Inventory Costing Methodologies
Inventory Costing is the method by which costs are recorded and applied to the valuation of inventory.
In a simple world, you would record the cost against each specific item purchased and then recognise this as the cost when selling the product. However, this is not always possible or economically viable. Consider, where you manufacture - you may not be able to identify specific inputs to the manufacturing process or in other retail businesses where you might sell millions of widgets, it would be impractical to try and track each widget.
Therefore, accountants (and mathematicians and others) have come up with various methodologies to value stock when we hold it for resale and allocate cost when selling products. These are collectively known as costing methodologies.
The costing methodology employed can cause significant variations in your financial results. Consider the simple example below:
You use the first in first out method where you assume the first item you buy is the first item you sell - i.e. items are in a queue You buy the first item for 100 and the second item for 200 - you then sell 1 item for 400. At balance date you would have: Sales of 400 Cost of Sales of 100 Profit of 300 Inventory of 200
You use Last In First out method where you assume the last item you buy is the first item you sell - i.e. imagine a shelf where new items are added to the front.
You buy the first item for 100 and the second item for 200 - you then sell 1 item for 400. At balance date you would have: Sales of 400 Cost of Sales of 200 Profit of 200 Inventory of 100
There are a wide range of costing methods that have been defined. Generally, you should use only one method for financial reporting although many business keep costs for different reasons - such as determining impairment, market valuations, and for management reporting. This method should be one approved by the relevant authorities in where you are based, which may include International Financial Reporting Standards or your countries implementation of IFRS, tax and industry rules, regulations and standards.
Various Costing Methodologies can be identified as follows:
- Specific Identification
- Purchase Costing
- Standard Costing
- Activity Based Costing
- Direct Costing
- Job / Project Costing
- Process Costing
- Throughput Costing
- Target Costing
- Industry Costing methods - such as retail costing
The costing methodology employed does depend on the industry in which the business operates. For instance, costing of paint or financial derivatives is necessarily different from the costing of motor vehicles held for resale or the retail of food products.
This page discusses various costing methodologies and how they relate to Adempiere.
Costing methods are implemented within schemas in Adempiere. You can have a number of schemas and each one can have only one costing methodology - this does not prevent you from having one schema for financial reporting and another for management reporting.
Standard Costing is the default costing in Adempiere.
It works well if your purchase prices rarely change and you have the time to update the product costing manually (few articles and rare price changes).
The standard cost is set on a product the first time a vendor invoice arrives for the given product. Any difference in purchase price compared to the standard cost is booked on the Invoice Price Variance account.
With standard costing, you change the costing manually.
FIFO is a costing method based on actual cost. It is normally used in a business environment where product cost is very stable. The end result is inventory at financial year will be valued at cost that reflects its actual cost.
In contrast LIFO was created in a highly volatile price fluctuation business environment. This method does not find favor with many tax authorities as it can be used to depress profit.
Last In First Out is prohibited from use under IAS2.IN13
It is recognised in IAS2.BC20 that in some jurisdictions, use of the LIFO method for tax purposes is allowed only if that method is also used for accounting purposes.However, the IASB concluded that tax considerations do not provide an adequate conceptual basis for selecting an appropriate accounting treatment and that it is not acceptable to allow an inferior accounting treatment purely because of tax regulations and advantages in particular jurisdictions. This may be an issue for local taxation authorities.
Invoice based pricing of inventory is popular in the retail business where cost is determined as a percentage of selling price (margin).
One major issue in average invoice costing is correcting the costs, if the product has been sold before receiving the invoice. Adempiere does not retroactively adjust the costs used in the receipt and sales transaction, but adjusts the actual cost price for future use.
Purchase Order pricing of inventory is used in non manufacturing type businesses e.g. in the distribution business where inventory cost can be easily determined from the buying price of the goods (merchandise).
Average PO is the current costing method to use if you have many products and or prices changing frequently.
Key points are:
- When receipts from suppliers are accounted, the actual purchase order price is used to calculate the increase in inventory.
- When shipments to customers are accounted, the average PO price is used to calculate the decrease in inventory.
- If the invoice price differs from the PO price, the difference is accounted on Invoice Price Variance.
One major issue in average PO costing is Adempiere does not allow the receipt posting if it is not matched to any PO, thus PO is a mandatory document. See: Merging Average PO & Average Invoice Cost Methodology
(NOT IMPLEMENTED IN ADEMPIERE)
The retail method is a costing methodology often employed in the retail industry to measure large numbers of rapidly changing items with similar margins for which it is impractical to use other costing methods.
The cost of the inventory is determined by reducing the sales value of the inventory by the appropriate gross margin percentage. The percentage must include inventory that has been marked down below its original selling price. An average percentage per department is often used.