PayTraq Blog

Costing and Inventory Valuation

Posted in inventory, warehousing, accounting, business, PayTraq U

Sooner or later all new entrepreneurs ask themselves: Why is costing necessary?

Cost analysis is vital for businesses because entrepreneurs cannot optimize expenses unless they clearly understand what they consist of and which business performance indicators will be impacted by the changes and which will not.

Costing is needed to valuate inventory objectively, determine the wholesale and retail prices, calculate and control the return on sales (ROS) of each specific item.
Knowing the unit cost, you can easily determine the required/minimum acceptable markup for the selling price to reach the projected profits.

One of the key factors contributing to accurate financial reporting is the correct inventory valuation. Inventory is considered to be short-term assets, and as working capital it should be valuated based on its acquisition cost.

Why is the cost generally not equal to the latest purchase price?

Current stock may include goods purchased at different times at different prices. They will be sold over a period of time. Thus, inventory should not be valuated based on the latest purchase price.

Inventory valuation methods

The two most common methods used for inventory valuation are FIFO and AVG (Weighted Average Cost method).

The FIFO method is based on the assumption that the goods are sold in the same chronological order in which they are bought, meaning the oldest items are the first to be sold. Thus, the inventory is valuated based on the latest purchase prices. Due to the specifics of this method, the product’s cost price could be calculated only in case of non-zero stock of the product in the warehouse.

Under the Weighted Average Cost method, inventory is valuated based on the average cost of the goods available for sale. Average cost is calculated by dividing the total cost of the goods available for sale by the total number of the units available for sale.

Systems of inventory

It should also be mentioned that two systems of inventory are generally used for keeping records of inventory: periodic inventory system and perpetual inventory system.

Periodic inventory management allows a company to know its beginning inventory and ending inventory within an accounting period, but it does not track inventory on a daily basis. Inventory is tracked by a physical inventory count. Under this system, all purchases are recorded as an expense in the purchases account, with no cost posting made at the moment of the sale. When in the end of the period physical inventory is done, the balance in the purchases account is shifted into the inventory account, which in turn is adjusted to match the value of the ending inventory only after the actual cost is calculated.

In contrast, the perpetual inventory system keeps track of inventory balances continuously, and all purchases are recorded in the inventory account right away. At the moment of the sale there is a record of the value of the products sold (by standard cost) which is written off from the inventory account to the cost of goods sold account.
When the perpetual system is used, inventory value is displayed continuously and updated in the balance sheet after each new operation.

Standard cost is a projected cost of the product used in sales to write off the inventory value (under the perpetual (continuous) inventory system). Then, when the actual cost of the product is calculated, the cost of goods sold account is adjusted according to the difference between the actual cost and the standard one.

Standard cost can be set for every product manually or calculated automatically when the actual cost is calculated for the first time for the goods with not yet standard cost specified. When subsequent calculations of the actual cost are made, you can update, if needed, the standard cost of products by selecting those of them which standard cost deviation from the actual cost is higher than the specified percentage.

Overhead expenses

By default PayTraq uses only direct expenses in costing, meaning only the prices of the goods purchased or the unit prices specified during adjustment.
If any overhead expenses need to be included in the unit cost, such as expenses related to transportation, storage or customs clearance, this can be done individually for each shipment by selecting the supplier’s invoice corresponding to the given shipment and then the tab “Overhead Costs”. Overhead expenses are posted by specifying the expenditure account to which the overhead expenses relate and the amount of the expenses.

Actual cost calculation

It is recommended that actual cost is calculated at the end of the period in which all the operations have been completed, meaning all incoming and outgoing invoices have already been posted for this period. For example, the calculation date can be the last day of the previous month.
If cost is calculated on the current date or a date close to the current one, the chances are high that new operations will be posted impacting the accuracy of the calculation. Therefore, posting of the new operations will get the given calculation deleted.