Most companies share at least one financial goal: Stay profitable. And to know how much you’re earning, you need to know how much you’re spending.
Luckily, various costing methods measure the expenses associated with manufacturing inventory. All reveal your inventory’s value, but which method you use to track production costs significantly impacts compliance and reporting.
Keep reading to learn more about each method and how to calculate it so you know which to choose for your business. If you already have a costing method, jump to the end to discover how Fishbowl helps streamline costing to boost your bottom line.
Understanding costing methods
Costing methods help you determine the cost of manufacturing the goods you sell, considering factors like raw materials, labor, overhead, and production time.
Knowing these costs greatly improves your ability to competitively price goods and keep your business profitable. It also gives insight into potential inefficiencies or opportunities to reduce unnecessary expenses. For example, identifying high labor costs could lead you to invest in more efficient production technology or automate assembly line steps.
The 9 most common costing methods
When it comes to costing methods, the most common fall into two categories — inventory costing and production costing.
Inventory costing
Inventory valuation methods determine the cost of the products you manufacture and sell to better optimize your inventory. Knowing the cost of a best-selling product lets you assess its impact on profitability and make better-informed decisions about allocation, restocking, or pricing.
Most manufacturers rely on one of these four inventory costing methods.
1. First in, first out
If you’re using the first in, first out (FIFO) method, you assume you’re selling goods to customers in the order you produced them. Under this assumption, assign the cost of your oldest inventory items to those you sell first when recording. This method aligns with most industries’ inventory management and generally accepted accounting principles (GAAP).
Since FIFO assigns the cost of the oldest, often lowest-priced inventory to the cost of goods sold (COGS), the remaining inventory is valued at more recent, higher prices.
Calculate COGS with FIFO using this formula:
Inventory COGS = Cost of oldest goods x Total quantity of goods sold
2. Last in, first out
In contrast with FIFO, the last in, first out (LIFO) costing method assumes the newest inventory items are sold first. Apply the cost of the most recent inventory purchases to goods sold.
LIFO helps deal with inflation because it matches higher, more recent costs with current revenues, reducing taxable income. However, this approach can result in lower reported profits than FIFO, which may lower shareholders’ income and investment returns.
Additionally, LIFO is permitted under GAAP guidelines in the U.S., but it’s not allowed in some other countries. If you operate internationally, LIFO may not be an appropriate method to choose.
Calculate COGS with LIFO using this formula:
Inventory COGS = Cost of most recent goods x Total quantity of goods sold
3. Weighted average cost
The weighted average cost (WAC) method calculates the value of inventory based on the average price of all units available for sale. To determine this average cost, you add the total cost of all items in your inventory and divide that by the number of units.
Note that in Fishbowl, the new WAC is only calculated when new units are received into inventory, not when they’re sold. And if the inventory never reaches zero, the WAC will reset to the value of inventory that is added next.
One advantage of this method is that it’s simpler to calculate since you don’t have to track the cost of each item in your inventory. But one disadvantage is that the WAC may not accurately reflect the price tag, if costs fluctuate.
This formula shows the WAC of your COGS:
Inventory COGS = (Cost of all goods for sale / Number of units) x Total quantity of goods sold
4. Actual cost
Actual costing is exactly what it sounds like — you track the actual cost incurred for each item in your inventory, including factors like overhead, labor, and materials. This method ensures that your financial statements reflect the true cost of each item, providing a clear and accurate picture of your inventory expenses. But it’s labor-intensive and complex to maintain, especially with frequent cost changes or large volumes of transactions. It’s best suited to companies creating customizable and high-value goods, like jewelry companies.
There’s no formula for this method since it relies on totaling values individually. To make this costing method effective, you need to enable at least one tracking method on each item in your inventory, whether that’s serial numbers, lot numbers, or expiration dates.
