Introduction
One of the most important decisions for manufacturing firms to make when implementing NetSuite is the costing method to use.
Once you set the costing method of an item, you can not change it. You must delete the item and recreate it which can be challenging if you have already have transaction history.
- Average Costs
- Standard Costs
- LIFO
- FIFO
Each come with their own benefits and drawbacks.
Average Costs
Average costs work by taking a moving average of the inventory currently in stock. When inventory is added to the system, the average cost is updated in proportion to how much you currently have in inventory.
Suppose you buy 100 of an item for $100 each. Then the average cost will be $100. Now suppose you buy another 50 for $75. The average cost will be \(\frac{100 * $100 + 50*$75}{100 + 50} = $91.66\).
Now if you use or sell 20, the rate on the transaction will be $91.66 and the total will be $91.66 * 20 = $1833.33.
We now have 130 of the item at $91.66 each.
If receive another 50 at $80 each NetSuite will calculate the new average as follows: \(\frac{130 * 91.66 + 50*80}{130+50} = 88.42\)
The costing engine doesn’t run after every transaction. It runs every hour or based on a custom schedule.
Standard Costs
Standard costs work by assigning a fixed price to each item. This price has to be set manually, although tools such as NetSuite’s cost rollup can help simplify this process.
When a transaction posts a line item, the price is set to the standard cost. Then NetSuite will post the difference in the actual cost to a variance account. This variance account is set in the item record.
When revaluing inventory and changing the standard cost of an item, a variance account will be posted with the difference of the new standard cost * the quantity in inventory.
So I have 100 of an item at $100 and I want to change the standard cost to $120, a variance account will be posted with $20 * 100 = 2000. This variance account is set when revaluing inventory.
LIFO and FIFO
LIFO and FIFO are inventory costing methods that depend on the sequence in which items are added to the system. Consider having 100 items at $100 each and purchasing an additional 50 items at $120 each.
When using 20 items, the LIFO method values them at $120 each, resulting in a total cost of $2,400. This is because the $120 items were Last In and are therefore First Out.
In contrast, the FIFO method values them at $100 each, totaling $2,000. This is because the $100 items were First In and are therefore First Out.
When using another 40 items, the LIFO method values the first 30 items at $120 each, totaling $3,600. The remaining 10 items are valued at $100 each, as the inventory purchased at $120 has been used up, resulting in another $1,000 cost and a combined total of $4,600.
With the FIFO method, all 40 items are valued at $100 each, since the initial purchase of 100 items was at that price, so we have enough inventory at $100, leading to a total cost of $4,000.
Full Example
Suppose I buy 20 of an item at $100 each on Monday. I buy 10 more on Tuesday at $120 each. I sell 15 on Wednesday at $110 each.
Here is the value of the inventory on Thursday:
| Method | Value |
|---|---|
| Average | \(\frac{20 * 100 + 10 * 120}{30} = $106.66\)1 |
| LIFO | $100 (All the $120 dollar items were sold as they were Last In) |
| FIFO | $120 (All the $100 dollar items were sold as they were First In) |
| Standard | $105 (Whatever the standard cost is set to)2 |
Drawbacks of Costing methods
Standard costs have a high maintenance cost associated with them. Managing the standard cost of all your items can be challenging. Also, you have to create, configure and track multiple variance accounts for each item.
Average costs are easier to manage but can cause issues if you have mistakes in your transactions. If you have a mistake in the rate of one transaction, you will have mistakes on future transactions that use the same item. If you close the period when you have such a mistake it can get very hairy trying to untangle the mess.
LIFO and FIFO are straightforward, but it is important to make sure it matches your business process. With LIFO, you can have inventory last a long time, if we buy 20 of an item at $100, after which we keep buying more at $120, as long as we maintain a minimum of 20 in inventory, we will always use the $120 rate.
Conclusion
If you are a consultant, some of these decisions are out of your hands. Make sure you have a good grasp of the different costing methods and how they work. It’s possible (if not using standard costing) that you will be able to simply set the costing method and forget about it. But if you don’t understand how it works, you might have a hard time explaining different GL lines to your client.
For more information on NetSuite, check out my other posts on the blog. Feel free to leave a comment below if you have any questions or suggestions.
It doesn’t matter if some of the items were sold, the average cost is still the same, although when new inventory is added, the average cost will be updated with only 5 item. ↩
A purchase price variance will be posted with the difference between the standard cost and the actual cost for the two purchase transactions. ↩