3 things you need to know about inventory

Your business carries inventory. You’ve heard the controller spout off terms like FIFO, LIFO, costing layer, and landed cost. All you know is you need to sell. That’s well and good, but understanding your inventory is critical to running your business and efficiently deploying capital.

Today, we dive into the basics of inventory. This is just the first layer of the onion, but even the basics give you increased control over your business.

 Average Cost vs. FIFO vs. LIFO

At some point in the creation of your business you made the decision on how to report the cost of your inventory. This decision could have been dictated by the systems you chose (some inventory systems only handle average cost) or as a strategic decision. Whatever the reason, there are pros and cons to each. Below, each costing method is dissected and laid out in layman's terms.

Average Cost

As the name implies, average cost is the moving average cost of inventory as units are moved in and out of inventory. This is often the go-to costing method for smaller businesses due to the lower administrative burden and the wide availability of applications that support average cost.

When an item is sold, the cost reported to COGS (cost of goods sold) on the Income Statement is calculated by taking the total dollar value of that unit's inventory divided by the total number of units on hand. Thus, the fluctuations in inventory prices over time are smoothed out via average costing.

Let’s take an example from The World’s Best Widget Company (WBWC), whose business model is buying and re-selling widgets:

Number of Widgets Cost per Widget Total Cost
First Purchase (July 2015) 2 $50 $100
Second Purchase (August 2015) 3 $35 $105
Inventory Value on 8/31/2015 5 $205
Sale of 3 Widgets on 9/1/2015 (3) ($41) ($123)
Third Purchase (September 2015) 5 $55 $275
Inventory Value on 9/30/2015 7 $357
Sale of 3 Widgets on 10/1/2015 (3) ($51) $153
Inventory Value on 10/31/2015 4 $204

When WBWC makes the first sale, the cost of the sale is based on a total inventory value of $205 for 5 units for a unit cost of $41. Compare this with the second sale where the unit cost is $51 based on 7 units in inventory at a total value of $357.

Your first takeaway: average cost presents less administrative burden relative to other costing methods due to the simple costing approach. To determine a unit’s cost at a point in time simply take the unit's total inventory value divided by number of units in inventory.

FIFO

FIFO stands for First In, First Out. An easy way to think about this is the milk section (or maybe the almond milk section if you live in Austin) at the grocery store. The store stocks from the back so that the oldest milk is taken first and continually cycles through.

Since prices most often rise over time, FIFO gives an accurate and real-time view into the cost of goods and margins of your business. Each purchase of inventory creates a new costing layer under FIFO from which sales are drawn.

Let’s see what this looks like for WBWC from the example above:

Number of Widgets Cost per Widget Total Cost
First Purchase (July 2015) 2 $50 $100
Second Purchase (August 2015) 3 $35 $105
Inventory Value on 8/31/2015 5 $205
Sale of 3 Widgets on 9/1/2015 (3) ($45) ($135)
Third Purchase (September 2015) 5 $55 $275
Inventory Value on 9/30/2015 7 $345
Sale of 3 Widgets on 10/1/2015 (3) ($41.67) $125
Inventory Value on 10/31/2015 4 $220

At WBWC’s first sale there are two costing layers; one for two widgets at $50 and one for three widgets at $35. Thus, the first sale draws both units from the first layer and one unit from the second layer for a total cost of $135 or $45 per unit. After the sale WBWC only has one costing layer remaining, two units at $35 for a total inventory value of $70. When WBWC makes the second sale it will draw two units from the first costing layer at $35 and one from the second costing layer at $55 for a total cost of $125. At the end of October, inventory consists of 4 widgets from the third costing layer ($55/widget), and inventory is valued at $220.

In most industries, FIFO mirrors the real world movement of inventory. The oldest items are sold first and the associated costs are recognized. This enables management to get a current understanding of unit costs.

LIFO

LIFO stands for Last In, First Out. This is a lesser used costing method and probably not the right fit for your business unless you’re an oil company. But we’re here to learn, so dive in anyway!

Again, WBWC will be our guinea pig for this example:

Number of Widgets Cost per Widget Total Cost
First Purchase (July 2015) 2 $50 $100
Second Purchase (August 2015) 3 $35 $105
Inventory Value on 8/31/2015 5 $205
Sale of 3 Widgets on 9/1/2015 (3) ($35) ($105)
Third Purchase (September 2015) 5 $55 $275
Inventory Value on 9/30/2015 7 $375
Sale of 3 Widgets on 10/1/2015 (3) ($55) $165
Inventory Value on 10/31/2015 4 $210

Under LIFO, the first sale is drawn from the second costing layer. Therefore all three units are valued at $35 for a total cost of $105. Contrary to FIFO, the first costing layer remains in inventory while the most recent costing layer in drawn upon. At the point in time the second sale occurs, the most recent costing layer is at $55 a unit and the total cost is $165.

Under LIFO, the costing layers quickly become burdensome. Although certain inventory systems will handle the back end work of tracking costing layers, there are only certain use cases when operating under LIFO makes sense.

How Does This Affect Your Business?

Alright, that felt like sitting in accounting class. What does that actually mean and how does it affect my business?

Average costing presents some obvious benefits that are attractive to new businesses. First, almost all inventory systems support average costing, which provide a wide range of options for back office solutions. Second, as smaller businesses may not be able to negotiate prices or purchase in quantities to warrant a certain price, average cost will smooth the ups and down in cost often experienced by small and medium size businesses.

LIFO is the most difficult of the inventory costing methods. In a majority of instances LIFO does not represent the physical movement of goods in the business. Further, LIFO requires substantial reporting requirements according to GAAP (Generally Accepted Accounting Principles), such as a LIFO reserve calculation. For these reasons, LIFO should only be your costing choice after a discussion with an accountant to absolutely determine it’s the right choice.

On the other hand, FIFO is a costing methodology that in the majority of circumstances provides the most accurate and realistic costing methodology. For many businesses, first in, first out reflects the everyday movement of inventory and thus, financial statements are more representative of the operations of the business. FIFO marries the best of both worlds; representative costing and reasonable administrative tracking.

The intricacies of inventory are many and varied. No one blog post is going to be the silver bullet to all your inventory questions, but even a basic understanding of inventory will empower you to be a better and more confident business owner.

#OnwardAndUpward

 

Contributed by:
Alex Mette
Senior Accountant