Inventory Valuation and Cost Accounting for Manufacturers: FIFO, Job and Process Costing

Inventory valuation decides how much of what you spent on stock sits on the balance sheet and how much becomes cost of goods sold. Under IAS 2 you measure inventory at the lower of cost and net realisable value, assign cost with FIFO or weighted average (standard cost is allowed when it approximates actual cost), and for manufactured goods you add conversion costs: direct labour and a systematic share of production overhead.

This guide works through the rules with numbers: a FIFO versus weighted average example, job order and process costing, overhead absorption and what to do with under- or over-absorbed overhead, equivalent units, lot and serial tracking with FEFO and specific identification, scrap and subcontracting on production orders, material requirements planning, and the statement of cost of goods manufactured. The last part shows how Ledgeriano's inventory and cost accounting module records each step.

#At a glance: the rules that matter most

#What does IAS 2 count as the cost of inventory?

The cost of inventory is everything you spend to bring goods to their present location and condition: the purchase price, the cost of converting materials into products, and other directly attributable costs. Anything that does not add to the goods themselves goes straight to the income statement.

Two rules catch people out. Fixed overhead is absorbed on normal capacity: in a slow month you do not load the few units you made with the whole factory rent, and the unabsorbed part is an expense of the period. And inventory is carried at the lower of cost and net realisable value (estimated selling price minus the costs to complete and sell). When damaged, obsolete or discounted goods are worth less than their cost, you write them down and recognise the loss.

US GAAP (ASC 330) rests on the same ideas, with two differences worth knowing: it still allows LIFO, and it never lets a write-down be reversed, while IAS 2 reverses it when the value recovers. The examples below read the same way for a company in Dubai, Paris or Chicago.

#Which cost formulas does IAS 2 allow: FIFO, weighted average or standard cost?

When identical units are bought at different prices, a cost formula decides which price leaves the warehouse first. IAS 2 allows first-in, first-out (FIFO) and weighted average for interchangeable items. LIFO is not permitted.

• FIFO assumes the oldest units are used first, so closing stock is valued at the most recent prices.
• Weighted average values each issue at the average cost of the units on hand. A perpetual system recalculates the average after every receipt (moving average).
• Standard cost values receipts and issues at a predetermined cost per unit. IAS 2 accepts it as a measurement technique when the result is close to actual cost and the standards are reviewed regularly.

#Worked example: FIFO vs moving weighted average

A furniture maker buys and issues steel sheet during March. Amounts are in USD.

FIFO. The 10 March issue takes the whole first layer and part of the second: 100 × 10.00 + 50 × 11.50 = 1,575. That leaves 150 units at 11.50. The 25 March issue takes those 150 (1,725) plus 30 of the new units at 12.00 (360), so 2,085. Seventy units remain at 12.00, worth 840.

Moving weighted average. After the first two purchases there are 300 units costing 3,300, an average of 11.00. The 10 March issue costs 150 × 11.00 = 1,650 and leaves 150 units worth 1,650. The 20 March purchase brings the balance to 250 units and 2,850, an average of 11.40. The 25 March issue costs 180 × 11.40 = 2,052, leaving 70 units worth 798.

Both columns add up to the same 4,500; only the split changes. With rising prices, FIFO gives a lower cost of goods and a higher closing stock. When prices fall, the effect reverses. Pick one formula for items of a similar nature and use it consistently, because switching is a change in accounting policy. The FIFO vs weighted average guide compares the formulas over a full quarter, with periodic averages, LIFO under US GAAP, tax and ratio effects and net realisable value write-downs.

#Standard cost and the purchase price variance

With standard cost, the warehouse always moves at the standard. If steel sheet has a standard of 11.00 and you buy 100 units at 12.00, inventory is debited 1,100, the supplier (or goods received not invoiced) is credited 1,200, and the 100 difference goes to a purchase price variance account. Standard costing makes production planning and variance analysis easy, but the standards must be kept current or the balance sheet drifts away from real cost.

#Perpetual inventory: every stock movement is also a journal entry

In a perpetual system each receipt, issue and transfer updates quantities and values immediately, and the general ledger moves with it. That is what keeps the inventory account in the trial balance equal to the stock report.

