Costing Methods for Manufacturing & Inventory

Costing methods are techniques used to determine and record the total costs associated with producing a product or providing a service. A costing method involves cost analysis of labour, overhead expenses, materials, and other related costs that contribute to the total cost of sales.

3 benefits of costing methods in product businesses:

• They facilitate accurate price-setting for maximised profitability.
• They enable companies to calculate profit and tax obligations.
• They help forecast future revenue and income potential.

Inventory costing, also known as inventory cost accounting, is the process of ascribing a monetary value to a company’s available inventory. The purpose of inventory costing is to accurately determine profitability and ultimately improve inventory control processes.

In inventory management, the term ‘costing method’ is sometimes used interchangeably with ‘inventory valuation method’, which refers to techniques used for determining the total value of all stock-on-hand inventory.

For clarity, we will refer to the tactics that fall under this definition as ‘inventory costing methods’ for the rest of this guide.

It’s important to note that inventory costing isn’t just necessary for income reporting at the end of each financial year; it should be used to guide how products are priced throughout the year to maximise profit.

Inventory costing methods govern what you spend, aid in accurate financial reporting, and help ensure you’re paying correct taxes.

The four most common inventory costing methods are:

• FIFO
• LIFO
• Weighted average
• Specific identification

Once you’ve chosen your inventory costing method, you’ll be expected to stick to this method each financial period – so take the time to understand which approach is right for you.

1. First-In, First-Out (FIFO)

FIFO is an inventory costing method that assumes the first goods you buy or produce will be the first that you sell to customers.

Imagine you purchase 100 cans of peaches for $1 per can and then the next month you purchase another 100, but the price has gone up to $2 per can. Under FIFO, you would calculate your cost of goods sold based on a purchase price of $1 for the first 100 sales, then $2 for the next 50 sales.

This example demonstrates how the FIFO costing method takes into account inflation. Because prices typically increase over time, FIFO often shows higher levels of profit compared to other methods because it assumes you sold the cheaper goods before the goods with inflated prices.

2. Last-In, First-Out (LIFO)

Last-in, First-out (LIFO) is an inventory costing method that assumes the goods purchased most recently will also be sold first. This method is widely regarded as a poorer indicator of ending inventory value compared with FIFO because it can understate the true value.

The LIFO costing method can produce lower recorded profits at the end of a financial year, which in turn might reduce taxes, making it attractive to some business owners. However, it also produces a lower net income for shareholders making it unpopular among public entities.

It’s worth noting that LIFO is only recognised in the USA under the Generally Accepted Accounting Principles (GAAP). This method is forbidden to organisations in countries following the International Financial Reporting Standards (IFRS).

Read more: LIFO vs FIFO – Advantages and Disadvantages

3. Weighted average cost

The weighted average cost method uses the average cost of items bought or produced that are ready for sale to calculate cost of goods sold (COGS) and inventory value.

Using our earlier example in which 100 cans of peaches were purchased at $1 per can one month and $2 per can the next month, the weighted average inventory costing method would total the purchase price of all the peaches ($300) and divide that by the number of units (200) to get a weighted average cost of $1.50 per can.

Because it uses a blended average, the weighted average method is easier to calculate than FIFO or LIFO. You don’t need to keep track of every little purchase price throughout an accounting period. However, a business with variable yearly costs may not recover the costs of more expensive products under this method.

4. Specific identification method

The specific identification method involves tracking every item bought or produced from the time it enters your business to the time it’s sold. This differentiates it from the FIFO, LIFO and weighted average methods which group costs together.

Imagine an antique furniture retailer purchases 100 tables to resell.

Because the items are all unique their costs range from very low to very high. Using the specific identification costing method, the value of each item is tracked individually, rather than grouping the data together. This ensures an accurate reflection of precise costs.

The specific identification method is the slowest to calculate as it requires a business to keep track of all its items individually. But it guarantees the most accurate ending inventory value out of all these methods and produces useful accounting data.

