A Quick Guide to Costing Method Types and NetSuite Accounting Software

NetSuite accommodates several different costing methods, so a customer can choose what works best for their business. But each one has its pros and cons.



LIFO

The opposite of FIFO, the “Last In, First Out” costing method calculates the COGS, starting with the cost of the most recently purchased item and working backward. Note that the International Financial Reporting Standards (IFRS) don’t endorse this method. You can only use it under the United States’ Generally Accepted Accounting Principles (GAAP). 

Many companies choose this method because costs increase in a typical inflationary environment, leading to a higher cost of goods and lower profit per item sold. This, in turn, lowers the tax burden as net income reduces.

Example: On day one, you purchase 10 widgets for $5. On day two, you purchase 10 more for $6. On day three, you sell 15 widgets. The COGS for the first 10 widgets will be $6, and the COGS of the remaining five will be $5.

Pros

• Compares recent costs to current revenues, improving the quality and reliability of earnings. 
• Decreases the likelihood that a price decline will affect net income. 
• Alleviates profit  overstatement and, thus, lowers the amount of income tax owed.

Cons

• Drops reported earnings during inflation.
• Allows for easy earnings manipulation.
• Allows the working capital position to look worse than it is because this method understates inventory.
• Can encourage poor buying habits since companies must buy goods in large quantities to avoid reported income inflation and higher tax payments. 

Average Costing

Average costing, also known as weighted average costing, calculates the COGS by totaling the cost of all inventoried items and dividing it by the total quantity. This costing method helps mitigate the effects of price fluctuation by incorporating the costs of older inventory into that of newer merchandise.

Example: On day one, you purchase 10 widgets for $5. On day two, you buy 10 more for $6. Your average widget cost is now $5.50. On day three, you sell 15 widgets for $10 each. Your COGS for each item would be $5.50.

Pros

• Simplifies calculation and record-keeping.
• Easily processes high volumes of inventory orders.
• Requires little to maintain inventory costs or calculate COGS for sales.
• Doesn’t require ongoing maintenance costs.
• Allows users to run ad-hoc or scheduled searches to find data or produce inventory cost reports.
• Widely accepted and permitted by several accounting standards.
• Useful when you can’t tell one batch of goods from another since all cost is averaged.
• Can produce data that NetSuite accounting software automatically converts into various currencies.

Cons

• May produce ending inventory cost that significantly differs from prevailing prices at a certain date, thus hampering decision-making.
• May use a rounding process for long decimals that can distort gross profit and current asset figures for large transaction volumes.
• Can cause frequent price changes if you’re using a cost-plus-pricing strategy.
• Makes it challenging to determine an item’s value since all goods lose their identity during averaging. This can cause problems when a unit’s age factors into the pricing.
• Can still be affected by cost fluctuations if you buy large quantities at the start or end of a period, particularly if the cost of those purchased goods varies significantly from the rest of the period.

Standard Costing

Standard is the traditional costing method for manufacturers. It bases the COGS on a predetermined, estimated cost for each inventory item. And when actual costs differ from the estimate, the difference is captured in a variance account. Eventually, the company must reconcile that account to get an accurate idea of its current inventory value.

Example: A widget is composed of two components, part A and part B. At the beginning of the year, you estimate part A will cost $2 and part B will cost $3. So, the estimated cost of a widget is $5. Therefore, the COGS for the product will be $5. 

However, after three months, data shows the actual cost of part A is $4. A variance account will capture the difference in actual cost versus expected cost. So, your COGS would remain $5, and you would also have a variance account for part A, debited $2. After an inventory reconciliation, you would account for the debit in the variance account and add it to the inventory cost of part A, making it $4 and the cost of the widget $7.

Pros

• Can be compared with actual cost to measure efficiency.
• Can measure employee productivity and efficiency, depending on positive or negative variances.
• Fixes standards for specific activities, encouraging employee efficiency.
• Helps estimate production costs when the actual production cost isn’t known.
• Allows management to control production and make decisions about cost elements, like wages and material purchases.
• Emphasizes cost-effectiveness and quality, improving production.
• Identifies waste in the production process.
• Helps accurately estimate the cost of new products. 

Cons

• Uses standards that are difficult to determine, and incorrect standards can cause losses.
• Uses standards that must be revised periodically to reflect current marketing conditions, technology, and consumer habits.
• Requires specialists and experts to set standards.
• Expensive to use since standards must be carefully researched and analyzed.
• Only viable when you use budgetary techniques.
• Only suits companies with uniform production and set quality.
• Requires three steps for every inventory item entered with NetSuite accounting software.
• Can become frustrating since NetSuite accounting software doesn’t allow any actions until you set a predetermined standard on an item bracket. This includes transaction processing and receiving an item against a purchase order. 
• Tedious for users with inventory in tens or hundreds of thousands.
• Requires that you perform a standard cost rollup with NetSuite accounting software to update the assembly cost (process shown later in the post).
• Requires that you revaluate standard cost inventory in NetSuite to calculate an updated inventory cost (process shown later in the post).
• Can take hours or days to complete in NetSuite if you have an extensive inventory. This can cause a lag in data accuracy.
• Can only be done using a single currency at a time, creating difficulties for multinational corporations.



Note: Standard costing requires nearly perfect data to work properly. However, companies without flawless data can use a custom field in NetSuite that mimics standard cost functionality.

Serialized Costing

With this costing method, an ERP accounting system can track each part or item individually using unique serial numbers. If the parts are used in a project, the COGS for the project will reflect the exact sum of every individual part used. 

Example: Widget 001 was built containing part A ($3), part B ($4), and part C ($5). The total COGS is $12.

Pros

• Highly accurate since you can record exact costs in inventory records.
• Offers greater accuracy with gross profitability since an item’s actual cost is used for the COGS when the serialized item is sold.

Cons

• Tedious for any business with a large inventory.
• Can only be used with lot/serialized item types.
• Can’t be used to track all items in a company’s system because not all have unique lot/serial numbers.
• Restricted to specialized items and businesses involved in equipment, cars, etc.

Selecting Costing Methods with NetSuite Accounting Software

Select a costing method when creating an item. You can find the Costing Method dropdown menu under the Purchasing/Inventory subtab. 

By default, standard costing won’t be enabled in NetSuite. To enable it, navigate to Setup > Company > Enable Features. 



Then, click on the Items & Inventory subtab.



Scroll down to the Inventory section and check Standard Costing. Then, click Save.

Now, standard costing will be available from the Costing Method dropdown.

Performing a Standard Cost Rollup in NetSuite

Navigate to Lists > Accounting > Planned Standard Cost Rollup.



Performing a Revaluation of Standard Cost Inventory in NetSuite

Navigate to Lists > Accounting > Revalue Standard Cost Inventory.

A costing method can determine whether your business experiences profits or losses, so pick the right one. SuiteDynamics consultants and financial advisors can help determine which will serve your business best in the market and in NetSuite. Call today and let us know how we can help.