Who decides which of the many inventory accounting methods a company should use?

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When to use weighted average costing

The weighted average method works well if you are purchasing inventory stock on a regular basis. When your inventory has a relatively fast turnover, there is generally very little difference between average costing and an alternative LIFO costing method. Even with a high reorder frequency, average costing is easily processed because you aren’t tracking every purchase or its respective price and volume. This method is commonly used when inventory items are so blended or identical to each other it is impossible to assign specific costs to individual units. Many manufacturing businesses rely on weighted average costing because inventory is often stockpiled or combined making it difficult to differentiate between older and newer materials. For instance, in coffee roasting, one batch of coffee beans may be mixed with another batch of the same beans. The difficulty in accounting for the separate coffee beans suggests the company would use a weighted average cost approach. Equally, if the day-to-day costs of raw ingredients are unpredictable, change often yet remain within a stable range, using average costing will smooth inventory costs over time. It is worthwhile to note however that work-in-process figures are not kept separate in the average costing method, they are instead combined with material costs and then averaged out. This can cause confusion, increase the risk of human error and makes it difficult to effectively track work-in-process for company records.

Industries suited to weighted average costing

Manufacturing is not the only industry suited to average costing. In the agricultural sector weighted average costing is often used because produce such as fruit, vegetables and grain or any other product grown in pastures and mass harvested, cannot be accounted for individually. Likewise, some animal products are also collected in large quantities making it difficult to differentiate them on an individual basis. For these types of products, weighted average costing makes it simpler to allocate costs. The manufacture of chemicals or the extraction, collection and storage of liquid fuels and related products makes it necessary for chemical, gas and petroleum industries to utilise weighted average costing. The method would be applied in both the manufacture and sale of these products because there is no capacity to separate batches of chemicals or fuel from each other when they are stored together.

When is average costing not the best approach?

For retailers or manufacturers that purchase in bulk and when there are significant time lapses between purchases, using average costing will produce substantially different results from other costing methods. If batch units are not identical, and/or there are significant price variances between each batch, they cannot be treated in an identical manner for costing purposes. In this instance, you would achieve greater accuracy in tracking costs on a per-unit basis. Alternative costing methods provide a more detailed level of costing for each individual cost element. If you need to track overhead costs LIFO and FIFO, unlike average costing, allocates a more accurate inventory cost to those products that actually incur the costs.

One of the most important parts of building a profitable, viable, and scalable online business is ensuring that you always manage inventory effectively. Whether you’re an ecommerce rookie or veteran, inventory management can definitely be challenging –, especially when deciding which inventory accounting method is best for you.

In this article, we’ll look at what inventory accounting methods are and why they’re important.

Finally, we’ll highlight how to make the right choices for your online business when various inventory obstacles enter your path to success.

What Are Inventory Accounting Methods?

As an ecommerce seller, inventory management is the task of tracking all your products while maintaining enough stock to meet demands, but not so much that capital is tied up in slow-moving products.

Your products are considered an asset, and you need a consistent way of measuring its value for many different reasons. Using an inventory accounting method is the perfect way of assign value to your inventory in a dependable fashion. These methods allow you to apply a particular price to each product, which is important information that helps in many different areas of your business.

Why Are Inventory Accounting Methods Important?

Inventory accounting is an essential part of inventory management. It allows you to evaluate the Cost of Goods Sold (COGS) and, subsequently, your overall profitability. To effectively price your products, you must truly understand how much they cost you. There are different methods of tracking the cost, just as there are different types of online businesses. The important thing to remember is that they all can affect your bottom line – so you must choose wisely.

Common Inventory Accounting Methods

Below, we outline the most familiar methods available to you and why they may or may not be the best option for your business.

First In, First Out (FIFO)

The FIFO method is the most popular inventory method because it’s the one that most closely matches the actual movement of inventory for most businesses. This method assumes that the first products you acquired will be the first that are sold. It’s a theoretically sound method.

Here’s why: In times of increasing prices (which is almost always the case), the earliest units in your inventory were purchased at the lowest prices. But when they are sold, they are sold at today’s market value. Thus, the FIFO method will lower your COGS which, in turn, leads to a higher reportable income and more taxes paid.

The FIFO method will provide the healthiest balance sheet. If your business is looking to impress investors or needing to qualify for a loan, the FIFO method is your best bet.

Last In, First Out (LIFO)

The LIFO method assumes that the products you acquired last are sold first. That also means that products that remain in your inventory are the oldest ones. This doesn’t follow the natural flow of inventory for most businesses. It’s also a method that the International Financial Reporting Standards prohibits, making it illegal in many other countries, and closely regulated in the U.S.

LIFO isn’t a good indicator of your ending inventory value because your leftover stock could be very old or even obsolete. That will result in a valuation much lower than today's market prices. The LIFO method will show lower profitability because the COGS is higher, which means lower taxes are paid.

If you’re looking for tax benefits, then LIFO may be the strategy to use. However, because it’s closely regulated, you should consult a tax expert to determine if it’s the right strategy for you.