Other inventory costing methods

In addition to the inventory costing methods above, there are a few other, less-common approaches worth mentioning:

• Highest-In, First-Out (HIFO): This method assumes the highest-cost items are sold first. This can dramatically increase the COGS value but is not recognised by the GAAP.
• Lowest-In, First-Out (LOFO): This method assumes the lowest-value goods are sold first. This practice is not accepted by the IFRS (but is recognised by the GAAP), as it can lead to abnormally high inventory valuations.
• First-Expired, First-Out (FEFO): This method assumes that products with the shortest expiry dates are sold first. FEFO can help food and pharmaceutical manufacturers reduce waste by prioritising items which will perish sooner. This method is preferred by the EU for pharmaceutical retailers.
• Next-In, First-Out (NIFO): This method prices goods based on what it would cost to replace them, rather than their initial purchase price. Some businesses price items using NIFO to account for inflation, but then report end-of-year income using a more common method. NIFO does not conform to the GAAP which says items should always be recorded at their purchase price.
• Retail inventory costing: This costing method measures the cost of goods relative to their purchase price. It considers the value of available stock and reduces it by your markups. This is easy to calculate for a small retailer but can become inaccurate if there are big price fluctuations or markup variations during the year.

To choose the right inventory costing method for your business, you must first understand your costs and how they change over a year.

Focus on these questions to help guide your decision:

• Are your costs stable?
• Do you have a high or low inventory turnover?
• Which methods are possible with your current inventory management system?
• Are your goods perishable?
• What are the legal requirements for inventory costing in your country?

Here’s a quick table summarising which inventory costing methods are suitable for specific purposes:

Production costing is the process of figuring out how much an item costs to produce.

There are two types of production costs to consider in manufacturing:

• Variable costs: Production costs that vary depending on your level of output, such as direct materials and sometimes labour.
• Fixed costs: Production costs that are static regardless of output. For example, factory overheads like the building lease or insurance premiums.

Like inventory costing, there are many production costing methods you can use to determine manufacturing costs. We’ll cover those now.

Costing methods in manufacturing, also known as production costing methods, are techniques for determining how much it costs to produce finished goods. Some methods can be used to determine total manufacturing costs, while others focus on evaluating specific processes, materials, or labour.

The 6 main costing methods for manufacturing are:

• Absorption costing
• Job costing
• Process costing
• Direct costing
• Throughput costing
• Target costing

Let’s break these down.

1. Absorption costing

Absorption costing, also called full costing or total absorption costing, is a production costing method that’s used to calculate all the direct and indirect costs required to manufacture a particular product. It allocates fixed overhead costs to a product regardless of whether it was sold in the measured period or not.

The absorption costing method considers manufacturing costs such as:

• Raw materials
• Utility costs
• Employee wages
• Insurance
• Rent

This costing method is typically used for external reporting purposes, such as calculating your cost of goods sold.

You can use this formula to calculate absorption costs:

(Direct Labour Costs + Variable Overhead Costs + Fixed Overhead Costs + Direct Material Costs) / Number of Items Produced = Absorption Cost

2. Job costing

Job costing, also called job order costing, tracks all the costs and revenue of a specific manufacturing project or ‘job’. This can include a specific, one-off manufacturing service; the development of new products; or the production of a set number of products that are manufactured at the same time.

Job costing can be broken down into four components:

• Materials
• Direct labour
• Direct expenses

If you’re a manufacturer producing goods with varying costs to produce, job costing can help break down what those costs are so you can accurately determine profits later.

Products you believe are winners can often contain hidden costs that are eating away at profit. Similarly, products that appear to sell poorly may generate higher profits due to lower job costs. Job costing mitigates the risk of grouping big variations, which can hide some of your potential wins and losses.

3. Process costing

Process costing is a cost accounting method that calculates the cost of each manufacturing process involved in producing finished goods. Process costing is mainly used in businesses where it can be safely assumed that the cost to produce each order is going to be the same, such as mass-produced food or chemical processing.

The process costing method first considers the total number of units passing through a particular part of the production process, then tallies up the total costs and divides the result into a per-unit cost.

4. Direct costing

The direct costing method only takes into account the variable costs associated with production, ignoring fixed costs such as factory overheads. Instead, fixed costs are assumed to be tied to the accounting periods in which they happened.

Direct costing is useful when you want to make short-term business decisions about strategic direction but can be harmful if used for long-term decision-making as it excludes important indirect costs.

Some examples of useful applications for the direct costing method:

• for determining the cost benefits of automation
• for determining the break-even point in a break-even analysis
• for checking the profitability of an individual customer
• for plotting changes in profit margins as sales volumes scale.

Important: Direct costing is prohibited under both the GAAP and IFRS for reporting inventory costs; you must also include accurate allocation of indirect costs.

