So there you are, about to add a new stock item into Sage, when you see the drop-down for ‘Costing Method.’ I’m sure some of you are aware of what the three options available refer to, but in case you aren’t, or if you would just like to touch-up on your knowledge, this handy little blog may just help. First of all, let me give you a quick explanation of what a costing method actually is. A Costing Method is a way of deciding what to put for your cost of buying a raw material or a product. There are 3 main methods of costing, FIFO, Average Costing, and Standard Costing.
Let’s use an example to help understand each method:
1 December Bought 10 Cakes @ £5 each
3 December Sold 7 Cakes
5 December Sold 2 Cakes
6 December Bought 10 Cakes @ £6 Each
8 December Sold 6 Cakes
We’ve bought 20 cakes in total (because who wouldn’t?) and sold 15 of them. How shall we decide on the cost of selling each cake?
Let’s start with FIFO:
FIFO or First in First Out, does exactly what it says on the tin. We assume that the first products bought are the first to be sold. So of the 10 cakes bought on 1st December, 9 sold at a cost of £5 each. Then we bought 10 more and sold a further 6 on the 8th December, the first of those 6 sold will be at a cost of £5 (as we still have 1 cake left from the £5 each purchase on the 1st) and the other 5 will be at a cost of £6 each. So in total we sold 10 cakes at a cost of £5 and 5 cakes at a cost of £6. We also have 5 cakes left, and because we sold all the cakes worth £5 each the value of those cakes must be £6 each.
Total Cost of Sales = £80
Closing Inventory = £30
Next we’ll take a look at Average Costing:
Average Costing again does exactly what it says on the tin (how easy it this?) but this time it comes with an equation:
Weighted Average Unit Cost = Total Cost of Inventory / Total units in Inventory
So let’s look at how this equation works out the Average Cost for our example.
(£110)/ (20) = £5.50 this is the average cost per unit, we can then use this value to calculate the cost of sales for our cakes and the closing inventory.
Total Cost of Sales = £82.50 (Average Cost Per Unit x Number of Units Sold)
Closing Inventory = £27.50 (Average Cost Per Unit x Closing Inventory)
Finally let’s take a look at Standard Costing:
Probably the most complicated method of costing, as in this method you are assigning an expected cost of purchasing or producing goods. As with any expected value, there may be some variance analysis that needs to take place, but let’s leave that subject for another day and give you a brief example of how Standard Costing works.
Once we have calculated what we expect the cost of each unit to be, we can work out our total cost of sales and closing inventory in the same way as we did with Average Costing.
Total Cost of Sales = £78
Closing Inventory = £26
So there you have a brief overview of what each of those costing methods actually mean and how they calculate the cost of a unit for your year end reports. What you may notice is that the Total Cost of Sales and Closing Inventory totals differ depending on the method that you use, it would be difficult to say which was more accurate, however there are certainly some advantages to using each of the methods.