Most companies share one financial goal: stay profitable. To know what you earn, you first need to know what you spend.
Costing methods measure the expenses tied to manufacturing inventory. The selected inventory costing method impacts your cost of goods sold, taxable income, and reported margins.
Keep reading to learn each method, how to calculate it, and how to choose the right one.
Key Takeaways
- Costing methods split into inventory costing, which values products, and production costing, which tracks the expenses of the manufacturing process.
- First in, first out assigns older costs to goods sold and is accepted worldwide, while last in, first out uses newer costs and is US-only.
- Activity-based costing assigns expenses to specific production activities instead of whole products, giving complex operations granular cost visibility.
- The selected inventory costing method impacts your reported costs, margins, taxable income, and asset value, so switching methods later is disruptive.
What are costing methods?
Costing methods are accounting techniques that calculate the total expense of manufacturing goods. They track raw materials, labor, overhead, and production time. Businesses use them to value inventory and find the true cost of products sold.
Knowing these costs improves your ability to price goods competitively and stay profitable. It also surfaces inefficiencies and chances to reduce unnecessary expenses. High labor costs, for example, might lead you to automate assembly line steps.
What are the 9 most common costing methods?
The most common costing methods fall into two categories: inventory costing and production costing.
1. Inventory costing
Inventory valuation methods determine the cost of the products you manufacture and sell. Knowing the cost of a best-selling product helps you make better decisions about allocation, restocking, and pricing.
Most manufacturers rely on one of these four inventory costing methods.
1. First in, first out
With the first in, first out (FIFO) method, you assume you sell goods in the order you produced them. You assign the cost of your oldest inventory to the first units sold. This method aligns with most industries and with generally accepted accounting principles (GAAP).
Because FIFO assigns the oldest, often lowest-priced inventory to the cost of goods sold (COGS), the remaining inventory is valued at more recent, higher prices.
Calculate COGS with FIFO using this formula:
Inventory COGS = Cost of oldest goods x Total quantity of goods sold
2. Last in, first out
In contrast with FIFO, the last in, first out (LIFO) costing method assumes the newest inventory sells first. You apply the cost of the most recent inventory purchases to goods sold.
LIFO matches higher, recent costs with current revenue. As AccountingTools explains, LIFO moves high-cost inventory into the cost of goods sold, letting a company defer income taxes in periods of rising prices. This can report lower profits than FIFO, which may reduce shareholder income and returns.
LIFO is permitted under US GAAP but banned under the International Financial Reporting Standards (IFRS). The KPMG IFRS Institute notes that IAS 2 prohibits LIFO, while US GAAP allows its use. If you operate internationally, LIFO may not fit.
Calculate COGS with LIFO using this formula:
Inventory COGS = Cost of most recent goods x Total quantity of goods sold
3. Weighted average cost
The weighted average cost (WAC) method values inventory using the average price of all units available for sale. You add the total cost of all items in inventory, then divide by the number of units.
In Fishbowl, the new WAC recalculates only when new units are received, not when they sell. If inventory never reaches zero, the WAC resets to the value of the next inventory added.
WAC is simpler to calculate because you do not track each item’s cost individually. The limitation is that WAC may not reflect the current price tag when costs fluctuate.
This formula shows the WAC of your COGS:
Inventory COGS = (Cost of all goods for sale / Number of units) x Total quantity of goods sold
4. Actual cost
Actual costing tracks the real cost incurred for each item, including overhead, labor, and materials. Your financial statements then reflect the true cost of every item.
The catch is that actual costing is labor-intensive to maintain, especially with frequent cost changes or high transaction volumes. It suits companies making customizable, high-value goods, like a custom jewelry maker.
There is no formula for this method, since it relies on totaling values individually. To use it, enable at least one tracking method per item: serial numbers, lot numbers, or expiration dates.
2. Production costing
Production costing determines the expenses tied to the production process itself. There are five popular production costing methods.
5. Job costing
Job costing tracks and allocates all direct costs tied to specific jobs or projects. It gives a thorough view of a project’s expenses, though tracking the details can be complex and time-consuming.
Here is the job costing formula:
Total job cost = Direct material costs + Direct labor costs + (Predetermined overhead rate x Actual allocation base)
6. Activity-based costing
The activity-based costing (ABC) method is a type of job costing. You identify the production activities that use resources and assign costs to those activities. AccountingTools describes ABC as a methodology for more precisely allocating overhead costs to products and services.
To use ABC:
- Identify what goes into creating a product.
- Assign each item to a cost pool that shares one activity, like sourcing materials or labor hours.
- Divide each pool’s overhead by its cost drivers to find the rate.
Use this formula to calculate activity-based costing:
ABC = Cost pool total / Cost driver
Because ABC is detail-heavy, reporting can lag. Fishbowl AI Insights lets you build custom cost dashboards in plain language, without waiting on manual report requests.
7. Process costing
Process costing is simpler than job costing because it aggregates costs across production processes. Its drawback is that it may not reflect cost variations between different production runs.