Weighted Average

The weighted average method falls right in the middle of FIFO and LIFO. It’s not an inventory method that very many companies use. This method averages the cost of any new inventory purchases with the cost of existing inventory to arrive at a weighted average cost, which is then readjusted as more inventory is purchased.

If your company sells similarly priced products, then this may be a viable option. For companies that sell products of widely varying prices, final figures will be much less accurate.

Specific Identification

Specific identification is the most accurate inventory accounting method. It tracks the cost of each item in your inventory and the actual price of each item that sold. This method requires a massive amount of information tracking, so it is typically only used for unique, high-cost items, like cars, works of art, jewelry, and other luxury items.

If your business specializes in items that are expensive and you don’t have a large product catalog, then the Specific ID method will provide you with very accurate records. However, if that doesn’t describe your business, the Specific ID method will be way too much work. Choose FIFO or LIFO instead.

The examples above are the most common inventory accounting methods. There are other methods out there, but you can likely find one that works great for your business from the list above. Choosing the best inventory valuation method for your company depends on various factors, such as where your business is based, whether costs are increasing or decreasing, and how much your stock fluctuates.

The most popular inventory accounting method is FIFO because it typically provides the most accurate view of costs and profitability. However, because there isn’t a one-size-fits-all solution, it’s a good idea to talk with your accountant or tax expert to determine what will work best for your business.

Common Inventory Obstacles You May Encounter

It’s inevitable to face challenges when managing inventory. If you aren’t utilizing the best inventory management methods, you’ll experience far more than your fair share. Once you have your accounting method in place, be sure to keep it consistent. That will eliminate many headaches down the road.

Being prepared for inventory challenges and having solutions in mind ahead of time may mean the difference between a lucrative and unprofitable year.

Here are some of the common inventory challenges that ecommerce retailers, like you, may experience and how to deal with them:

Too Much or Not Enough Inventory

When you’re not using the right methods to manage your inventory, you may find yourself in the position of having too many products or, conversely, running out of stock.

While overstocking has little or no impact on your customers and may seem like a good idea, having too much inventory can create problems:

• It can be costly. You must store your unsold items and that isn’t free. Tying up your capital in unsold inventory isn’t an effective way to grow your business.
• Products don’t last forever. Even if you don’t sell perishable products, there are ways that overstocking can lead to dead stock. There are seasonal changes, discontinued product lines, shifting trends, upgraded branding, and worn packaging to contend with when you have too much inventory. All of those factors can make products unsaleable.

On the other hand, when you aren’t proactively managing your inventory, you risk running out of products. When you oversell (allow buyers to purchase items that are out of stock), you will face customer service challenges that mar your reputation.

Whether it’s overstocking or overselling, the challenges can be detrimental to your bottom line.

Solution: The best solution for this type of obstacle is forecasting. Accurately forecasting your product needs is both a science and an art. To start, you need to study your sales across each platform over the last year. Monitor for trends and seasonality. From there, you can determine your typical sales on a 30-, 60-, and 90-day span. Once you’ve calculated these numbers, factor in your supplier’s lead time. Always make forecasting a priority – your sales will always fluctuate but having a base line to start will help you get a hold on your inventory needs.

No Scalability

Another challenge that online businesses may experience is not adjusting as the business grows. Scalability is easily overlooked when your business is new. It’s not difficult to manually track inventory and fulfill orders yourself, even when you are selling across multiple platforms, when you’re seeing a humble amount of sales orders. But, as your business grows, it can become increasingly difficult and time-consuming to continue using those methods.

In fact, when you are relying on manual data entry to manage inventory, you’ll reach a point at which it becomes impossible to handle any more growth without sacrificing accuracy. Inaccuracy, when it comes to inventory, can quickly lead to dissatisfied customers when you’re unable to fulfill orders.

Not being able to see your total inventory across all channels and warehouses is another challenge you will face as you expand to more channels. As the demand for your products increases, managing your stock will become more complex.

Without having a clear picture of what you have available, you’ll have a hard time making the best decisions when forecasting and restocking.

Solution: The best way to plan for scalability is to either hire more resources or incorporate a software solution. There are many inventory solutions out there that can help automate many of the data entry tasks and allow you to focus on the bigger picture.

Final Thoughts

Just about every piece of an ecommerce business is affected by inventory. Without an effective system to manage stock, you’ll see other areas of the business start to struggle.

First, you need to choose the best inventory accounting method for running your online business. Consult your accountant before deciding, because this isn’t something you can change easily mid-way through the year. Once you’ve chosen the best option, you need to start tracking your inventory effectively with human or software resources. These obstacles will be fewer and farther between when you keep your inventory under control, which will ultimately lead to a healthier bottom line.

What are the methods of accounting for inventory?

What is the best accounting method for inventory?

Which inventory method is typically used when accounting for expensive and unique?

Which inventory costing methods are based on assumptions that accountants make about the flow of inventory costs?