In the world of accounting and inventory management, selecting the right costing method is crucial. Different industries and businesses have unique needs, and the choice of costing method can significantly impact financial reporting and decision-making.
Some common costing methods that can be applied when you implement an ERP system are weighted average (average costing), standard costing, and first-in, first-out (FIFO). Each method has its advantages and disadvantages, and understanding these can help you make an informed decision for your business.
Here is a breakdown of each of these methods, along with some of its pros and cons:
Average cost method
The average cost method, also known as the weighted-average method, calculates the cost of inventory items by dividing the total cost of goods purchased or produced in a period by the total number of items. It offers a straightforward way to assign costs to inventory.
The calculation is simple, and it evens out the costs of stock throughout the year.
Businesses that prefer the average cost method are often those in industries with high stock movement and where basic or simple analytical tools are required.
Pros:
- Easily understandable.
- Evens out costs of stock during the year.
- Stock adjustments can be done over all stock quantities, including specific stock items.
Con:
- Less suitable for tracing variances within stock movements and pricing.
Standard costing
Standard costing is a practice used to estimate the expenses of a production process based on historical data and probable future changes. It is used by manufacturers to plan their costs for the coming year on various expenses, such as direct material, direct labour or overhead.
This method involves comparing budgeted costs to actual costs. It is more complex and requires a detailed historical dataset of stock prices and movements to accurately implement budgeted figures.
Standard costing is the preferred method of businesses that want to trace variances regularly and in more depth, including price and quantity variances for materials, labour and overheads.
Pros:
- Provides beneficial analytical information when implemented correctly.
- Allows tracking of variances and costs in a structured way.
Cons:
- Requires established accounting teams and detailed historical data.
- Involves a significant initial time investment in determining budgeted costs.
FIFO
FIFO costing tracks the price of items based on their cost at the time of purchase order receipt. It applies this cost to each shipment of the item until the receipt quantity is exhausted.
FIFO is calculated by adding the cost of the earliest inventory items sold, ensuring that the oldest stock is used first.
Industries that require the sale of the oldest stock items first, such as those dealing with perishables, prefer FIFO. It also helps monitor stock obsolescence.
Pros:
- Easily understandable.
- Accurate gross profit at a given point in time when implemented correctly.
Cons:
- Less suitable for tracing variances within stock movements and pricing.
- Stock adjustments can be more complex and time-consuming, as they need to be done per cost layer.
The choice between these methods may vary depending on the focus of your industry or the reporting requirements of your company.
Below are a few examples of where you can apply the above costing methods depending on your stock movement:
For businesses that stock or buy to order, all three methods can be applicable.
- FIFO is highly beneficial in industries dealing with goods that have a limited shelf life, such as food products. FIFO is also advantageous for businesses with specialised stock and low quantity movement.
- In industries with high quantity movement and similar items, all three methods can be considered.
- In industries where stock prices are highly volatile, both average and FIFO methods can provide advantages.
For manufacturing-focused businesses, streamlined processes may make average cost methods or standard costing more appropriate
In short there is no single costing method that trumps all others. The choice of costing method should align with your business’s unique needs, industry focus and analytical requirements.
Contact epic ERP for an assessment. We will help you chose the right costing model for your business.