5. Throughput costing

Throughput costing is a manufacturing cost accounting method that takes direct materials into account as an inventory cost and regards all other expenses (such as labour and overheads) as period expenses relevant only to the time when they were incurred.

Throughput costing is mostly used for short-term, incremental cost analysis. For example, to identify whether you can afford to offer a special deal to a new customer.

6. Target costing

Target costing is an accounting method that’s calculated based on forecasts, rather than historic data. Research and expected material costs are used to estimate targets for pricing, margins, and product costs in advance of production.

Using the target costing method, you would follow this process:

1. Identify a competitive market price for the product you wish to develop.
2. Decide your desired profit margin and subtract it from the competitive market price to find your target cost.
3. Use forecasted material and production costs to determine whether the product can be produced at your target cost.

Target costing is ideal for planning and developing product lines with high profit potential. It enables manufacturers to filter out ideas that won’t be feasible before they become a waste of effort and resources.

The production costing methods you should use will depend on your business model, your goals, and the decisions that these results will inform.

Costing methods that only consider direct or indirect costs, but not both, will not be appropriate for reporting inventory costs as part of your tax obligations. However, they can be very useful for identifying which systems, materials, processes, and overheads impact profitability – and how.

This table summarises how the most common production methods are used:

We’ve covered some of the most vital costing methods for determining the value of inventory in a business and the costs associated with producing finished products. However, there are some additional cost accounting methods worth mentioning.

Four cost accounting methods for inventory control and production:

• Activity-based costing
• Standard costing
• Historical costing
• Marginal costing

Let’s take a look.

1. Activity-based costing (ABC)

Activity-based costing or ABC costing is a method that calculates the costs of specific activities and divides them into a per-product cost based on the cost consumption of that specific product. In essence, this costing method assigns overhead and other indirect costs into direct costs.

In traditional cost accounting, you usually tally up your overheads and split them evenly across your activities. This can help to understand costs at a glance, but it doesn’t take into account significant variations between activities. For example, one product might require more electricity to produce than another.

In an ABC system, the goal is instead to split those overheads up and work out how your different production activities affect or are affected by indirect costs.

For example, a computer equipment manufacturing company might produce monitors that contribute towards 5% of the monthly electrical usage and also produce towers that account for 20% of the usage.

In traditional cost accounting, both products would be assigned the same share of the electricity costs. But ABC costing would distribute those costs based on usage, so you could price the products with a more accurate understanding of their true production costs.

Learn more: Using ABC Analysis in Inventory Management

2. Standard costing

Standard costing is where you substitute actual costs with an assumed cost. Then, over the course of the accounting period (often a year), you regularly report on the difference between your assumption and reality.

For standard costing to work, you must first create ‘standard’ costs. These are estimations for the cost of various activities within the business. Because calculating actual costs can sometimes be time-consuming, standard costs function as a near-enough figure that can be used to increase accounting efficiency.

However, since standard costs are inexact, this costing method is not practical for many manufacturing situations and should be used with caution.

3. Historical costing

Historical costing is a costing method that determines an organisation’s total inventory and production costs based on previous costs, not a predetermined value. The historical costing method helps create an accurate picture of your profits for the year and is useful for setting standard costs for the next accounting period.

Under the historic cost principle, an asset is recorded on your balance sheet at the figure you purchased it for, regardless of whether it has increased in value since that point. If the asset depreciates, you record that alongside its historic cost too.

4. Marginal costing

In manufacturing, a marginal cost is the change in total production cost that occurs when one additional unit is manufactured. Marginal costs are calculated to optimise production and determine the point at which your business is likely to achieve economies of scale.

The formula for marginal costing is:

Change in Production Costs / Change in Quantity of Units Produced = Marginal Cost

Marginal costing can tell you whether it’s possible to produce more items, all sold at the same price point, without a significantly higher production cost. This process allows you to maximise profit by determining exactly how increased production impacts margins.

Imagine your business sells 1,000 units per month and total production costs equate to $3 per unit. The $3 is made up of $1 materials costs and $2 fixed costs. Marginal costing could reveal that 1,500 units can be produced at the same time without increasing your fixed costs.

The per-unit fixed cost comes down to $1.40 ($2,000 per month is now spread over 1,500 units), and your total per-unit cost to produce one unit drops from $3 to $2.40. In this way, marginal costing has enabled you to reduce your cost to produce by $0.60 per unit.