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Inventory Costing Methods

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FIFO, LIFO, and Average Costing #

Understanding Inventory Costing Methods: FIFO, LIFO, and Average Costing (VMG WMS Uses Average Costing) #

It’s important to understand different inventory costing methods because you might discuss these concepts with senior personnel and accountants at our workshop customers. While our VMG WMS system uses the average costing method, knowing about FIFO and LIFO will provide a broader understanding of inventory valuation.

Inventory Valuation: A Quick Overview

Inventory valuation is how we determine the cost of the parts we have in stock. This is crucial for calculating the Cost of Goods Sold (COGS) – the direct costs associated with the parts used in workshop repairs – and ultimately, our profitability. It also affects how our inventory is valued on our financial statements.

There are three main methods:

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What Is the Average Cost Method? (This is what VMG WMS uses) #

The average cost method calculates a new average cost each time new stock of a particular part is received.

How it Works in VMG WMS:

  1. When you receive new stock of a part, the total cost of all units of that part currently in stock (including the new ones) is added together.
  2. This total cost is then divided by the total number of units now in stock.
  3. The result is the new average cost per unit.
  4. When a part is used on a job card, the average cost at that time is used to determine the cost of that part.

Example:

Let’s say we have 10 of a specific filter in stock, each costing $10 (total value $100). We then receive another 20 of the same filter, but this time they cost $12 each (total value $240).

The new average cost per filter would be:

Total Cost = R100 (old stock) + R 240 (new stock) = R 340
Total Units = 10 (old stock) + 20 (new stock) = 30
Average Cost = R 340 / 30 = R 11.33 per filter (approximately)

Now, if a technician uses one of these filters on a job card, the cost recorded for that filter will be R 11.33.

When is the Average Cost Method Most Appropriate?

  • When dealing with a large number of similar parts where tracking the individual cost of each item isn’t practical.
  • When the price of raw materials (in our case, the parts we purchase) fluctuates. The average cost helps to smooth out these fluctuations for costing purposes.
  • It’s generally easier to track compared to FIFO or LIFO as you don’t need to remember which specific batch of stock was used.

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What Is the FIFO (First In, First Out) Method? #

FIFO assumes that the first parts we received into our inventory are the first ones we use or sell. Think of it like a queue – the parts that have been in stock the longest are used first.

How it Would Work (If VMG WMS used FIFO):

If a job card required a part, the cost of that part would be based on the cost of the oldest units of that part in our inventory. Only when the entire initial stock is used would we start costing based on the next batch of stock received.

When is the FIFO Method Most Appropriate?

  • When the physical flow of inventory naturally follows a first-in, first-out pattern (e.g., perishable goods).
  • In times of rising prices, FIFO can make a business appear more profitable because the older, cheaper inventory is being used for the cost of goods sold, leaving the newer, more expensive inventory in stock.

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What Is the LIFO (Last In, First Out) Method? #

LIFO assumes that the last parts we received into our inventory are the first ones we use or sell. It’s the opposite of FIFO.

How it Would Work (If VMG WMS used LIFO):

If a job card required a part, the cost of that part would be based on the cost of the most recently received units of that part in our inventory.

When is the LIFO Method Most Appropriate?

  • LIFO can sometimes be used to reduce taxable income during periods of rising prices because the higher cost of the newest inventory is assigned to the cost of goods sold, resulting in lower profits on paper.

Important Note: LIFO is not permitted under International Financial Reporting Standards (IFRS), which are used in many parts of the world. It is primarily used in the United States under US GAAP.

Key Differenes Summarised

In Conclusion:

While FIFO and LIFO are other methods for valuing inventory, our VMG WMS system uses the average cost method. This means that the cost of parts used in workshop repairs is based on the constantly updated average cost of those parts in our inventory. Understanding all three methods will help you have more informed conversations with our workshop customers about their inventory management and accounting practices.