What a costing method decides
When a unit leaves the warehouse, the ledger needs its cost. That cost becomes cost of goods sold on the income statement, and what is left becomes the stock value on the balance sheet. When every purchase is made at the same price, the question never arises. When prices move, the method decides which price each sale carries.
A costing method does not decide which carton the picker takes; that is the picking rule. Two items picked the same way can carry different costing methods, and the choice should be made for accounting reasons, with your accountant.
Weighted average: one blended cost
Weighted average blends every receipt into one running cost per unit. Each new receipt moves the average, and every issue leaves at the average of that moment. It is simple to explain, smooths out price swings, and suits goods that are interchangeable and bought often, which describes much of what a distributor sells.
TipWeighted average is the safe choice for most fast-moving goods; pick another method only when you can name the reason.
FIFO: cost follows the layers
FIFO, first in, first out, keeps each receipt as a layer at its own price and charges issues from the oldest layer first. The stock left on the shelf is valued at the latest prices, so the balance sheet stays close to what it would cost to buy that stock today.
Take the same receipts as above. FIFO charges the 250 cartons to the 200 old ones first and the rest to the new receipt, so the sale carries less cost and the stock left carries more.
When prices rise, the methods part ways
In the two examples, the same stock and the same sale give different results. FIFO charged SAR 2,575.00 to cost of sales, weighted average SAR 2,625.00. The SAR 50.00 difference is not money lost or found; it sits in the stock value instead of the margin, and comes out when that stock is sold.
- With rising prices, FIFO shows a higher margin and a higher stock value.
- With falling prices, it is the other way round.
- Weighted average moves more slowly in both directions.
- Once all the stock is sold, both methods have charged the same total cost.
- Changing method part way breaks comparisons between months.
TipCompare the methods on one real item with last quarter’s receipts before deciding, not on a textbook example.
Standard, specific and first-expiry cost
Three other methods fit special cases. Standard cost values an item at a fixed price set in advance and books the gap between that standard and what you actually paid as purchase price variance, which makes buying performance visible. Specific cost carries each lot or unit at its own price, for high-value goods where one unit’s cost really differs from the next.
First-expiry cost charges issues to the lot that expires first. It suits goods picked that way where a later receipt can carry an earlier date, so the cost follows the cartons that actually leave.
Choose before the first receipt
A costing method should stay fixed for the life of an item, because changing it rewrites what past sales cost and breaks every comparison. Decide per item group before the first receipt, and record the decision so new items follow it.
- Group your items: fast-moving, short shelf life, high value, bought at a fixed price.
- Give fast-moving interchangeable goods weighted average.
- Give goods picked by expiry the first-expiry method where lot prices differ.
- Give high-value lot or serial goods specific cost.
- Use standard cost only where someone will review the variance every month.
- Add the rule to your item setup checklist, so new items follow it.
TipEach month, set the stock valuation against the inventory account in the ledger, and find the cause of any gap before you close.
Checklist: Costing method checklist
- Agree the costing policy with your accountant
- Group items by how they are bought and sold
- Default fast-moving goods to weighted average
- Test FIFO against average on one real item
- Use standard cost only where variance is reviewed
- Set the method before an item’s first receipt
- Never switch an item’s method part way
- Check stock value against the ledger each month