Guide to Inventory Costing Methods in Manufacturing

Two manufacturers build the same product. They sell it for the same price, ship the same volume and even use the same materials. But at the end of the quarter, one reports a gross margin 10% higher than the other. The difference? Inventory costing.

In manufacturing, how you account for inventory impacts profitability, tax exposure and even how your business is valued. From rising input costs to supply chain disruptions, manufacturers need to understand which costing methods support smarter decisions and better margins.

Let’s walk through the core inventory costing methods, when to use them and how to make sure they support your long-term strategy.

 

 

Understanding the true cost of your inventory

In manufacturing, inventory costing plays a critical role in financial reporting, budgeting, pricing, cash flow planning and tax compliance. The way you assign costs to inventory shapes the financial picture of your business.

Inventory is typically split into three categories:

• Raw materials
• Work in progress (WIP)
• Finished goods

Each stage adds value and incurs costs. The key question is how to assign those costs to individual units of inventory in a way that is both accurate and defensible.

According to the Financial Accounting Standards Board (FASB), manufacturers must use a consistent method of inventory valuation under Generally Accepted Accounting Principles (GAAP). This includes direct costs like materials and labor, as well as allocated overhead such as depreciation, utilities and factory supervision.

Done correctly, inventory costing enables meaningful comparisons across reporting periods and supports better forecasting. Done poorly, it can distort your cost of goods sold (COGS), understate your margins or even put you out of compliance.

Let’s say raw material prices rise sharply in Q1. If you use a method that doesn’t account for that increase quickly, your reported profitability could appear artificially high. That might look good on paper until your cash flow tightens and your margins shrink in real life.

On the other hand, strategic use of inventory costing methods can help reduce taxable income or stabilize gross margin in periods of volatility. But that only works if you’re using a method that reflects the realities of your production flow and pricing environment.

Common inventory costing methods explained

Inventory costing methods help determine how product costs move through your books. Each method assigns value to inventory in different ways, impacting your cost of goods sold (COGS), profit margins and taxable income. Here are the four most commonly used inventory costing methods in manufacturing.

FIFO (First-In, First-Out)

Under FIFO, the oldest inventory costs are assigned to COGS first. In other words, the first materials you purchase are the first ones recorded as sold. This method aligns well with physical flow in many manufacturing environments and tends to reflect higher profits when prices are rising. However, it can result in higher taxes in inflationary periods since older, lower costs are being used in COGS.

LIFO (Last-In, First-Out)

LIFO assumes that the most recent inventory purchases are the first to be sold. This can lower your taxable income during inflation because newer, higher costs are applied to COGS. But LIFO is not permitted under IFRS (International Financial Reporting Standards), and using it may complicate financial reporting if your company operates internationally. In times of declining material costs, it can also inflate your profit margins.

Weighted Average Cost

The weighted average method smooths out price fluctuations by averaging the cost of all inventory units available for sale during the period. Each unit sold or remaining in inventory carries the same average cost. This method is straightforward and easy to automate within most ERP systems. It’s especially useful when inventory is fungible or when prices fluctuate often but not significantly.

Specific Identification

This method tracks the exact cost of each item or batch of inventory, assigning those costs directly when the item is sold. While it offers the most accuracy, it’s only practical in environments with low-volume, high-value products like aircraft components or specialized machinery. It’s rarely used for high-volume manufacturing due to the administrative burden.

Each method presents a different financial picture, even when the underlying operations remain the same. Manufacturers should choose a method that not only satisfies accounting requirements but also supports business goals, cash flow predictability and pricing strategy.

To learn more about how each of these methods impacts reporting under federal guidelines, refer to the IRS overview on inventory valuation.

Choosing the best method for your manufacturing business

There’s no single “best” costing method for all manufacturers. The right approach depends on your business model, product type, input cost volatility and even your financing needs.

For example, if your raw materials experience frequent price increases, FIFO will show higher profits and stronger balance sheets. That may help with investor or lender reporting but could increase your tax liability. On the flip side, LIFO could reduce tax exposure during inflation but may not reflect the true economic value of your inventory.

Weighted average costing is often the method of choice for manufacturers with a high volume of uniform products and limited price variation. It’s consistent and reduces administrative effort while still aligning with GAAP.

If you manufacture custom products or run a job shop, specific identification may give you the accuracy needed to analyze project-level margins. But the additional work involved in tracking and applying costs might outweigh the benefits unless your average order value is high.

Additionally, your business’s growth stage matters. If you’re planning to raise capital or seek financing, a method that improves your financial ratios could work in your favor. If you’re optimizing for tax savings in the near term, the opposite may be true.

Once you choose a method for GAAP purposes, consistency is expected. Changing methods later requires justification and approval from your CPA, along with retroactive adjustments. This is where guidance from an experienced financial advisor becomes critical.

