The cost method is used to determine the value of your current inventory and the cost of sales when you sell your inventory items.
Cost of goods sold shows up on your income statement while current inventory is shown on the balance sheet under current assets. You can also view inventory costing information on some inventory and sales reports.
FIFO (First-In, First-Out) - This method assumes that the first unit put into inventory is the first unit sold.
LIFO (Last-In, First-Out) - This method assumes that the last unit put into inventory is the first unit sold.
Average- This method uses a weighted average of the cost of the items to determine the value of inventory and cost of goods sold.
Specific Unit - This method is only used for serialized items. The specific cost of the item is known because the items are assigned serial numbers when they are put into inventory which allows you to know the exact cost of the serialized items that you have in inventory or are selling. You must use specific unit costing for your serialized items.
Let's say you sell pens. Last week, you bought 20 pens for $1 each. This week, you bought 40 more pens for $1.50 each. Today you sell 25 pens.
FIFO - cost of goods sold would be $27.50 [(20 x $1) + (5 x $1.50)], value of pens remaining in inventory would be $52.50 (35 x $1.50)
LIFO - cost of goods sold would be $37.50 (25 x $1.50), value of pens remaining in inventory would be $42.50 [(15 x $1.50) + (20 x $1)]
Average - average cost would be $1.33 [(20 x $1) + (40 x $1.50)]/60, cost of goods sold would be $33.25 (25 x $1.33), value of pens remaining in inventory would be $46.55 (35 x $1.33)
Tips: Once you save an inventory item, you can't change its cost method.
You should generally use the same costing method for all of your inventory items. Your accountant will be able to help you determine which cost method to use if you aren't sure which method is right for your business.
The cost method is only used for items that you keep in stock. It doesn't apply to non-stock, service, or labor items.