Transfers between warehouses move cost from one location to another and usually need no journal entry when both use the same inventory account. Landed costs that arrive after the goods (freight, duty, insurance) are added to the units still on hand; the share that belongs to units already sold goes to cost of goods sold.

#Job order costing vs process costing: which one do you need?

Job order costing collects cost per order, batch or contract; process costing collects cost per department for a period and spreads it over the units that went through. The choice follows how the factory works, not personal preference.

Many factories use both: process costing for a continuous line, job order costing for special orders made on the side.

#Overhead absorption with a predetermined rate

Overhead cannot be traced to a single product, so it is absorbed with a predetermined overhead rate: budgeted overhead for the year divided by budgeted activity (labour hours, machine hours, labour cost or units). Using a rate set in advance lets you cost a job the day it finishes instead of waiting for the month's electricity bill.

If the assembly department budgets 600,000 of overhead and 20,000 direct labour hours, its rate is 600,000 ÷ 20,000 = 30 per labour hour.

#Worked example: costing a production order

Order PO-104 makes 200 dining tables in the assembly department.

The entries follow the cost as it moves through the factory:

#Under- and over-absorbed overhead

At the end of the period you compare actual overhead (rent, power, indirect labour, depreciation posted to the department) with applied overhead. Suppose all jobs in the month used 1,700 labour hours, so 51,000 was applied, while actual overhead was 54,000. Overhead is under-absorbed by 3,000. Had actual been lower than applied, it would be over-absorbed.

There are two accepted ways to clear the difference:

1. Write it off to cost of goods sold when it is small. Closing entry: debit overhead applied 51,000, debit cost of goods sold (or an overhead variance account) 3,000, credit overhead control 54,000.
2. Prorate it over work in progress, finished goods and cost of goods sold when it is material, so inventory carries a cost closer to actual. For illustration, with period-end balances of WIP 20,000, finished goods 30,000 and COGS 50,000, the 3,000 is split 600, 900 and 1,500.

Remember the IAS 2 rule from above: if the under-absorption comes from running well below normal capacity, the unabsorbed fixed overhead is a period expense and should not be pushed into inventory.

#Allocating service department costs

Maintenance, stores and the factory canteen serve production departments without making products themselves. Their costs are reallocated to production departments before rates are set or overhead is closed:

• Direct method: each service department allocates only to production departments and ignores services provided to other service departments.
• Step-down method: service departments are closed one by one, usually starting with the one that serves the most others, and a closed department receives nothing back.
• Reciprocal method: solves simultaneous equations so each service department's total includes its share of the others, then allocates everything to production. It is the most accurate when services serve each other heavily.

#Production variances on a job

When a job has standards (from its bill of materials and routing), comparing standard with actual tells you where the money went:

Here the tables used 100 kg more steel than the bill of materials allows and took 20 extra hours: both point at the same problem on the shop floor. At department level, overhead is often split further into a three-variance analysis: spending (actual against the budget for the hours worked), efficiency (hours worked against standard hours) and volume (fixed overhead absorbed against budget, caused by output above or below normal capacity).

#Process costing and equivalent units

Process costing turns partly finished units into equivalent units: 1,000 units that are 40% converted count as 400 equivalent units of conversion cost. Materials and conversion (labour plus overhead) are counted separately because they are added at different points.

#Worked example: weighted average method

The mixing department of a paint factory reports for April:

Weighted average equivalent units are units completed plus the equivalent units in closing WIP:

• Materials: 16,000 + 4,000 × 100% = 20,000. Cost per unit = (9,000 + 81,000) ÷ 20,000 = 4.50
• Conversion: 16,000 + 4,000 × 50% = 18,000. Cost per unit = (3,200 + 68,800) ÷ 18,000 = 4.00

The 162,000 equals opening WIP (12,200) plus costs added (149,800), which is the check every production cost report must pass.

#The FIFO method

FIFO keeps last month's cost separate and only measures this month's work: the work needed to finish opening WIP, plus units started and completed, plus closing WIP. Here that is 0 + 14,000 + 4,000 = 18,000 equivalent units for materials and 2,000 × 60% + 14,000 + 2,000 = 17,200 for conversion. The current-period costs give 81,000 ÷ 18,000 = 4.50 and 68,800 ÷ 17,200 = 4.00, the same rates as last month, so both methods agree in this example. When unit costs change from one month to the next, FIFO shows the current month's efficiency more clearly.

