1. Overview

Inventory costing is an important part of accounting because it determines the cost of goods sold (COGS) and the value of inventory remaining in stock.

LocalizeBook supports inventory costing concepts that help businesses calculate product costs and maintain accurate financial records.

Two commonly used inventory costing methods are:

1. Weighted Average Cost (WAC): Calculates an average cost per unit based on the cost and quantity of available inventory.
2. FIFO (First In, First Out): Assigns the oldest available inventory costs to goods sold or issued first.

Both methods are used to calculate inventory costs, but they can produce different results when purchase prices change.

2. What Is Weighted Average Cost (WAC)?

Weighted Average Cost calculates the average cost per unit by dividing the total cost of available inventory by its total quantity.

Formula

Weighted Average Cost per Unit = Total Cost of Available Inventory ÷ Total Quantity of Available Inventory

This method combines the costs of inventory purchased at different prices into one average unit cost.

Example: Purchasing Inventory

A business purchases the same product twice:

The weighted average cost is:

$2,200 ÷ 200 units = $11 per unit

Under this example, the average cost of available inventory is $11 per unit.

Example: Selling Inventory

The business sells 120 units.

Using the weighted average cost:

120 units × $11 = $1,320 COGS

The remaining inventory is:

Under WAC, the cost of the sale and the remaining inventory are calculated using the same average unit cost in this example.

Key Characteristics of WAC

1. Combines different purchase costs into an average cost.
2. Applies an average unit cost instead of consuming individual purchase cost layers.
3. Can reduce the impact of fluctuations in individual purchase prices.
4. Is often straightforward to understand and use for products that are interchangeable.

Note: Weighted average costing can be calculated periodically or recalculated as inventory is received, depending on the system's implementation. The example above assumes the average is calculated using all 200 units available before the sale.

3. What Is FIFO Costing?

FIFO stands for First In, First Out.

This method assumes that the oldest inventory costs are assigned to goods sold or issued first. Inventory received at different prices is maintained in separate cost layers.

Example: Purchasing Inventory

Using the same purchase transactions:

The inventory has two cost layers:

1. Layer 1: 100 units at $10 per unit.
2. Layer 2: 100 units at $12 per unit.

Example: Selling Inventory

The business sells 120 units.

Under FIFO, the system uses the oldest cost layer first.

After the sale, the remaining inventory is:

Under FIFO, the oldest cost layer is consumed first, leaving the newer inventory cost layer in this example.

Key Characteristics of FIFO

1. Maintains inventory cost layers based on receipts.
2. Assigns the oldest available costs to goods sold or issued first.
3. Calculates ending inventory value using the costs of the remaining layers.
4. Can be useful when businesses need to understand the cost flow associated with inventory receipts.

Important: FIFO is an accounting costing assumption. It does not automatically mean that warehouse staff must physically pick the oldest goods first.

4. WAC vs. FIFO: Side-by-Side Comparison

Both methods use the same purchases and sales in this example, but they produce different COGS and ending inventory values.

5. How Purchase Price Changes Affect Each Method

When purchase prices change, the costing method can affect reported profit and inventory value.

When Purchase Prices Increase

Assume the cost of new inventory is higher than previous purchases.

1. WAC: The average cost generally increases as higher-cost inventory is included in the calculation.
2. FIFO: Older, lower-cost inventory is assigned to COGS first, while newer, higher-cost inventory may remain in stock.

In the example above:

FIFO produces lower COGS and higher ending inventory in this example.

If the selling price and all other expenses are the same, FIFO also produces higher gross profit for this sale.

When Purchase Prices Decrease

When newer inventory costs less than older inventory, the opposite pattern may occur.

1. WAC: The average cost generally decreases as lower-cost inventory is included.
2. FIFO: Older, higher-cost inventory is assigned to COGS first, while newer, lower-cost inventory may remain in stock.

The actual results depend on the purchase and sale transactions, the costing implementation, and the inventory available when the transactions occur.

6. Which Costing Method Should You Choose?

The right method depends on the nature of the business, its inventory processes, and its accounting requirements.

Choose WAC When:

1. You manage large quantities of interchangeable products.
2. Purchase prices fluctuate and you prefer an average unit cost.
3. You want a costing method that is relatively straightforward to understand.
4. Your inventory management process does not require cost reporting based on individual receipt layers.

Typical examples include businesses trading interchangeable raw materials or bulk commodities, where averaging costs is appropriate.

Choose FIFO When:

1. You want the oldest available inventory costs assigned to sales first.
2. You need to maintain a cost history across different inventory receipts.
3. You want ending inventory to reflect the costs of the remaining inventory layers.
4. FIFO is appropriate for your accounting policies and reporting requirements.

Typical examples include retailers, wholesalers, and trading businesses with inventory purchased at different prices.

Important: The accounting costing method should be selected according to applicable accounting standards, business requirements, and professional accounting advice. It should not be chosen solely to achieve a preferred profit result.

7. Accounting Standards: FIFO, WAC, and LIFO

Under International Financial Reporting Standards (CIFRS), IAS 2 Inventories permits businesses to use either FIFO (First In, First Out) or the Weighted Average Cost (WAC) formula for ordinarily interchangeable inventory.

LIFO (Last In, First Out) is not permitted under IAS 2.

When choosing an inventory costing method, businesses should consider the following:

1. Choose one appropriate cost formula: Use FIFO or Weighted Average Cost for inventory with similar nature and use.
2. Apply it consistently: Use the selected cost formula consistently for inventory with similar nature and use. Different cost formulas may be justified for inventories with different natures or uses.
3. Follow applicable accounting requirements: Select the method that best fits your inventory and accounting policies, rather than choosing a method solely to achieve a preferred profit result.

Important: Consult your accountant or accounting adviser to ensure your inventory costing policy complies with the CIFRS requirements applicable to your business.

8. Can FIFO Costing Work with Lot Control?

Yes. FIFO Costing and Lot Control can be used together when the inventory system supports both functions.

FIFO costing calculates the accounting cost of goods sold and the value of remaining inventory.

Lot Control tracks which batch the physical inventory belongs to, including lot numbers, expiry dates, and quantities.

For example, a food distributor may use FIFO costing for financial reporting while using Lot Control to track expiry dates and identify which batch was delivered to a customer.

The system must correctly connect physical lot movements with accounting cost calculations. Selecting a particular physical lot does not automatically mean that its cost must be the next FIFO cost layer consumed.

more detail see : FIFO vs Lots Control

9. Summary

Weighted Average Cost and FIFO are two different inventory costing methods.

1. WAC calculates an average unit cost for available inventory.
2. FIFO assigns the oldest available inventory costs to goods sold or issued first.
3. Both methods affect COGS and the value of ending inventory.
4. When purchase prices change, the two methods may produce different financial results.
5. FIFO Costing, Lot Control, and expiry-based stock rotation serve different purposes and may be used together.

Understanding these differences helps businesses choose an appropriate costing method, improve inventory valuation, and make more informed financial decisions.

With LocalizeBook, businesses can manage inventory transactions and use inventory costing to support their accounting and financial reporting workflows.