Costing Methods

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General

The costing method you select determines how your company tracks costs and margins.

FIFO

FIFO, or First In First Out costing, matches parts with their individual purchase costs.

Cost Layers

Under FIFO, cost layers are consumed in the order that they were purchased (hence, First In First Out).

For Example:

You purchase a quantity of 10 at $1 ea, then your first cost layer is $10.
Then you purchase 10 more at $2 ea, and add another cost layer for $20.
Now your total inventory value is $30.

Once you've sold the first 10, with an associated cost of $1 ea, then you will begin to consume the second cost layer and sell 10 more with an associated cost of $2 ea. Your cost layers and total inventory value will always match.

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Average

Average costing sums the total purchase costs of a part and divides it by the quantity to obtain the total average cost. That average cost is then applied to each part in stock, regardless of the items original purchase cost. This average cost will update as more parts are purchased.

Cost Layers

With the Average costing method, the average cost of all parts in stock will be taken and applied to each part as it is sold.

For Example:

You purchase a quantity of 10 at $1 ea, then your first cost layer is $10.
Then you purchase 10 more at $2 ea, and add another cost layer for $20.
Now your total inventory value is $30.
But, the average cost is $30/20 which comes to $1.50 ea.

As you sell parts, the associated cost will be $1.50 for all 20 parts sold. The first 10 parts will be sold at $1.50 ea, which is $0.50 higher than the purchase cost, and will show that your inventory is valued at $15 instead of the $10 that you bought it for. The last 10 parts will be sold at $1.50 ea, which is $0.50 lower than the purchase cost, and will show that your inventory is valued at $15 instead of the $20 that you bought it for. Once all parts are sold, the total inventory value balances out to $30.

Once you sell all parts, the average cost will return to $0 until the part is purchased again.

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Standard

This form of costing is a method of applying a single (or standard) cost to a part, regardless of the purchase price(s). Standard costing is most common for manufacturers. Note that cost layers are not used in Standard costing.

For Example:

You purchase a quantity of 10 at $1 ea, and your standard cost is $1 so the value is $10.
Then you purchase 10 more at $2 ea, and your standard cost is $1 so the value is $10.
Now your total inventory value is $20.

As you sell parts, the only associated cost is $1 for all parts sold. Companies which use the Standard method track the variance between the standard cost and the purchase cost to determine where adjustments should be made: in the warehouse or to the standard cost itself.

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