Inventory Costing Methods in Business Central: Which One to Choose

Alfredo Iorio
22 hours ago
8 min read

Choosing the right inventory costing method in Business Central is a decision that will influence how the system calculates the cost of sales and gross margin of transactions that include inventory items.

Most of the BC clients I have helped since I started working as a consultant approached costing methods as a simple configuration problem, delegating the choice to the finance team.

While the finance team plays a vital role in choosing the correct costing methods in Business Central, the decision also affects other areas of the system, including how the system calculates expected and actual costs when items are purchased, assembled or manufactured.

Why is the costing method one of the most consequential setup decisions in Business Central

The costing method determines how the value of physical products flows from receipt through to shipments. In the General Ledger, and for accounting purposes, this means tracing the value of inventory as an asset all the way down to when it becomes cost of goods sold.

Inventory costing methods are not limited to purchases and sales, but apply more broadly to inventory increase and decrease (or Inbound and Outbound). That means the same principles apply to manufacturing, where items are consumed and produced.

Choosing one costing method or another will change how the system calculates inventory valuation, standard cost variance and gross margins. In addition to affecting the company's books, profitability, and the tax bill, inventory costing methods are a key element of analysing the organisation's performance.

One of the most common mistakes made with new BC implementations is to assume that costing methods must be chosen based on data analysis, such as scrap or variance, but this is not a good way to address this problem. Business Central stores inventory costing details on various ledgers, such as item ledger entries and value entries. These ledgers store all the costing elements of inventory transactions, and any report or analysis should be based on these.

Costing methods determine the logic used to calculate the value of such transactions, but do not add more information to what the system will produce.

How Business Central calculates item cost: the basics

Business Central registers inventory costs to the Item Ledger Entry via Value Entry. Costs can be of two types: expected or actual.

Expected costs are for receipts or shipments not yet invoiced. Once the invoice is posted, the expected costs are reversed, and the actual costs are posted. The costing method controls how the unit cost on each Value Entry is calculated.

Before Business Central can calculate and apply expected costs to receipts and shipments, a temporary cost is applied to sales, purchases and production orders that acts as a placeholder. The Cost Adjustment batch job ensures that every time an item cost is updated, for example, when a purchase invoice is posted, the placeholder value on open orders is also updated.

The actual costs are always posted to the general ledger, but posting the expected costs is optional. If you want to post expected costs, you must enable Expected Costs Posting.

FIFO (First In, First Out)

With FIFO, costs are calculated assuming the oldest inventory item - received or produced - is shipped or consumed first.

On receipt or output, FIFO items are valued using the actual cost. For items purchased, it's the purchase price. For items produced, FIFO updates the actual costs of production to the finished items.

When items are shipped or consumed, the rules work on the typical flow of physical items: goods that arrived first are the first to go out. The remaining inventory consists of the most recently purchased or produced items.

The cost of what is shipped is as important as the cost of the inventory left. For example, A company purchases the same items at two different prices over ten days. The unit cost of the first order of 100 pieces is £10, and the second order is for 150 pieces at £12 per unit.

Date	Transaction	Quantity	Unit Cost	Total Cost
March 1	Purchase	100	£10	£1,000
March 10	Purchase	150	£12	£1,800
March 20	Sale	200	-£11	-£2,200

Before shipping a customer order, FIFO values inventory as a weighted average; the company's balance sheet shows £2,800.

When 200 units are shipped, the first 100 units are costed at £10. The remaining 100 at £12. Total cost of goods sold is £2,200. Ending inventory is £600.

For credit controllers: During inflationary periods, FIFO results in higher profits because older/ cheaper inventory is used first. Higher profits result in higher taxable income. This is why companies that trade volatile inventory don't choose FIFO because profitability can vary significantly as prices change.

Ending inventory is valued at the most recent price, which makes the balance sheet more accurate.

FIFO is accepted under IFRS, UK and US GAAP.

Average Cost

The average costing method in BC is a weighted average, and it is the only method with global settings that applies to all items.

On the inventory setup page, users define the weighted average cost calculation by choosing to calculate the average by item, item and variant or item, variant and location. There is also an option to define the average periods that can go from days to the whole accounting period.

The choice between averaging inventory costs by day or year can make a drastic difference in the system's performance, but it will also affect inventory valuation. The longer the period, the slower the system. Business Central uses a moving average version of this costing method, where costs are updated after every purchase.

Back to our previous example: same items and same purchase price, but this time we use the average costing method.

Date	Transaction	Quantity	Unit Cost	Total Cost
March 1	Purchase	100	£10	£1,000
March 10	Purchase	150	£12	£1,800
March 20	Sale	200	-£11.20	-£2,240

Before shipping a customer order, Averge values inventory as a weighted average; the company's balance sheet shows £2,800, just like FIFO.

The difference this time is about the cost of the 200 units shipped. The weighted average after 10th March is £2,800 / 250 = £11.20 per unit.

When 200 units are shipped, the cost of the 200 units will be £2,240 (200* 11.20). The value of the remaining inventory will be 50*11.20 = £560.

The same transaction compared shows that when the inventory price goes up, the weighted average results in lower gross margins, assuming the selling price remains the same.

