Inventory Costing Methods

The Inventory Management module supports the following six separate methods of costing your inventory. These valuation methods determine the current value of the on-hand inventory, allocate the cost of goods sold, and determine gross profits as items are sold from inventory.

Each item can be assigned a different valuation method, or all items can be valued using the same method. Selecting the appropriate valuation method ensures that the financial and inventory reports provide the most accurate picture of the status of your business. Consult with your accountant to determine which valuation method (or combination of valuation methods) best suits your needs.

Standard Cost Method

Standard Cost is the simplest inventory valuation method. When this method is used, the cost is determined by the value assigned for the item in the Std Cost field on the Item Maintenance Main tab. The standard cost does not change unless you manually enter a new cost for the item. The total inventory value of each item equals the quantity on hand multiplied by the standard cost. As items are sold, the standard cost is used to determine the cost of goods sold.

This method is appropriate only if the standard cost for each item does not change frequently.

After a standard cost item is established, the standard cost can only be changed using the standard cost adjustment utilities on the Utilities menu. These utilities ensure the appropriate Inventory Management and General Ledger adjustments are posted.

When items are received into inventory using Transaction Entry or the Purchase Order module, the difference between the cost received and the standard cost is posted to the Adjustment account.

Average Cost Method

Average Cost is the most commonly used method of costing inventory. Each time new units of an item are purchased (received), a new average cost is calculated. The total inventory value of an item is the quantity on hand multiplied by the average cost. The cost of items shipped (issued or sold) equals the quantity multiplied by the average cost. As items are sold, the average cost for this item and warehouse is used to determine the cost of goods sold.

Note For average cost items, if the quantity on hand is negative, the average cost will be an estimate because the actual cost is not yet known. If an item's quantity is expected to perpetually remain negative, use the FIFO, LIFO, or standard cost valuation method instead.

The following table illustrates how the average cost changes as receipts and issues are entered.

Transactions	Qty on Hand	Total Cost	Avg. Cost
Opening Inventory	0	$0.00	$0.00
Receive 100 @ $5.00 each	100	$500.00	$5.00
Receive 200 @ $6.50 each	300	$1800.00	$6.00
Issue 50 ( @ $6.00 each )	250	$1500.00	$6.00
Receive 250 @ $7.00 each	500	$3250.00	$6.50
Issue 100 ( @ $6.50 each )	400	$2600.00	$6.50

First-In, First-Out (FIFO) Method

The First-In, First-Out method assumes the first units purchased (first in) are the first units issued (first out). This method is appropriate for businesses that value inventory based on the most recent purchases.

Unlike the Average Cost method, the FIFO method retains the actual cost associated with each unit received into inventory. The cost information for each receipt consists of the receipt date, quantity received, and unit cost, and is recorded as a "cost tier" for the item. As items are sold, the oldest cost tier (the cost tier with the oldest receipt date) is used to determine the cost of goods sold, thereby matching the oldest cost to the current revenue.

When all units in the oldest cost tier are sold, the next oldest cost tier is used. There are no limits to the number of cost tiers that can be maintained for an item.

The following table illustrates how the FIFO method works as receipts and issues are entered.

Transaction	Cost Tier	Qty on Hand	Total Cost	Unit Cost
Opening Inventory		0	$0.00	$0.00
Receive 100 @ $5.00	01/06	100	$500.00	$5.00
Receive 200 @ $6.50	01/06	100	$500.00	$5.00
	01/12	200	$1300.00	$6.50
Issue 50 ( @ $5.00 )	01/06	50	$250.00	$5.00
	01/12	200	$1300.00	$6.50
Receive 250 @ $7.00	01/06	50	$250.00	$5.00
	01/12	200	$1300.00	$6.50
	01/23	250	$1750.00	$7.00
Issue 100 units,	01/06	0	$0.00	$0.00
50 @ $5.00 / 50 @ $6.50	01/12	150	$975.00	$6.50
	01/23	250	$1750.00	$7.00

Last-In, First-Out (LIFO) Method

The Last-In, First-Out method assumes that the last units purchased (last in) are the first units issued (first out). This method is most appropriate for businesses that value inventory based on the oldest purchases.

Like the FIFO method, the actual cost associated with each unit received into inventory is recorded for each item. The receipt date, quantity received, and unit cost are recorded as a "cost tier" for the item. As items are sold, the most recent cost tier (with the latest receipt date) is used to determine the cost of goods sold, thereby matching the most current cost to the current revenue.

When all units associated with the most recent cost tier are sold, the next most recent cost tier is used. There are no limits to the number of cost tiers that can be maintained for an item.

Using this method for items with low turnover rates (the quantity on hand is high compared to the quantity sold) results in an inventory valuation that differs significantly from the current purchase costs.

The following table shows how the LIFO method works as receipts and issues are entered.

Transaction	Cost Tier	Qty on Hand	Total Cost	Unit Cost
Opening Inventory		0	$0.00	$0.00
Receive 100 @ $5.00	01/06	100	$500.00	$5.00
Receive 200 @ $6.50	01/12	200	$1300.00	$6.50
	01/06	100	$500.00	$5.00
Issue 50 ( @ $6.50 )	01/12	150	$975.00	$6.50
	01/06	100	$500.00	$5.00
Receive 250 @ $7.00	01/23	250	$1750.00	$7.00
	01/12	150	$975.00	$6.50
	01/06	100	$500.00	$5.00
Issue 100 @ $7.00	01/23	150	$1050.00	$7.00
	01/12	150	$975.00	$6.50
	01/06	100	$500.00	$5.00

Lot Number Method

Items can be grouped and identified by lots for costing and tracking purposes. The Lot Number method is appropriate for items that must be identified in groups of units and is often used by food, drug, and chemical manufacturers or distributors.

The quantity and cost associated with each lot is retained for each item. In addition, a lot identification number must be used whenever units are received or issued (sold) out of inventory. If more than one lot is involved in a receipt or issue, each lot number and quantity of the transaction must be entered.

Because the lot number is specified when units are sold, the cost of goods sold matches exactly the purchase cost of the items in the lot.

If the Sales Order module is installed, a detailed sales history of lot numbers can be produced if the Lot Items or Both Lot & Serial Items is selected in the Retain Lot/Serial Sales History field in the Sales Order Options window. This report includes the invoice number, invoice date, customer, and quantity sold.

Serial Method

The Serial Number method allows you to identify each item with a unique serial number, and retain the purchase cost of each item separately. This is often required for large-ticket items such as appliances, computers, furniture, and stereo equipment. Because the serial number is specified when units are sold, the cost of goods sold matches exactly the purchase cost of the items in the lot.

Serial number costing differs from lot number costing in that only a single unit can be assigned to each serial number. If the Sales Order module is installed, a detailed sales history by serial number can be produced if Serial Items or Both Lot & Serial Items is selected in the Retain Lot/Serial Sales History field is selected in the Sales Order Options window. This report includes the invoice number, invoice date, customer, and quantity sold.

For more information, see:

Average Cost Calculation for a Standard Cost Item

Hierarchy of Costs

Negative Quantity Adjustments