Inventory Cost Flow Methods – What you need to know!

In a recent article we touched on the topic of Inventory and mentioned some of the innerworkings of this part of the Balance Sheet to help better comprehend one of the more complex parts of a businesses’ financial statements.

Click here to read: Inventory – 3 Important things that you need to know!

We will continue this week with the topic, but today we are going to dig a little deeper and discus the different cost flow methods that can be used with inventory.

What is a Cost Flow Method?

A cost flow method is simply the terminology used to refer to the mechanism that a company decides to utilize to establish the cost of the products that a company sells.

Why is this so important in a company? It is important because what it costs to make your product today, will likely change and depending on the products or raw materials that you have to source the costs – they can change quickly. Therefore, if you do not pay attention to the cost of your inventory, before you know you may actually start selling at a reduced profit that isn’t sustainable for your business model or worse – you could be selling at a loss!

Why is it necessary to establish a Cost Flow Method?

Establishing a Cost Flow Method is important because to begin it is the policy for which costs will be assigned to product sales and therefore will directly affect gross profit.

Secondly, it is important to establish a Cash Flow Method because it is a requirement to notify the tax administration of which method is being used and this means that you can not use whatever method you want, when you want or how you want. This is because if a methodology of cost flow is changed, this usually results in significant changes to your gross profit and taxes, pursuant to article 44 of the Tax Concertation Law of Nicaragua.

Inventory is not something that should be ignored.

What Cost Flow Methods can be used?

Here are some of the methods that are permitted by the Tax Concertation Law of Nicaragua, Law 822:

• FIFO – First in First Out

With FIFO or First in First Out method, the assumption is that the inventory item that was first bought will be the first sold, therefore the cost of inventory items bough in between the dates will not be costed until what was initially bought is all sold.

• LIFO – Last in First Out

The LIFO or Last in First Out method assumes that the products being sold are the last products that were purchased, which is the opposite of the FIFO method. The principle behind this method is that the costs of goods sold reflect the latest market price available, which in itself seems a justifiable premise, but when the cost of sourcing a product or raw materials frequently fluctuates your inventory can become somewhat strange since products that were purchased a previously now misrepresent considerably actual costs.

• Weight Average Cost

This method consists of dividing the total cost of goods available for sale by the quantity available which there for gives a unitary cost of cost of goods sold. The result of this method will usually fall between both FIFO and the LIFO method.

• Other Methods

The Law 822, Tax Concertation Law of Nicaragua, also permits the usage of other methods of cost flow methods. Nonetheless, there are two criteria that any of these methods meet, which are as follows:

1) Authorization must be requested to the Tax Administration;

2) Method must be accordance with Generally Accepted Accounting Principles or adhere to International Financial Reporting Standards.

We hope that this article has helped you to better understand the inner workings of the different cost flow methods that exist. If you have any questions, or would like assistance with your inventory, contact us HERE.