Inventory valuation methods for cost accounting

First In, First Out (FIFO) is a concept used by businesses that track inventory. As the name implies, QuickBooks Online will always consider the first units purchased (First In) to be the first units sold (First Out) and will adjust your assets and Cost of Goods Sold (COGS) accordingly whenever sales of inventory items are entered.

Here are sample scenarios to help you understand the concept of FIFO in QuickBooks Online.

As you can see, if you then sell more widgets from your current inventory to a third customer, they will all be valued at $7 apiece. Remember that FIFO has a consequence for reports that can be confusing unless you know to expect it. When you run a transaction report that includes a transaction on which two different rates occurred for the same inventory item, that transaction will have separate lines on the report for each COGS or asset amount.

For example, if you recorded an invoice for the second customer in the scenario above, the transaction report would show two line items for that invoice: one with a $30 change in COGS and/or assets, and another with a $105 change in COGS and/or assets. This is intended behaviour, and the report totals and subtotals will be correct.

Modify the cost and initial quantity of an item

Entering the incorrect cost and initial quantity of the item during the initial set up will result in an incorrect value in the inventory asset account. To correct this:

1. Go to Settings ⚙ and select Products and services.
2. Find the item, then select Edit from the Action column.
3. Select Starting value.
4. Enter the item's correct quantity and cost.
5. Select Save.

When you sell products, you must account for the cost of your inventory to determine profit. One method for assigning a cost to what you sell (Cost of Goods Sold or COGS) and the inventory you still have on hand is the Moving Average Cost (MAC) method.

Moving Average Cost method explained

Moving Average Cost, also known as Weighted Average, calculates an average cost for all units of an item in inventory. This average updates after every purchase. When units are sold, they are valued at the most recently calculated average cost.

MAC doesn't track costs based on when the item arrived, like FIFO or LIFO. Instead, it uses the same average cost for every unit you have for sale. This balances out the effect of price changes since it doesn’t favour the price of the first or last items you bought.

Calculate inventory costs with Moving Average Cost

Moving Average Cost is a way to figure out a new average cost every time you buy something new. Here's how QuickBooks Online calculates MAC:

Formula:

New Moving Average Cost = (Total Cost of Goods Available Before Purchase + Cost of New Purchase) / (Total Units Available Before Purchase + Units in New Purchase)

Let's walk through an example:

Imagine a business sells custom-designed surfboards. Here's a look at your inventory activity for the month of January:

Let's apply the Moving Average Cost method step-by-step:

1. January 1: Beginning Inventory

• Units: 10
• Total Cost: $2,000
• Moving Average Cost: $2,000 / 10 = $200.00

2. January 5: Purchase

• Units Purchased: 15 at $210 each = $3,150
• Before Purchase: 10 units @ $200.00 average cost ($2,000 total)
• After Purchase:
  • Total Units: 10 + 15 = 25 units
  • Total Cost: $2,000 (from beginning inventory) + $3,150 (new purchase) = $5,150
  • New Moving Average Cost: $5,150 / 25 = $206.00

3. January 12: Sale

• Units Sold: 8
• Cost of Goods Sold (COGS): 8 units * $206.00 (current moving average cost) = $1,648
• Remaining Inventory:
  • Units: 25 - 8 = 17 units
  • Total Cost: $5,150 - $1,648 = $3,502
  • Moving Average Cost (remains the same until next purchase): $3,502 / 17 = $206.00

4. January 18: Purchase

• Units Purchased: 12 at $205 each = $2,460
• Before Purchase: 17 units @ $206.00 average cost ($3,502 total)
• After Purchase:
  • Total Units: 17 + 12 = 29 units
  • Total Cost: $3,502 (from remaining inventory) + $2,460 (new purchase) = $5,962
  • New Moving Average Cost: $5,962 / 29 = $205.59 (rounded to two decimal places)

5. January 25: Sale

• Units Sold: 10
• Cost of Goods Sold (COGS): 10 units * $205.59 (current moving average cost) = $2,055.90
• Remaining Inventory:
  • Units: 29 - 10 = 19 units
  • Total Cost: $5,962 - $2,055.90 = $3,906.10
  • Moving Average Cost (remains the same until next purchase): $3,906.10 / 19 = $205.58 (slight difference due to rounding)

Summary for January:

• Total Cost of Goods Sold: $1,648 (Jan 12 sale) + $2,055.90 (Jan 25 sale) = $3,703.90
• Ending Inventory Value: 19 units at an average cost of $205.59 = $3,906.21 (slight difference due to rounding from $3906.10 and the $205.59 average cost)

Moving Average Cost is a good choice for businesses that:

• Sell homogenous, undifferentiated products: If your inventory items are essentially identical, like sand, grains, liquids, or mass-produced goods where individual units aren't unique, MAC makes sense because it treats all units equally.
• Experience fluctuating purchase prices: MAC gives you a stable COGS and inventory valuation. This helps you avoid the ups and downs of purchase costs that you see with FIFO or LIFO.
• Don't need to track the exact flow of specific inventory items: If knowing which specific unit was purchased first or last isn't crucial for your operations or compliance, MAC simplifies inventory tracking.
• Prefer a middle-ground approach for financial reporting: MAC can give you COGS and inventory values between FIFO and LIFO in periods of rising prices. It offers a more balanced financial view.
• Utilize a perpetual inventory system: Moving Average Cost works best for perpetual inventory systems, where inventory records update after each transaction. The average cost is figured out again with each new purchase.