Cost Calculation Methods
The Profit Module can calculate the cost in one of two ways:
- Fixed Cost Method (FXCO)
- Average Cost Method (AVCO)
You need to make sure that the way you initially set this up reflects how you manage stock in your business.
FIXED COST METHOD
You should only use the Fixed Cost Method when either of the below two statements are true for your business:
- My product cost is always the same
- I restock only after I sell all the products I have in stock
Fixed Cost Method does not take into account difference in costs of product you already have in stock. It is only suitable for a tiny portion of the businesses we work with. Let us explain why:
Product costs usually change over time. Sometimes you have more than one supplier for the same product and they don't sell you the product at same purchase price.
You buy 10 units of product ABC123 for $100 each.
A week later, you buy another 5 units of product ABC123 for $90 each (Maybe a sale from the same supplier or you buy them from a different supplier). When you receive the 5 units at the lower price, you add them to your inventory using the new cost price of $90.
Using Fixed Cost Method, all 15 items you have in stock now have a cost of $90. This value will be used for calculations, even when a customer buys all 15 ABC123 you have in stock.
This is not accurate because you have 10 units of product ABC123 in stock with a cost price of $100. As a result, data in profit reports will be not accurate.
AVERAGE COST METHOD
Average Cost Method takes into account:
- Your previous product costs associated with the current stock quantity
- New product cost with restock quantity
The formula that is used in the calculations using this method is quite simple:
Average Product Cost = Total Stock Value / Total Stock Quantity
Let’s revisit the example from before:
You buy 10 units of product ABC123 for $100 each. A week later, you buy another 5 units of product ABC123 for $90 each.Using the Average Cost Method, the calculations would look like this:
((10 * 100) + (5 * 90)) / 15 = 96.67
Your new product cost is now $96.67 and this value will be used when a customer buys one or more of the ABC123s that you have in stock.
Product ABC123 is a great selling product for your business. On the first day you already sold 7 units. You now have 8 units left in stock with a cost price $96.67. Planning for future demand, you buy another 5 ABC123s, but from a different supplier that can deliver them tomorrow. The catch is the cost price is $110 each!Using the Average Cost Method, the calculations would now look like this:
((8 * 96.67) + (5 * 110)) / 13 = 101.80
Your new product cost for ABC123 is now $101.80.