The Best Inventory Costing Methods for eCommerce

Proper inventory management is crucial to success in the eCommerce, but the method you choose for calculating inventory costs could have an even greater impact on your bottom line. You can choose from several different methods for calculating cost of goods sold, but which is the best for your growing online store? We’ll explain everything you need to know to about the best inventory costing methods for eCommerce in this handy guide straight from the accounting pros at Tax Hack. 

What Are Inventory Costing Methods?

Inventory costing involves assigning costs to the products that make up your inventory. When you’re calculating these expenses, make sure you take incidental fees into account, which include but are not limited from storage and administration to market fluctuation. Proper inventory costing is necessary to manage expenses and make sure you don’t carry too much of a specific product at a given time. 

What Are the Most Popular Types of Costing Methods for eCommerce?

The following section cover four of the most common inventory costing methods. Each method has advantages and disadvantages, so the best choice will depend on your business goals and tax strategy.

Last In First Out (LIFO)

The LIFO records your most recently obtained items being sold first. With this strategy, the products that are kept in your inventory are the ones that have been there the longest. Keep in mind that inventory doesn’t naturally flow in this manner. In fact, the International Financial Reporting Standards have made this strategy illegal in many countries. It’s also heavily regulated within the U.S.

Companies that sell their most expensive items first will have a lower taxable income alongside higher costs. Businesses in the oil industry often use LIFO because of how volatile pricing can be. Since oil prices are often increasing, businesses that are part of this industry can take advantage of these changes. The same is true of companies in the fashion and technology industries. If a company’s most recently acquired items are more valuable and relevant than their older inventory, this technique is more useful than the rest. 

For example, a business receives a barrel of oil that costs $20 to acquire. The next day, they get a barrel for $25. Later that day, they sell one barrel for $50. Under LIFO, the profit on the sale would be $25, since were using the “last in” price of $25 as the basis for calculating the gross proceed to the business.

First In First Out (FIFO)

The FIFO method occurs when a business assumes that the initial products it acquires will be the first ones sold. Many businesses use this method to manage their inventory and set prices. This strategy is popular because prices almost always increase, which means that the oldest products in your inventory were bought at a lower cost. However, these products will be sold at their current market value, which can lead to higher income. 

The one drawback to using this method is that taxes will also be higher. FIFO makes it easier to maintain a healthy balance sheet. This strategy is regularly used by companies that have time-sensitive or perishable products in their inventory. For example, FIFO is prevalent among businesses in the electronics, food and beverage, and pharmaceutical industries. When a grocery store sells older food items before newer ones, they can offload these products before they expire. 

If we go back to our oil barrel example, FIFO would use the first barrel’s cost as the basis for calculating its profit on the sale. Instead of deducting $25 from the total sale price of $50, we deduct $20, i.e. the cost of the first barrel. Under FIFO, our gross profit from the sale increases to $30.

Average Cost

Average cost is a strategy that’s used when the prices of products rarely change. If you use this strategy, you’ll need to average the cost of existing inventory with the price of new purchases. Once you make this calculation, you’ll have a weighted average cost that can be assigned to your inventory. You’ll need to recalculate this cost whenever you buy additional inventory. 

The main advantage of using this strategy is that you can more effectively track costs without needing to know which group of units a specific product was sold from. However, averaging costs together means that the final calculation may be slightly inaccurate. There aren’t many companies that use this strategy. 

Under average cost, we calculate an average cost of our two oil barrels. Instead of adjusting the cost depending on the sequential order of the sales, we average out the costs of the two barrels to $22.50. So, our profit under average cost comes to $27.50.

Specific Identification Method

Specific Identification Method is a highly effective and popular technique that allows you to track the actual price of each individual item that’s part of your inventory. This technique is typically used by companies that sell high-priced or unique items.

Let’s say that a jewelry store is selling a diamond ring for $8,000 that they initially acquired for $5,000. In this scenario, the Specific Identification Method would record the cost as $5,000, which would lead to a $3,000 profit. 

While this method is more precise than other strategies, it’s also more complicated. Tracking every item in your inventory when identifying costs can be a time-consuming process. If your eCommerce business sells a lot of items, this strategy likely isn’t right for you. 

What Is the Best Inventory Costing Method for eCommerce?

The four methods discussed in this guide are the most popular ones for a reason. They offer very distinct advantages while having very few drawbacks. However, this doesn’t mean that your business will benefit equally regardless of the method you choose. If you want your company to use the most effective management strategies, your best option for inventory costing is likely the FIFO method. 

FIFO paints an accurate picture of expenses and profitability. However, you’ll likely bring in a higher net income than you would if you used other methods, which could result in a higher tax bill. 

Average cost is probably the most balanced option, but it might not be the best choice in an industry where price fluctuations are common.

Closing Thoughts on the Best Inventory Costing Methods

Choosing the right inventory costing method is crucial if you want your business to grow and properly manage expenses. To determine which of these strategies is best for your business, consider whether your costs are decreasing or increasing. You should also measure how often your stock fluctuates. While FIFO is the best method for most businesses, LIFO may be the better option when dealing with volatile prices.

Ultimately, the best inventory costing method for your eCommerce business depends on many factors. This guide should provides a broad overview, but you should consult with a tax advisor to determine the best choice for your business.

Tax Hack specializes in cutting-edge tax strategies for growing eCommerce empires and other high-tech businesses. Our talented tax pros can help you rack up big savings on your annual tax bill. Connect with us now for a complimentary one-on-one strategy seen with a Tax Hack pro to see how much you can save!

About the Author

Miguel Alexander Centeno

Miguel Alexander Centeno is an author, speaker, and tax leader at Tax Hack Accounting Group. A former Big 4 tax manager, he represents taxpayers in all matters before the IRS, including the U.S. Tax Court. He has been quoted in the Wall Street Journal, Fox Business, and MSNBC on tax related articles and has testified before the U.S. House of Representatives as a part of hearings for the Tax Cuts and Jobs Act. A father of three, Miguel is an avid acoustic guitar player, gravel cyclist and once-a-week yogi.
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