Let’s explore the accounting methods for COGS. Depending on the accounting method of your business, the value of COGS can vary. Here are the 4 different methods you can use to measure inventory:
- First in, first-out (FIFO)
- Last in, first-out (LIFO)
- Weighted average cost
- Special identification method
First-in, first-out (FIFO)
First in, first-out (FIFO), is the management approach where items produced or purchased first are sold first. This is the best application if you’re selling perishable products or products with a short shelf life.
If prices are likely to go up over time, you should use FIFO when you plan to sell your products from the lowest to the highest prices. FIFO makes your closing inventory higher, and your COGS will be lower for the year. As a result, your gross margin, calculated by deducting COGS from revenue, will be higher. With lower COGS, your net income, or profit, will increase as well.
When prices are decreasing, you have the opposite impact.
In addition, a higher closing inventory under FIFO will contribute to higher asset value for your company. This is a great benefit if you’re trying to get a bank loan to expand your business, as your asset liquidity is an important factor for the bank to make their decision.
Last-in, first-out (LIFO)
The opposite of FIFO is LIFO, which stands for “last-in, first-out”. It means you first sell the items that you most recently purchased or produced. If prices are growing and the goods with higher inventory costs are sold first, your COGS will be higher. Therefore, the closing inventory will be lower, and the net income will decrease as well.
During a time of inflation, LIFO leads to a higher COGS on your financial statement, lowering your taxable income.
Weighted average cost
Weighted average cost is the method of taking the average price of all products in stock to calculate the value of goods sold, regardless of purchase date. It’s the best method for mass-produced items such as water bottles.
By using the average product cost over a period, you can avoid extreme costs for some of the temporary purchases or acquisitions, and give your COGS a smoothening effect. In addition, this method will average your inventory carrying cost and cost you less time and effort to manage inventory than the other methods.
Special identification method
The special identification method tracks the cost of each specific product to identify COGS and the ending inventory of each period. This method is used when a business knows precisely which items were sold and the exact cost. Some industries that prefer this method are cars, jewelry, real estate, and other luxury items.