Production costing
Production costing determines the expenses associated with the production process itself. There are five popular production costing methods:
5. Job costing
Job costing is a method for tracking and allocating all direct costs associated with specific jobs or projects. This provides a thorough understanding of the expenses associated with a project, but it can be complex and time-consuming to track the details.
Here’s the job costing formula:
Total job cost = Direct material costs + Direct labor costs + (Predetermined overhead rate x Actual allocation base)
6. Activity-based costing
The activity-based costing (ABC) method is a type of job costing, but you identify the production activities that use resources and assign costs to these activities. Then, you determine what drives these costs to understand where your costs come from, how they impact production processes, and how to price products accordingly. It’s much more complicated, but it distributes costs across manufacturing activities to understand spending.
To use ABC, start by identifying what goes into creating a product, then assign each item to a cost pool. Each pool should share a type of activity, like sourcing raw materials or labor hours. Determine what drives the cost of this pool, whether that’s the number of materials purchased or the hours required to complete a production stage. Find the cost driver rate by dividing the overhead of each cost pool by the cost drivers.
Use this formula to calculate with the ABC method:
ABC = Cost pool total / Cost driver
7. Process costing
Process costing is simpler than job costing because it aggregates costs across production processes. However, it may not accurately reflect cost variations between different production runs.
To calculate process costs, add all the direct and indirect expenses associated with each production stage. Then, divide that sum by the number of units produced during that stage to determine the cost per unit.
Here’s the simplest formula to calculate process costing:
Cost per unit = Cost of inputs / Expected output
8. Standard costing
Standard costing involves setting predefined costs for production factors like materials, labor, and overhead. Then, compare these standard costs to the actual expenses incurred during production to identify variations between your expected and actual costs. This helps you budget better and evaluate your performance more precisely.
Since you set standard costs, there’s no specific formula to follow, but the easiest method is to multiply materials or labor by cost to determine the cost of each production factor. For example, if you’re paying workers $15 an hour and the standard number of hours required to produce the item is 15, the standard direct labor cost is $15x15hr = $225/hr.
9. Direct costing
Direct costing, or marginal costing, only considers the variable costs associated with production. Variable costs usually fluctuate with production volume, and they include the cost of materials and direct labor. And the cost of materials should include the material cost of any scraps or manufacturing waste. Fixed costs remain constant regardless of production volume, like a factory mortgage or insurance payments.
In direct costing, you treat fixed costs like operating expenses for that production period. This method is the opposite of absorption costing, which allocates variable and fixed costs to the production process. Absorption costing may provide a more complete picture of production costs but it’s complicated to calculate.
There’s no exact formula to calculate direct costs since they vary across industries.
How to choose the right method for your business
With all these options, how do you know which costing method to choose? Here are four tips you can use to settle on the best approach:
- Match your production style: If your manufacturing process involves distinct jobs, continuous processes, or specific activities, some costing methods might seem more intuitive than others. If your production line is project-driven, job costing may work best. Choose a method that matches your production process.
- Determine how much your products vary: Process costing is well-suited for companies manufacturing large volumes of uniform products. But job costing is particularly useful for businesses that produce unique or custom products that vary from batch to batch. The uniqueness of your products affects which method is best.
- Decide how accurate you need to be: If you need detailed and precise cost allocation to make informed business decisions, consider the ABC method. Although complex and resource-intensive, it gives you a crystal-clear view of how costs are incurred and allocated.
- Plan ahead: If you expect increases in production volume and complexity, ensure the method you select can accommodate these changes. Switching to a different method later on may be challenging, so the ideal approach should serve you as your business grows.
Discover how Fishbowl can revolutionize your costing methods
Need more guidance on costing methods? Let Fishbowl help.
Fishbowl’s inventory management solutions are designed to streamline and enhance your costing processes. With seamless QuickBooks integration, Fishbowl helps you monitor costs accurately for more informed decisions. Plus, Fishbowl Time simplifies job costing by tracking labor costs.
Don’t wait — boost your profits and transform your financial management with Fishbowl today.