#Spoilage, joint products and by-products

• Normal spoilage is the loss you expect from a healthy process. Its cost stays in the cost of the good units.
• Abnormal spoilage is anything above that. It is costed like good units and written off as a loss of the period, which IAS 2 requires.
• Joint products come out of one process together, like cream and skimmed milk. The joint cost up to the split-off point is shared by physical units, by sales value at split-off or by net realisable value. If a run of 90,000 produces 6,000 kg of product A (sales value 120,000) and 4,000 kg of product B (sales value 60,000), physical units give A 54,000 and B 36,000, while sales value gives A 60,000 and B 30,000.
• By-products have a small value compared with the main products. Their net realisable value is usually deducted from the joint cost before it is shared.

When one department hands its output to the next, the cost travels with it as transferred-in cost, which the next department treats like materials added at the start of its process.

#Lot and serial tracking: FEFO, specific identification and traceability

Lot tracking records which batch every unit came from, and serial tracking does the same for single units. You need it when goods expire (food, medicines, chemicals), when a recall has to reach the right customers, or when each unit has its own cost (machinery, vehicles, jewellery).

A lot (or batch) groups units made or received together, with a manufacturing date and usually an expiry date. A serial number identifies exactly one unit. Every receipt creates a lot or adds to one, and every issue records which lots it consumed, so the stock of each lot is known in each warehouse.

#FEFO: first expired, first out

FEFO issues the lot with the earliest expiry date first, whatever its arrival date. It is a picking rule, not a cost formula: you can value stock with FIFO or weighted average and still pick by expiry.

A dairy distributor holds three lots of yoghurt on 10 May:

A delivery of 450 cartons takes all 300 of L-302 (earliest expiry) and 150 of L-301, leaving 50 of L-301 and all of L-303. Picking by arrival date would have shipped L-301 first and left L-302 to expire in the warehouse six days later. Expired lots should never reach a customer; they go to a write-off or back to the supplier.

#Specific identification

IAS 2.23 requires specific identification for items that are not ordinarily interchangeable and for goods made for specific projects: each unit or lot carries its own actual cost. If a dealer buys three generators for 4,100, 4,350 and 4,600 and sells the second, cost of sales is exactly 4,350, where FIFO would have charged 4,100. For ordinary interchangeable stock specific identification is not appropriate, because choosing which unit to ship would let you choose the profit.

#Traceability, backward and forward

Lot genealogy links each production order's material issues to the finished lots it produced. A backward trace answers "which supplier lots went into finished lot FG-118?". A forward trace answers the recall question: "the supplier reports a problem with milk powder lot MP-77; which orders, finished lots and customers received it?". With that link a recall reaches a handful of customers instead of all of them.

#Scrap, subcontracting and other direct costs

Normal scrap is the loss a healthy process always has. Its cost stays in work in progress and raises the cost of the good units. Abnormal scrap is anything beyond that; IAS 2 does not allow it in inventory, so it is moved out of WIP to a loss account at its cost.

Back at order PO-104, a machine fault ruins 4 table frames. The standard cost of a table is 189.50 (17,000 of materials, 9,500 of labour and 11,400 of overhead for 200 tables), so the abnormal loss is 4 × 189.50 = 758: debit abnormal spoilage loss 758, credit work in progress 758. Normal scrap needs no entry; the order simply delivers fewer good units for the same cost.

Some costs belong to an order without being materials or in-house labour: an outside workshop that powder-coats the frames, a design fee, special tooling. Charge them straight to the order as direct expenses. If the coater invoices 200 frames at 6.00, the entry is debit work in progress 1,200, credit the supplier 1,200, and the job cost sheet shows the 1,200 as its own line. In process costing these costs are treated as conversion costs.

#What is material requirements planning (MRP)?

Material requirements planning works backwards from what you plan to make to what you must buy: it explodes the bills of materials level by level into gross requirements, subtracts what is on hand and what has already been issued to open orders, and what is left is the net requirement.

The furniture maker has order PO-104 open (200 tables, materials already issued) and plans 300 more tables. Each table needs 8.5 kg of steel sheet, one oak top and 16 screws.

