What This Article Covers
- Introduction to the Cost of Inventory
- The Types of Inventory Cost
- Inventory Cost, Inventory Price, Inventory Valuation Methods and the Valuation of Inventory
- Inventory Accounting with the LIFO Method or Last In First Out Method, FIFO Method or First In First Out Method
- Inventory Accounting with the Weighed Average Method, Average Cost Method and the Costs of Goods Sold
- The Concept of Average Inventory Formula
In this article, we will cover the cost of inventory. The cost of stock is critical to both how inventory is managed as well as the final determination of the profits of a company. And the calculation method of the cost of inventory must be set up within the inventory management and financial system or systems of the entity.
There are many methods of determining the cost of inventory that relates to the inventory accounting, inventory valuation, etc.
The Types of Inventory Cost
The types of inventory cost are related to things like the purchasing cost of the inventory. However, other types of inventory cost are absorbed into things like facility costs. This is included in the carrying cost formula that is used by many companies to estimate the cost of holding inventory for a year or a month.
Other types of inventory cost include obsolescence and breakage. The types of inventory cost are quite numerous and impact a balance sheet in a multitude of ways.
Inventory Cost, Inventory Price, Inventory Valuation Methods and the Valuation of Inventory
Inventory will almost always have an inventory cost and sometimes and inventory price if the inventory is a finished good. That is an inventory price is only necessary for inventory that is sold. And the margin is determined by subtracting the inventory cost from the inventory price when the same items are purchased and sold. But this becomes more complex when a material is converted into a finished good and then sold. In that case, the combined costs of goods sold that went into the finished good must be estimated. This means subtracting the inventory cost of various materials from the final inventory price of the finished good.
This means using inventory valuation methods that allow an entity to determine the valuation of inventory. Inventory valuation methods are constrained by the tax laws of the particular country, but typically there are some standard inventory valuation methods to choose from in almost every country.
An inventory cost or inventory valuation is necessary for all of the inventory that a company maintains.
Inventory Accounting with the LIFO Method or Last In First Out Method, FIFO Method or First In First Out Method
An entity will normally choose an inventory accounting method and then configure their system to operate that way. One of the complexities is that costs change over time. Therefore, raw material “A” may cost $20 on Jan 20th, but cost $25 on Feb 25th.
- If the raw material is issued on Feb 26th, then what is the correct cost of the raw material? When inventory is recorded in a location, it is not serialized (in most cases). Therefore the inventory at a location virtually “blends.”
- This makes the assignment of a cost to the material difficult as 1/2 of the inventory may have been purchased at the cost of $20, and the other half at the cost of $25.
Two of the most common inventory accounting valuation methods are LIFO Method or Last In First Out Method, FIFO Method or First In First Out Method.
- The LIFO Method or Last In First Out Method: This method values the inventory at the cost which goes to the last item cost received. So in the example above the $25 per unit cost would be used.
- The FIFO Method or First In First Out Method: This method values the inventory at the cost which goes to the first item cost received. So in the example above the $20 per unit cost would be used.
Inventory Accounting with the Weighed Average Method, Average Cost Method
Another inventory accounting method is to now use a specific price, but rather the weighted average method or average cost method.
- Weighted Average Method or Average Cost Method: This method values the inventory at the cost which is an average of the cost received. So in the example above the ($25 + $20),/2 or $22.5 would be the cost used.
Overall the weighted average method or average cost method has the advantage of being far less complex than the LIFO method or the FIFO method.
The Concept of Average Inventory Value
Average inventory value means taking an average of the inventory holding position and then applying a particular value (as determined as explained above). Average inventory value is used to improve the value determined in the system. The article up to this point has focused on the average inventory value for a specific product or product location combination. However, average inventory value also applies to the overall product database. The average inventory value for the overall product database is then typically tracked by companies and compared to a maximum stock level that the company wants to hold.
Cost of Goods Sold
Apparently, these various inventory accounting methods are used to determine the cost of goods sold. The costs of goods sold in total combined with the administrative and overhead will serve as the cost basis for the company.
While the inventory value is the average cost of the materials time the number of materials, the term inventory value can mean several things. Any one item can have an inventory value. Or the overall system or network-wide inventory can have an inventory value, or the inventory value can be just of the materials kept at a particular distribution center.
Most companies try to cap the overall inventory value at a specific number. Such as no more than $100 million in inventory.
Inventory valuation works behind the scenes in inventory but drives many decisions. At this point, most ERP systems have strong capabilities for the valuation of inventory. Once the ERP system is configured properly, the valuation of inventory is automatic. Most ERP systems can show the inventory valuation at any point in time.
Another important factor related to inventory valuation is sales and operations planning. This is where the company projects supply and demand, and the impact on the overall inventory valuation of the planned inventory to be carried.
Brightwork MRP & S&OP Explorer
Safety Stock and Service Level Book
Important Features About Safety Stock
How Systems Set Safety Stock
The vast majority of systems allow the setting of safety stock by multiple means (static, dynamic, adjustable with the forecast in days’ supply, etc..). However, most systems do not allow the safety stock to be set in a way that is considerate of the inventory that is available to be applied.By reading this book you will:
- Understand the concepts and formula used for safety stock and service level setting.
- Common ways of setting safety stock.
- Service levels and inventory optimization applications.
- The best real ways of setting both service levels and safety stock.
Chapter 2: Safety Stock and Service Levels from a Conceptual Perspective
Chapter 3: The Common Ways of Setting Safety Stock
Chapter 4: The Common Issues with Safety Stock
Chapter 5: Common Issues with Service Level Setting
Chapter 6: Service Level Agreement
Chapter 7: Safety Stock and Service Levels in Inventory Optimization and Multi-Echelon Software
Chapter 8: A Simpler Approach to Comprehensively Setting Safety Stock and Service Levels