POS Inventory Costing (FIFO)

As you are reconciling your bank deposits for the night do you wonder what sort of profit you made?  In many cases it’s not that straightforward.  When you factor in costs of items, overheard such as rent and utilities and employee wages, how do you determine whether you are losing money or making money on each item you sell?

When it comes to managing your item costs accurately, businesses generally have two options: They can track by standard costs or actual costs to aid in understanding why their profits (or lack of profits) were different than they expected.  To effectively measure the cost of goods sold (COGS) the questions of material cost, labor cost and overhead cost can be derived from either your budget (standard cost) or your actual expenses (actual cost).  Here we look at the issue of item costing.

Q:What is Actual Costing vs. Standard Costing?

A: The actual cost (amount paid) is typically entered via the purchase order (and adjusted using the AP invoice from the vendor). Tracking item costs in this method tends to be more work but can produce more accurate cost reporting. With standard costing you assign predetermined estimated values (also referred as default cost) to each of your items.

Q:Which is more common? (Actual Costing vs. Standard Costing)

A: In general, standard costing is more common because inventory valuation is simplified and it’s easier to maintain.  The ability to identify and adjust for variances can be another upside to standard costing.

With standard costing, all inventory transactions involving that item (regardless of whether that item is being sold, received, transferred or adjusted in/out) will use the standard cost.  The standard cost reflects the value entered and saved on the item form. That standard cost value can be maintained as variances are identified (market price fluctuation, changes in vendor, etc…).

Q:Which is more accurate? (Actual Costing vs. Standard Costing)

A: Actual costing is more work but produces more accurate cost reporting. Actual costing requires vigilance with regard to maintaining inventory.  The use of purchase orders/receivers as well as timely inventory adjustments are absolutely essential.  By assigning actual costs for each item when entering a purchase order/receiver into the system it helps to insure an accurate inventory valuation.  Actual costing tends to be preferred by businesses that have frequently changing costs, but only implemented by those that have the internal resources to be able to handle the heavier workload involved.

Q:So what is FIFO and why does it matter?

A: FIFO is the first-in, first-out method of inventory valuation.  It works on the assumption that the first goods purchased are also the first goods sold. For most of us this assumption closely matches the actual flow of goods and is considered the most theoretically correct inventory valuation method.

For standard costing FIFO may have little impact since the item cost is often unchanged.  For actual costing it is the basis for the inventory valuation, as under the FIFO method the earliest goods purchased are the first ones removed from the inventory account. As a result the remaining items in inventory are being accounted for at the most recently incurred costs which are closest to what could be obtained in the marketplace. The FIFO method is a widely accepted standard and is allowed under both Generally Accepted Accounting Principles and International Financial Reporting Standards.

Q:So which inventory costing method should I use?

A: Both standard and actual costing options have benefits and limitations.  In most cases the choice of which method to use comes down to the needs of each individual business, but the recommendation to follow one method or the other should not be ignored as the benefits of accurate costing include reduced expenses, more effective budgeting, increase in profits and accurate price setting of items.  

LionWise POS for Retail and LionWise POS for Restaurant each offer both actual and standard methods of inventory costing.  We recommend that you consult with your LionWise representative to review your businesses needs to help determine the best choice for you.

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