Item	FIFO	Weighted Average
Cost of Goods Sold	£2,200	£2,240
Ending Inventory	£600	£560
Gross Profit*	Higher	Medium

Average costing smoothes out price fluctuations, and it's preferred by companies where product batches are indistinguishable. Ending inventory does not reflect recent price changes, which can hide trends in purchase prices or material and capacity variance in manufacturing.

LIFO

Last-In-First-Out is the opposite of FIFO. Though it is generally available in BC, this method is not allowed under IFRS, and it's limited to specific jurisdictions.

Specific Cost

The specific costing method in Business Central works only with serial tracking, and it uses the actual cost of the item. This is the most precise inventory costing method.

When the item is received or produced, specific costing uses the actual cost of the item. For inventory valuation, the specific costing method works like a moving average. When the item is shipped or consumed, the link between the serial number and the specific cost will be maintained.

I explain item tracking, including lot and serial numbers in this other post: https://www.d365training.com/post/the-complete-guide-to-lot-numbers

Using an example similar to the previous, let's see how the specific costing method works.

Date	Transaction	Quantity	SN	Unit Cost
March 1	Purchase	1	SN001	£5,500
March 10	Purchase	1	SN002	£5,650
March 20	Sale	1	SN002	-£5,560

The specific method is similar to FIFO, but it makes costing follow the exact flow of goods using serial numbers.

This method is widely used by companies that sell or produce unique or high-value items, for example, custom-built furniture and machinery, high-end electronics, artwork and antiques, jewellery and luxury items.

Standard Cost

Widely used in manufacturing, the standard costing method is a method on its own.

Here, a predetermined cost that represents the best-case scenario for inventory cost is set on the item card; any difference between the standard and actual costs at the point of receipt or production output goes to dedicated variance accounts.

More about inventory posting here: https://www.d365training.com/post/understand-inventory-posting.

When items are received or produced, the standard costing method acts as a budget which is compared to the actual cost of the item purchased or produced. When the item is shipped, the variance is irrelevant, and only the standard cost will be used as the cost of sales.

Our example using the standard costing method shows how this method keeps inventory valuation and cost of sales stable.

Date	Transaction	Quantity	Unit Cost	Standard Cost	Total Cost
March 1	Purchase	100	£10	£11	£1,100
March 10	Purchase	150	£12	£11	£1,650
March 20	Sale	200	-£11	£11	-£2,200

Ending inventory and cost of sales do not change until the standard cost is updated.

The main benefit of using this method is that the variance related to purchase or manufacturing is realised when the items are received or produced, not when sold. This gives organisations a sense of what causes the difference between actual and expected costs before inventory is sold.

Choosing the right method

Most content available online, including from Microsoft, explains that choosing the right costing method depends on the company type and the type of products, but that is not the whole truth. In fact, it can be misleading.

In general terms, Average is preferred in wholesale and distribution; FIFO is preferred in retail and for perishable goods, Standard is preferred in manufacturing, and asset-heavy companies prefer Specific.

However, the ultimate decision is for the credit controller, CFOs and sometimes even for the financial auditor; but, it is restricted by accounting standards and tax rules and in some jurisdictions, it is effectively prohibited mid-year without regulatory approval.

Accounting Standards and restrictions

Under IFRS, a change in the costing method is treated as a change in accounting policies under IAS 8. The change is only permitted if the change results in financial statements providing more reliable and relevant information.

Under US GAAP, the limitations are similar: The change requires justification that the new method is preferable and must be applied retrospectively.

When new clients adopt Business Central, they typically move from a legacy system where products are already set up with a costing method.

It is not the consultant's job to suggest one costing method or another, but to use what the client already has. If the client asks whether they can switch mid-year, the answer I give is to plan the change for the start of a new financial year and get the auditor and tax authority sign-off first, where required.

Can you change the costing method after go-live?

No, and for good reasons. In Business Central, the costing method is set per item at creation and cannot be changed once item ledger entries exist without a workaround. This is a system constraint sitting on top of the accounting/regulatory constraints.

The workaround consists of three steps:

Write off the existing stock of the item you want to change.
Rename the existing item so users can see it is an obsolete product.
Copy the item into a new one; this action will ensure all the dimensions, references and units of measure are copied. Then, change the costing method.
Updated the item number of the new item so it shows as the old one.
Block the old item.

This method is just a workaround that does not change the costing method of an existing item; rather, it is a way to clone an item and create a copy of it with a different costing method. That means old transactions and sales history will not be retained.

Common costing mistakes in Business Central implementations

The most common mistakes I have seen in BC implementations that affect costing are two critical routines and one setup that I never recommend: allowing negative inventory.

The accuracy of the costs in BC depends on two routines: Automatic Cost Adjustment and Automatic Cost Posting. Two routines that I always recommend turning on. The alternative is to let these two run on a schedule, which could lead to temporary inconsistencies. I never recommend running these two actions manually.

Allowing negative inventory is the single most common inventory costing crime that can make inventory costing impossible to manage. Business Central supports negative inventory under certain circumstances, but using it will make costing go wrong.

The risk with negative inventory is that this setup is the default in demo environments, which means the setup can be copied to production by mistake during a new project.