform cost for all inventory. It is particularly useful for businesses that experience fluctuating prices or have a large volume of similar products. It simplifies inventory valuation and keeps pricing consistent across all items.
What are the advantages of WAC for inventory costing?
WAC offers simplicity and consistency, making it a popular choice for ecommerce businesses with rapidly changing inventory prices. Since the cost is averaged across all units, businesses don’t need to track individual item prices, which reduces complexity in accounting and financial reporting. WAC is ideal for ecommerce sellers with large volumes of similar items, as it offers a streamlined approach to pricing and inventory management. Additionally, it provides a consistent basis for pricing decisions, which can be beneficial when inventory prices fluctuate frequently.
How can WAC inventory costing lead to better profit margins?
WAC reduces pricing confusion by offering a single, averaged cost for all inventory, allowing businesses to set prices more confidently. This consistent pricing can help stabilize profit margins, especially in environments where stock prices vary regularly. By avoiding significant fluctuations in inventory costs, businesses can maintain more predictable profit margins, making it easier to manage finances and forecast profitability. WAC can be especially advantageous in helping ecommerce businesses maintain stable cash flow, as it smooths out the effects of price swings on inventory costs.
Specific Identification
Specific Identification is an inventory costing method where each item in inventory is tracked individually, with its specific cost assigned when it is sold. This method is typically used for high-value or unique items, such as luxury goods, automobiles, or custom-made products, where the exact cost of each item needs to be known. Unlike FIFO, LIFO, or WAC, Specific Identification requires precise tracking of each unit, making it a more labor-intensive method but necessary for businesses dealing with high-ticket items.
What are the advantages of Specific Identification for inventory costing?
The primary advantage of Specific Identification is its precision. Businesses can assign exact costs to individual items, making it easier to track high-value products and assess their profitability. This method eliminates the guesswork involved in pricing, allowing businesses to have a clear understanding of how much each item cost to produce or acquire. Specific Identification is also beneficial for businesses selling unique or custom items, as it ensures that the cost associated with each sale is accurate and reflects the true value of the product.
What is the profit potential of using Specific Identification?
For businesses selling luxury or custom goods, Specific Identification can maximize profit margins by ensuring that pricing reflects the true cost of each item. Since the exact cost is known, businesses can set prices that account for the specific value of each product, preventing underpricing and ensuring higher profitability. This method is particularly effective for businesses that deal with limited quantities of expensive items, where accurate cost tracking is essential to maintaining profitability and ensuring that each sale contributes to the bottom line.
How to choose the best inventory costing method for your business
Selecting the right inventory costing method for your ecommerce business depends on several key factors — and will have a huge impact on how your business operates. As Jon Blair, serial CFO and strategic advisor, highlights “An ecommerce brand is a consumer goods business. The consumer good is their inventory… If you’re a DTC brand or, or an omni channel, like brand that has a heavy ecommerce presence, you are a product business, which means you are in the inventory business.”
Here are the steps to choose the right inventory costing method for your business:
Step 1: Consider the types of products you sell
First, consider the type of products you sell. For businesses dealing with perishable goods or products that go out of fashion quickly, FIFO might be the best choice. On the other hand, if your inventory consists of durable, non-perishable items, LIFO could offer tax benefits, especially in times of inflation.
Step 2: Keep abreast of market changes and trends
Market conditions, such as fluctuating inventory costs, and your business’s tax strategy play a crucial role in this decision. Choosing the right method can impact everything from profit margins to cash flow.
Step 2: Be clear on your goals
Understanding your business’s specific financial goals is critical when deciding which inventory costing method to use. Do you want to maximize short-term profits, or are you focused on maintaining stable pricing and long-term profitability? Are you looking for ways to reduce your taxable income, or do you want an easier way to manage stock in fluctuating markets?
Your business’s priorities will guide your choice. For many ecommerce businesses, the best method is one that aligns with their pricing strategy, stock turnover rate, and tax planning objectives.
Step 3: Choose the right tools to support you
Inventory management software, such as Linnworks, can be invaluable in simplifying the inventory costing process. By automating the tracking of stock levels, sales, and inventory costs across multiple sales channels, Linnworks allows businesses to manage their inventory efficiently.
Our solution also helps you implement the inventory costing method that best fits your business, providing real-time insights and ensuring that your inventory valuation is always accurate. This level of automation not only saves time but also helps you stay competitive and profitable in a fast-paced ecommerce environment.
Inventory costing methods: Choose yours with care
Choosing the right inventory costing method is a critical decision for ecommerce businesses. Whether you opt for FIFO, LIFO, WAC, or Specific Identification, each method offers distinct advantages and challenges that impact profitability, tax liability, and inventory management.
By carefully considering factors like product type, market conditions, and your financial goals, you can select the method that best supports your business’s success. With the help of powerful inventory management software like Linnworks, you can streamline your operations, reduce complexity, and ensure that your inventory costing aligns with your overall strategy—ultimately leading to higher profits.
Finally, choosing the right infrastructure on this journey is vital. Linnworks helps thousands of ecommerce businesses worldwide to take control of their inventory, and to manage their ecommerce operations from a single, centralized HQ.
If you’d like to find out how Linnworks can revolutionize your approach to inventory management, book a free demo today.
Inventory costing method FAQs
Q: What are the different inventory costing methods?
There are four primary inventory costing methods used in businesses: First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Weighted Average Cost, and Specific Identification.
Q. How does your choice of inventory costing approach impact taxes?
Different inventory costing methods can result in varying values for the cost of goods sold (COGS) and ending inventory. This, in turn, affects the business’s taxable income and liabilities.
The LIFO method, which assumes that the most recently purchased items are sold first, can lead to a higher COGS. It results in lower taxable income. Businesses using LIFO may be able to lower their taxable income and reduce tax liabilities, particularly in times of rising prices.
It’s important to note that businesses should consult with tax advisors or accountants to ensure compliance and make informed decisions regarding the most suitable method for them.
Q. What is the best inventory costing method?
FIFO is often preferred in industries where the costs of goods tend to increase over time. This is because it helps accurately valuing ending inventory at current market prices, giving a better representation of the business’s financial position.
FIFO can also result in lower taxable income during periods of rising prices, as older, lower-cost inventory is matched with current sales.
Q.What is the difference between perpetual and periodic inventory systems?
The perpetual inventory system offers real-time updates, keeping you constantly informed about your stock levels. On the other hand, the periodic inventory system involves periodic physical counts to determine inventory quantity and value.
The choice between the two depends on things like sales volume, inventory complexity, and your business’s need for real-time visibility.
Q. How does inventory cost affect profitability?
Your weighted average cost method directly impacts profitability. Different methods, like FIFO and LIFO, affect the cost of goods sold (COGS) and, subsequently, gross profit, ultimately influencing overall profitability.
For example, in inflationary periods, the LIFO method can result in higher COGS due to matching recent, potentially higher-cost inventory with sales. This may lower gross profit and overall profitability.
Choosing the right inventory costing method involves considering industry norms, accounting regulations, and business objectives.