Net requirements become purchase suggestions, usually rounded up to the reorder point or the maximum stock level you set for the item. The same plan also gives a capacity load: if assembly needs 2 hours a table, 300 tables add 600 hours, which you compare with the department's normal capacity before promising delivery dates.

#Statement of cost of goods manufactured and sold

The statement of cost of goods manufactured (COGM) explains how the manufacturing costs of a period turn into finished goods and then into cost of goods sold. Here is the furniture maker's month from the overhead example, with the 3,000 of under-absorbed overhead written off to cost of goods sold:

The last figure is the cost of sales line on the income statement. If materials, WIP and finished goods are kept in separate accounts, the statement can be produced straight from the ledger.

#How Ledgeriano handles inventory and cost accounting

Ledgeriano's inventory and cost accounting module sits on the same double-entry ledger as the rest of the books. It is switched on per business in the settings, and when you enable it the module maps the inventory, WIP, finished goods, cost of goods sold and variance accounts in your chart of accounts, creating any that are missing.

Stock. Items are valued with FIFO, moving weighted average or standard cost, per item and per warehouse, and items tracked by lot or serial number can use specific identification. Purchase receipts, returns, issues, deliveries (with optional revenue lines), transfers, adjustments, landed costs and write-downs to net realisable value are all stock documents, and physical stock counts create the adjustment for you. Movements are posted in strict date order per item and warehouse, and stock cannot go negative, so FIFO layers and averages are always reproducible.

Ledger. Every posted stock or production document creates a balanced journal entry automatically. These entries cannot be edited by hand; you cancel the document that created them, and a reconciliation report proves that the stock ledger agrees with the general ledger. Inventory reports include stock on hand, the item card (kardex), a movement summary, stock ageing and a reorder list.

Manufacturing. Bills of materials carry scrap percentages and operations, and roll up to a standard cost. Production orders follow job order costing: issue materials, record direct labour, apply overhead with predetermined rates (labour hours, machine hours, labour cost or units), receive output at standard or actual cost, and close the order with its production variances. The job cost sheet shows material usage and price, labour rate and efficiency, and overhead variances.

Lots, serials and planning. Items can be tracked by lot or by serial number, with a shelf life that sets each new lot's expiry date. Outbound documents use the lots you pick or allocate them automatically by FEFO, and deliveries skip expired lots. Reports show lot balances with expiry dates, lots expiring soon, backward and forward lot traces and the history of each serial number. Production orders record normal and abnormal scrap, and direct costs such as subcontracting are charged to an order or a department. The MRP report explodes multi-level bills of materials for open orders and an optional production plan, nets them against stock and suggests what to reorder, and a capacity load report compares required hours with each production cost center's normal capacity.

Period end. Service department overhead is allocated with the direct, step-down or reciprocal method, and overhead closing sends under- or over-applied overhead to cost of goods sold or prorates it. Process costing runs compute equivalent units with the weighted average or FIFO method, including transferred-in costs, normal and abnormal spoilage, joint products (physical units, sales value or NRV) and by-products. Reports cover the statement of cost of goods manufactured and sold, the three-variance overhead analysis and product profitability.

Everything is available in the dashboard and through the accounting API, including webhooks such as stock_document.posted. The features page has the full overview, and the glossary defines the terms used here. Budgets, break-even and contribution reporting built on these costs are covered in the management accounting guide, with deeper walk-throughs of budget vs actual variance analysis and break-even analysis.

#Common inventory and costing mistakes

1. Absorbing idle capacity into stock. Fixed overhead belongs in inventory only up to normal capacity.
2. Ignoring net realisable value. Slow-moving and damaged stock must be tested and written down.
3. Changing cost formulas casually. Moving from FIFO to average is a change in accounting policy with disclosure and comparatives.
4. Leaving under- or over-absorbed overhead open. It distorts monthly margins until it is closed or prorated.
5. Posting back-dated receipts. In a perpetual system a late receipt changes the cost of every later issue; post in date order or correct with an adjustment.
6. Letting stock and ledger drift apart. Manual journal entries to inventory accounts break the link with the stock report. Reconcile monthly as part of the month-end close checklist.
7. Leaving abnormal scrap in work in progress. It inflates the cost of good units; move it to a loss account when it happens.