Retail Inventory Tracking Comparison: 4 Costing Methods

2018-11-12T12:03:58+00:00July 31st, 2018|Categories: General, POS Functions, POS System, Retail POS|Tags: , , |

As we’ve discussed in previous blog posts, accurate retail inventory management is critical for your business’s success. For most small businesses, inventory is your largest asset and must be handled with care. It’s also important for ordering and stocking purposes, allowing you to be more efficient and keep popular items on your shelves. ABC retail analytics from your retail POS system identify your products that need to move more quickly and those that might need to come off the floor. But how about calculating your inventory costs? Accounting must use costing methods to determine your business’s profitability. This is key for your inventory as well as taxes. The IRS has made it pretty clear that it appreciates accurate financial reports. So what are the different retail inventory tracking options and costing methods? We’ll take a look at the 4 most popular.

  1. Weighted Average Method
  2. First In First Out (FIFO)
  3. Last In First Out (LIFO)
  4. Specific Identification Method

1. Weighted Average Method

Also known as the “Rolling Average Method,” this costing approach is perhaps the most straightforward. The average is weighted with the movement of the cost. This is based on the latest ordering and purchasing costs.

Let’s look at a simple hypothetical example using everyone’s favorite term from economics class: widgets.

  • Week 1 widget cost: Purchased 10 at $12
  • Week 2 widget cost: Purchased 15 at $10
  • Week 3 widget cost: Purchased 5 at $15

The average cost for 30 widgets: $11.50

  • Week 4 widgets sold: 20 at $20 each for a total of $400 in sales

After we take out the weighted cost of $230 for 20 widgets and subtract that from the $400 in sales, we’re left with a profit of $170. Additionally, there is $115.50 worth of widgets left in inventory.

Now, what if we had purchased another set of 5 widgets at $18 each. The average cost rose to about $12.86. The  20 sold widgets would now have a weighted cost of $257.14, leaving us with a profit of $142.86, and $128.60 remaining in inventory.

As you can see, the weighted average method accounts for changing costs and prices. It is not good if your costs change wildly because large price swings can skew an average, making profits look much larger or smaller than they actually are. Generally, however, retail inventory doesn’t see large swings in product costs. The weighted average method is the most suitable for the vast majority of retail stores.

2. First In First Out (FIFO)

“First In First Out” is another common inventory costing method. This most closely mimics the real-world ordering cycle. Simply put, the oldest costs paid for a product are assigned to the product that is sold, no matter where the retail price currently stands. Additionally, remaining inventory stock would be valued at the most recent incurred costs. Let’s go back to our widgets for a minute.

  • Week 1 widget cost: Purchased 10 at $12
  • Week 2 widget cost: Purchased 15 at $10
  • Week 3 widget cost: Purchased 5 at $15

Week 4 widgets sold: 20 at $20 each for a total of $400 in sales.

With FIFO, we assume that 10 of the widgets were from Week 1 and 10 were from Week 2. Therefore, the total costs stand at $220 against $400 in sales, for a profit of $180. Furthermore, we still have $125 in inventory remaining.

It’s ideal for retailers who have massive amounts of inventory, or who sell perishable items. FIFO inventory management minimizes spoilage waste by keeping older items ahead of newer products.

3. Last In First Out (LIFO)

“Last In First Out” is precisely the opposite of FIFO. Here, the most recent costs are assigned to any product that is sold. Let’s spend some more time with our widgets:

  • Week 1 widget cost: Purchased 10 at $12
  • Week 2 widget cost: Purchased 15 at $10
  • Week 3 widget cost: Purchased 5 at $15

Week 4 widgets sold: 20 at $20 each for a total of $400 in sales.

Here, 5 widgets were from Week 3 and 15 from Week 2. Total costs are $225, leaving us a profit of $175. Remaining inventory stands at $120.

This method is better employed during times of vast cost variation, most notably during periods of high inflation. It accounts better for future profits in this scenario, more accurately reflecting a business’s health. It also provides a practical solution for certain niche retail industries. For instance, sand or stone companies can use LIFO costing if their product is replenished by piling newer product on top of older.

This method is barred by certain international costing standards and must be employed carefully if it’s a good fit for your business. You also must use LIFO for financial reporting if it’s used for your cost reporting.

4. Specific Identification Method

Ok, we saved the easiest one for last. And we don’t even have to use widgets to help illustrate it! This method perfectly matches your inventory costs with the total items sold. Specific identification is nearly impossible for high volume retailers because it requires VIN numbers or some other form of individual item tracking. Instead, specific identification is best suited for high-end retail stores which make large profits off of selling only a handful of units. Car dealers, luxury jewelers, or electronics retailers might benefit from this inventory costing method. But just because it’s straightforward doesn’t mean it’s the best solution.

So What Is the Best Retail Inventory Tracking System?

It all depends on your business! But whatever works for you, be sure that it can be accounted for by your point of sale system. Your retail POS inventory software should make inventory tracking and accounting automatic for you. For instance, if you use the weighted average method, your point of sale should update the newest costs of any item ordered, adjusting the total average and reflecting the costs and profits in the final total. It’s meant to save you time, money, and a ton of stress. Click below to find out more on how KORONA can help with your retail inventory.

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About the Author:

As Content Strategist at KORONA, Michael comes from a background in blog writing and content management as well as extensive use of various point of sale systems. He's passionate about helping small businesses reach their potential, and Jeopardy. For inquiries and suggestions please contact our marketing team.