Appendix A - Inventory Costing Calculations

The AddonSoftware Inventory Control system is capable of maintaining two types of costs for each inventory item. The first cost may be average, last purchase (replacement), or standard cost; and the second may be LIFO/FIFO or Lotted/Serialized. This section discusses the costing calculations performed in a number of inventory situations. LIFO/FIFO tiers are explained in detail.

In order to use the last-in-first-out (LIFO) or first-in-first-out (FIFO) costing method, the LIFO/FIFO/None parameter in the Application Parameters task must be set accordingly. Once LIFO/FIFO is selected, cost tiers can be created for each inventory item, containing both a quantity figure and unit cost. The cost tiers are modified automatically every time an inventory transaction is updated.

This section describes how cost tiers are managed as inventory transactions occur. Keep in mind that while the quantity figures in the LIFO/FIFO tiers are updated regardless of the type of transaction, unit cost figures are only changed as items are added to inventory or when a change is made with the Cost Change Entry task.

NOTE: In a lotted or serialized inventory, the average unit cost changes as a result of issues and receipts. Additionally, a lotted or serialized inventory may not be costed at LIFO or FIFO.

How the FIFO Costing Method Works

In a FIFO system, items received with a cost different from the previous transaction result in the creation of a new cost tier (a new cost and quantity level) being added to the “bottom” of the list. When the cost of a received item is the same as that of the previous transaction, only the quantity is updated and no new cost tier is added. As transactions cause items to be relieved from inventory, they are taken from the “top” tier which provides the necessary information for calculating the cost of the transaction. When the quantity in a tier is reduced to zero, it is erased and the tiers below it are advanced up one level. An explanation of how the cost tiers are managed when the on-hand quantity for an item becomes negative is given further in this section.

How the LIFO Costing Method Works

In a LIFO system, items received with a cost different from the previous transaction result in a new cost tier being added to the next available tier (i.e., if tier one exists, tier two is added). Items received having a cost the same as the previous transaction result in only the quantity being updated, and no new cost tier is added. As items are relieved from inventory, they are again taken from the tier that was most recently created (last in, first out), which provides the necessary information for calculating the cost of the transaction. When the quantity in a tier is reduced to zero, it is erased. An explanation of how the cost tiers are managed when the on-hand quantity for an item becomes negative is given further in this section.

General Ledger Costing Effects

When adjustments are made to the quantity on-hand for an inventory item, a corresponding inventory asset account in the general ledger (and the offset account) must eventually be posted. The amount of this posting is taken from the cost extension for the item (or a group of items covered by the same inventory account). In some cases, this general ledger posting may occur automatically during the update process for the transaction. In other cases, it may be done during a separate journal entry using the cost totals shown on a transaction register. If the LIFO/FIFO costing method is used to keep track of costs within inventory, there are special implications to posting the general ledger.

The quantity on-hand for each inventory item is changed during the updating of eight different types of transactions:

For each of these transaction types where quantities are increased for an item (and each item only has one cost), the cost extension on the register is representative of the amount to be posted to the general ledger. Additions to item quantities in a LIFO/FIFO situation always result in the creation of a new cost tier. The situation is more complicated when item quantities are reduced, and more than one cost tier is relieved.

The methods used by each transaction to determine the cost extension on a corresponding register and its affect on the general ledger is explained below. Remember, if LIFO/FIFO costing is not used, the cost extensions on the registers are simply the standard unit cost for each item multiplied by the transaction quantity.

Updating Inventory Transaction Entries

The cost extensions shown on the Inventory Transaction Register are calculated using the actual values of LIFO/FIFO cost tiers or the current unit costs for each item. If the transaction is set to post to the general ledger (determined in Transaction Codes maintenance task), the general ledger posting amounts are also calculated using the same figures.

Updating Inventory Transfer Entries

The general ledger is updated based on each warehouse’s distribution codes (established in Accounts Receivable) if the Accounts Receivable Distribute Sales By Item parameter is checked. The From warehouse is credited and the To warehouse is debited. If the Distribute Sales by Item parameter is not checked, the Inventory Transfer Entry task does not automatically produce general ledger postings. FIFO/LIFO tiers for the From warehouse are relieved. If needed, new FIFO/LIFO tiers are created in the To warehouse.

Updating Physical Inventory Entries

The cost extensions shown on the Register and Update are calculated using the actual values of the LIFO/FIFO cost tiers or the current unit costs for each item. The Physical Inventory Count Entry task does not automatically produce general ledger postings. Postings must be made via a General Ledger system journal entry, using the cost extensions on the register.

Updating Purchase Order Receipt Entries

The cost extensions on the Purchase Order Receipt Register represent the receipt cost times the quantity received. The receipt cost might be the standard unit cost for an item, or another cost determined at the time the purchase order was entered or received. As this is a receiving-only process that adds to the inventory on-hand quantity, tiers are added as necessary during the update process, and current unit costs are re-averaged.

The receipt update does not automatically produce general ledger postings. Postings to the general ledger are made through the Accounts Payable Invoice Entry task, or through the Accounts Payable Manual Check Entry task, which records the actual costs as invoiced by the vendor.

Updating Invoice Entries

The actual current unit costs, or
The actual LIFO/FIFO costs for an item (from the cost tiers), or
The actual lotted/serialized cost for an item.

Costs updated to the Sales Analysis module and the Aging and Sales Summary tab in the Accounts Receivable Customer Maintenance and are also based on the same figures.

Updating Production Entries

The cost extensions on the Inventory Production Register are calculated using the actual values of the LIFO/FIFO cost tiers for the bill of materials components. When inventory is costed at standard, the general ledger postings relieve LIFO/FIFO inventory at actual LIFO/FIFO costs and post the finished good to inventory using standard cost for the finished item. Cost differences between the LIFO/FIFO cost and the standard cost result in general ledger entries to production variance accounts. When inventory is costed with a method other than standard costing, the amount posted to the inventory accounts represents the actual component cost.

Updating Materials Issues Entries

The cost extensions shown on the Materials Issues Register are calculated using the actual values of LIFO/FIFO cost tiers. If the transaction is set to post to the general ledger, the posting amounts are also calculated using the same figures.

Updating Work Order Close Data Entries

The cost extensions on the Closed Work Order Summary Register are calculated using the actual value of the LIFO/FIFO cost tiers for material issued to the work order. If the transaction is set to post to the general ledger, the finished good posting amount is the LIFO/FIFO costs when the work order type is closed at actual costs. If the work order type is closed at standard cost, the finished good posting amount is the standard cost for the finished item; cost differences between the LIFO/FIFO cost and the standard cost result in entries made to a production variance account.

Handling of Negative Quantity Items in LIFO/FIFO or Average Costing Systems

It is possible that inventory on-hand quantities will become zero or negative within the system. This commonly occurs when the receiving functions of the Inventory Control, Purchase Order, or Shop Floor Control modules are not kept current with the sales invoicing functions. When the on-hand balance is zero or negative, a decision must be made as to how the cost for items not yet “in inventory” are set.

When items are received into inventory subsequent to a zero or negative on-hand quantity situation, stock is replenished at its actual receipt cost. This method is used throughout the system whenever the on-hand quantity of an item becomes zero or negative.

Since average cost information cannot be optimally maintained in such situations, it is advisable that receipt transaction entry be kept up to date at all times.