 

 

Comparing standard costing vs. actual costing

While inventory costing methods help assign value to materials and goods, the way you track production costs internally is just as important. That’s where standard and actual costing come into play. Understanding the difference between the two can strengthen your ability to manage margins, price jobs correctly and spot inefficiencies early.

Standard costing involves assigning predetermined costs for materials, labor and overhead. These costs are based on historical data, estimates and expectations. Standard costing simplifies reporting and provides a stable baseline to measure performance against. Most manufacturers use it for internal budgeting, variance analysis and pricing decisions.

For example, let’s say your standard labor cost per unit is $25. If the actual cost rises to $30 due to overtime or inefficiencies, you can quickly identify and investigate the variance. This makes standard costing a valuable management tool for manufacturers with repetitive production cycles and predictable workflows.

Actual costing tracks the real costs incurred for each unit or batch produced. This includes actual material purchases, labor time and overhead allocation. While it provides a more accurate reflection of your cost of goods sold, it requires more detailed tracking and is often more complex to maintain.

For high-mix, low-volume manufacturers, actual costing can provide the transparency needed to understand job-level profitability. However, it can also create volatility in reported earnings if raw material prices or labor costs change frequently.

Both methods are accepted under GAAP, but many manufacturers use a hybrid approach. For example, they might use standard costing during the period and adjust to actuals at month-end or year-end to align with financial reporting.

Choosing the right approach depends on your production model, data systems and decision-making needs. A modern ERP system can support both methods and provide the reporting needed for each. But selecting and implementing the right costing approach requires a deep understanding of your operational realities.

Common costing mistakes manufacturers make (and how to avoid them)

Even the most sophisticated manufacturers can fall into traps when it comes to inventory and cost accounting. These missteps can skew financial reporting, reduce profit margins or even trigger compliance issues during audits. Here are some of the most common pitfalls we’ve seen and how to avoid them.

Failing to update standard costs regularly

Standard costs should reflect current market realities. If raw material prices or labor rates have changed but your standards haven’t been updated, you’re working with outdated assumptions. This leads to inaccurate pricing and distorted variances.

Overlooking overhead allocation

Many manufacturers underestimate the importance of properly assigning overhead costs to inventory. Indirect expenses like equipment depreciation, utilities and supervisory labor must be allocated in a way that aligns with production volume. Ignoring this step results in underreported inventory value and overstated gross margins.

Misclassifying scrap and rework

Manufacturing waste, rework and scrap are a reality in many operations. But if you’re not separating and accounting for these properly, they can mask inefficiencies and inflate production costs. Scrap should be tracked, valued and removed from inventory accurately.

Relying too heavily on spreadsheets

Spreadsheets can be useful, but they’re prone to errors and lack the controls of integrated accounting systems. Manual entries increase the risk of inaccuracies and make it harder to audit or trace changes over time. A robust ERP system can help reduce errors and improve costing accuracy.

Skipping physical inventory counts

Even with solid costing systems in place, actual physical counts are essential. Reconciliations ensure that what’s recorded matches what’s on the shelves. Discrepancies can indicate theft, spoilage or incorrectly recorded transactions that need to be addressed immediately.

Why inventory costing strategy matters more in today’s market

Manufacturers today are navigating slimmer margins, higher interest rates and rising material costs. Your inventory costing method actively shapes your pricing, profit reporting and ability to grow. This is especially true for manufacturers managing multi-tier supply chains, multi-state operations or seasonal production swings.

Cost visibility is a must. When input costs spike, you need to know if your margin decline is real or simply an artifact of outdated costing assumptions. Likewise, when your financials are under review by investors or lenders, you want your inventory and COGS figures to hold up under scrutiny.

Even small adjustments can have large ripple effects. For example, imagine you’re a plastics manufacturer switching from FIFO to weighted average costing during a time of sharp material price increases. That could let you defer a large amount of taxable income without compromising your operational insights.

Or let’s say you’re an equipment manufacturer who implemented standard costing for parts assembly and saw improved production planning due to real-time variance reports. That insight would help you make informed purchasing decisions and reduce downtime due to stockouts.

For a detailed explanation of federal inventory requirements and COGS rules, refer to the IRS guidance on accounting methods.

Which inventory costing method is best for manufacturers in 2025?

Inventory costing is more than a technical choice. It’s a strategic decision that affects your entire business. Whether you’re looking to reduce taxes, improve pricing accuracy or align with GAAP, the right method can support smarter financial planning and stronger growth. And the best method for your business depends on your products, your processes and your goals.

If you’re unsure whether your current approach is helping or hurting your margins, it might be time for a deeper review. Let’s talk.

Contact a James Moore professional to explore how we can help you build a stronger, more strategic inventory costing system that supports your growth.

 

 

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