Mastering Inventory Costing: Strategies for Accurate Financial Management

Inventory is one of your most valuable assets, as it allows you to meet customer demand and generate revenue for your business. To make your business even more successful, you need to master inventory costing — the process of assigning a monetary value to each item.

When you understand inventory costs, you can make better decisions regarding pricing, ordering, and shipping. This guide explains the four essential cost components of inventory, provides tips for reducing waste, and contains actionable advice to help you overcome common inventory costing challenges.

Understanding Inventory Costing Basics

Before you master inventory management, you need to understand the four essential cost components of inventory. Once you understand these costs, you can make better financial decisions. For example, you can easily compare product lines to determine which one costs the most to produce. 

Inventory costing affects the value of your company, as it influences the Cost of Goods Sold recorded on your income statement. You have to deduct the COGS from your gross revenue, so if you don't assign an accurate value to each item, you may end up with less profit than expected.

If your financial statements don't accurately reflect your company's financial position, you may also find it difficult to qualify for business loans or attract investors. To avoid these problems, familiarize yourself with the four essential cost components: direct materials, direct labor, manufacturing overhead, and packaging costs.

Direct Materials

Direct materials are the raw materials you need to manufacture your products. For example, a company that makes bakery products may stock sugar, flour, baking soda, and vegetable oil. This cost component includes every ingredient that goes into the final product.

Direct Labor

Direct labor includes wages and salaries for the employees directly involved in production. If you produce bakery items, you need employees to operate mixers, ovens, and packaging equipment. Their wages are included in your company's direct labor costs.

Manufacturing Overheads

Manufacturing overheads refer to all costs associated with production that can't be traced back to individual units. For example, you need electricity to operate machinery, but you can't trace the cost of each kilowatt back to a specific item. These are some of the most common examples of manufacturing overheads:

• Utilities: You need water, gas, and electricity to keep your plant running.

• Depreciation: Depreciation is a loss of value due to normal wear and tear. If you purchase a machine for $10,000, it loses some of its value as soon as you fire it up for the first time. It continues to lose value with each additional year of use.

• Maintenance costs: Production equipment requires regular maintenance, which — unfortunately — costs money. Manufacturing overheads include the cost of oil, spare parts, and other maintenance costs.

Factory rent and insurance: Rent isn't directly associated with the production of a specific item, but you have to pay it if you want to keep operating your business. You also need to pay for insurance to protect your equipment, inventory, and other assets.

Packaging Costs

Once you manufacture an item, you need to package it for sale. This cost component includes boxes, labels, wrapping, and other packaging materials, all of which protect your products and help you market them to buyers.

Implementing Cost-Effective Inventory Strategies

Now that you understand the four essential cost components, you're ready to master inventory management. We recommend these strategies for managing your inventory costs effectively, which is essential for minimizing costs and reducing waste.

Maintain Consistency

No matter which inventory costing method you choose, you need to apply it consistently. Last in, first out (LIFO), first in, first out (FIFO), and average cost are the most common options.

LIFO assumes that you sell the most recent items in your inventory first, while FIFO assumes that you sell the oldest items in your inventory first. The average-cost method takes the total cost of goods manufactured or purchased in a period and divides them by the total number of items. For example, if it costs you $500,000 to produce 250,000 items during the third quarter, your cost per item averages out to $2.

Perform Physical Counts

To ensure accuracy, it's critical you perform physical counts regularly. Sure, it might be more fun to hang out on the beach, but doing physical counts can save you a lot of heartache when it comes to calculating the value of your inventory.

Ideally, wineries should do physical counts at least once per month, and consumer package goods (CPG) companies should do physical counts once a week. Although frequent counts are ideal, they're not always practical, so do them as often as you can.

Use Appropriate Methods for Inventory Costing

Whatever you do, avoid using inappropriate methods for inventory costing. Each method significantly affects your COGS based on inventory turnover and price fluctuations.

For example, if you choose the FIFO method, your COGS will be lower because FIFO assumes the first goods you produce/manufacture are the first ones you'll sell. Prices increase over time, so the first items usually cost less than the most recent items. In contrast, LIFO assumes that you sell the most recent items first. Therefore, it increases your COGS.

Once you choose an inventory costing method, stick with it to avoid making your financial situation even more complex.

Allocate Overheads Consistently

You also need to choose a rational allocation method and allocate your overheads consistently. If you change your allocation method for no good reason, you'll end up with inconsistencies from one period to another.

Common Mistakes in Inventory Costing and How to Avoid Them

When it comes to inventory costing, some mistakes are more common than others. Fortunately, there are ways to correct and even prevent these mistakes.

Incorrect Classification of Freight Costs

One of the top mistakes we see is the incorrect classification of freight costs. Freight-in costs are the costs of getting raw materials from suppliers to your manufacturing or production facility. In contrast, freight-out costs are the costs involved in delivering finished goods to customers.

For a CPG food brand, it's essential to understand where to include these freight costs. Freight-in costs are associated with acquiring materials needed to produce goods, so they're typically included in COGS. Freight-out costs, also known as delivery expenses or distribution costs, aren't included in your cost of goods.

Instead, they're usually recorded as a selling expense on the income statement. This is because they're associated with the cost of distributing goods, not producing them.

Not Accounting for Obsolescence or Spoilage

CPG goods, particularly food items, can expire or become obsolete. If you don't do write-downs or adjustments for these items, your COGS won't accurately represent the cost of your sold inventory.

Ignoring Product Variances

In a perfect world, you wouldn't have to worry about product variances. However, it's common for CPG companies and wineries to encounter production inefficiencies, such as scrap and yield variances. You need to account for these variances, or else your COGS won't accurately represent your production costs.

Empowering Your Business Through Effective Inventory Management

Inventory costing clearly plays an important role in managing your company's finances. Avoid common pitfalls by maintaining consistency, performing regular physical counts, allocating overheads consistently, and using appropriate methods for inventory costing.

To learn more about how inventory costing affects your bottom line, read other articles published by the Balanced Business Group. If you need additional help with accounting and finance activities, contact us for personalized service.