To calculate process costs:
- Add all direct and indirect expenses for a production stage.
- Count the units produced during that stage.
- Divide total cost by units to find the cost per unit.
AccountingTools gives the simplest formula to calculate cost per unit:
(Total fixed costs + Total variable costs) ÷ Total units produced = Cost per unit
8. Standard costing
Standard costing sets predefined costs for production factors like materials, labor, and overhead. You then compare those standards to actual expenses to spot variances. AccountingTools defines standard costing as substituting an expected cost for an actual cost in the accounting records.
Because you set the standards, there is no fixed formula. The easiest approach is to set standard costs by multiplying materials or labor by cost. If workers earn $15 an hour and a unit needs 15 standard hours, the standard direct labor cost is $225.
9. Direct costing
Direct costing, or marginal costing, counts only the variable costs of production. Variable costs shift with production volume and include materials and direct labor. Material costs should include any scraps or manufacturing waste.
Fixed costs stay constant regardless of volume, like a factory mortgage or insurance. In direct costing, you treat fixed costs as operating expenses for that period.
This method is the opposite of absorption costing, which allocates both variable and fixed costs to production. Absorption costing gives a fuller picture but is harder to calculate. There is no exact direct-costing formula, since costs vary across industries.
How does the selected inventory costing method impact your financials?
Your choice does more than value stock. The selected inventory costing method impacts several lines across your income statement and balance sheet, and it shapes your inventory accounting and compliance. Here is where the effects show up:
- Cost of goods sold: FIFO, LIFO, and WAC assign different costs to units sold, so each reports a different COGS for the same period.
- Gross margin: A lower COGS lifts gross margin, while a higher COGS compresses it, changing how profitable your products look.
- Taxable income: In periods of rising prices, LIFO raises COGS and lowers taxable income, while FIFO does the opposite.
- Balance-sheet value: Leftover inventory is valued at recent prices under FIFO and older prices under LIFO, changing reported assets.
- GAAP and IFRS compliance: LIFO is allowed under US GAAP but prohibited under IFRS, so international reporting can rule it out.
Because these effects compound over time, switching methods later is disruptive. Model the tax and margin impact before you commit.
How do you choose the right costing method for your business?
With all these options, how do you settle on a method? Weigh these four factors:
- Match your production style: Distinct jobs, continuous processes, and specific activities each favor different methods. Project-driven lines often suit job costing.
- Gauge how much your products vary: Process costing fits high volumes of uniform products. Job costing suits custom products that vary from batch to batch.
- Decide how precise you need to be: For detailed cost allocation on big decisions, consider ABC. It is resource-intensive but precise.
- Plan ahead: If you expect rising volume and complexity, pick a method that scales. Switching later is hard, so the method should grow with you.
How does Fishbowl help you manage costing methods?
Need more guidance on costing methods? Fishbowl’s inventory management tools streamline your costing processes.
With direct QuickBooks integration, Fishbowl tracks costs accurately so you can make informed decisions. Fishbowl Time also simplifies job costing by tracking labor costs against each build.
The payoff shows up in the numbers. According to its Fishbowl case study, Prince Michel Vineyard & Winery used Fishbowl Manufacturing to speed up its cost-to-manufacture calculations. The winery went from six months after year-end to immediately upon manufacture, and increased accuracy by more than 10%.
Book a demo to see how Fishbowl keeps your costing accurate and your margins visible.
Frequently asked questions about costing methods
1. How does the selected inventory costing method impact your financial statements?
Your method sets the cost assigned to each unit sold, which changes COGS, gross margin, and net income on your income statement. It also changes the inventory value on your balance sheet. In periods of rising prices, LIFO lowers taxable income, while FIFO reports higher profits and inventory value.
2. What is the difference between standard costing and actual costing?
Standard costing uses predetermined costs for materials, labor, and overhead, then compares them to real results to reveal variances. Actual costing records the true cost incurred for each item, with no estimates. Standard costing suits budgeting and performance reviews, while actual costing suits custom or high-value production.
3. What is the difference between job costing and process costing?
Job costing tracks costs for a specific job, project, or batch, so it fits custom or made-to-order work. Process costing aggregates costs across a production stage and divides by units produced, fitting high volumes of identical goods. Job costing gives project-level precision, while process costing is simpler but hides differences between runs.
4. Can you change your inventory costing method later?
Yes, but it takes planning, because a change alters your COGS, reported profit, and inventory value. In the US, switching your tax method often requires filing with the IRS, and auditors expect year-to-year consistency. Document the reason, model the tax impact first, and restate comparatives where required.
5. Which costing method is best for a small manufacturer using QuickBooks?
Many small manufacturers on QuickBooks start with FIFO or weighted average cost, since both are GAAP-compliant and simpler than LIFO. FIFO tends to reflect current inventory value, while WAC smooths out price swings. If you build custom or high-value products, job costing adds project-level detail that Fishbowl tracks automatically.
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