Inventory Costing Methods in Business Central: FIFO, Average, Standard and More Part 3

What They Mean for Your Margins, Mindset, and Month-End

Part 3 of our Inventory Costing Series

If you’ve ever closed a month and thought, “Where did my margins go?”—this post is for you.

Inventory costing isn’t just an accounting formality in Microsoft Dynamics 365 Business Central. It’s the beating heart of your financials, and the method you choose can affect everything from your COGS calculations to your tax liability, to how confidently you price your next job.

In this installment of our Inventory Costing in Business Central series, I’m diving into costing methods—what they do, how they behave, and why they matter. I’ll pay special attention to Average Costing, because let’s face it, it’s popular, but often misunderstood.

The 5 Costing Methods in Business Central—A Quick Refresher

Business Central supports the following costing methods out of the box:

• FIFO (First In, First Out)
• LIFO (Last In, First Out)
• Average
• Standard
• Specific

Each method defines how cost flows from inventory receipts to inventory issues. Some are based on actual cost (e.g., FIFO, LIFO, Average, Specific), while Standard uses a budgeted or predetermined value. Let’s break each one down.

FIFO: First In, First Out

Best for: Businesses with perishable inventory, fast turnover, or where physical flow matches receipt order.

How it works: Oldest inventory receipts are applied first when calculating COGS.

What to expect:

FIFO is intuitive and widely used. Frankly, it’s one of the easier costing methods to track and clearly understand. If you buy items at increasing prices over time, FIFO means your COGS reflects older (typically lower) costs—leading to higher inventory valuations on your balance sheet and potentially higher tax obligations.

Note: FIFO in Business Central applies costs in the order of entry numbers, not always physical receipt dates. Make sure you manage any backdating issues carefully as they will not reapply entries.

Real-World Use Case:

A food distributor we worked with adopted FIFO to match their actual inventory rotation. After implementation, their COGS and profit margins became far more predictable, and financial audits were much smoother.

LIFO: Last In, First Out

Best for: Businesses that want to match recent costs with revenue in a rising price environment (rare).

How it works: Most recent receipts are applied first when calculating COGS.

What to expect:

LIFO may depress profits and reduce tax liability—but it’s disallowed under IFRS and not GAAP-compliant in many industries. In Business Central, it behaves similarly to FIFO in structure but applies costs in reverse sequence.

Warning: Only use LIFO with proper financial and regulatory oversight. We’ve seen cases where accidental LIFO use led to skewed margins and massive rework during year-end close.

Average Costing in Business Central: Popular—but Nuanced

Best for: High-volume environments with mixed or indistinct inventory (e.g., chemicals, bulk goods).

How it works: The cost of outgoing inventory is calculated based on the weighted average cost of remaining inventory at the time of issue.

Business Central allows you to configure the behavior of average costing based on key setup fields:

1. Average Cost Calc. Type

• Item – One cost for all inventory
• Item & Location – Separate cost per location
• Item, Location & Variant – Most granular; different averages per item, location, and variant

2. Average Cost Period

• Options include Day, Week, Month, Quarter, and Year

This defines the interval at which average cost is calculated. For example, with a Monthly period, cost is recalculated for each calendar month.

Important: If you backdate a receipt or shipment, Business Central recalculates and adjusts all impacted entries within that cost period. That’s powerful—but also a common source of confusion.

An Example: Average Costing in Action

Setup:

• Costing Method: Average
• Calc. Type: Item & Location
• Period: Month

Transactions at Location MAIN:

• Jan 1: Receive 100 units @ $10
• Jan 5: Receive 100 units @ $12
• Jan 10: Sell 50 units → COGS = 50 x $11 = $550 (avg of Jan receipts)
• Feb 2: Receive 50 units @ $14
• Feb 7: Sell 50 units → COGS = 50 x $14 = $700 (avg of Feb receipts only)

Key Insight: Business Central values issues using the average as of the transaction’s valuation date (i.e., when the issue is posted). Cross-period transactions can yield different results.

Microsoft Note: Changing the Average Cost Period or Calc Type retroactively could require adjusting all affected entries.

Standard Costing

Best for: Manufacturing where cost control and variance analysis are key.

How it works: Inventory is valued at a predetermined standard. Variances track deviations from actual cost.

What to expect:

Maintain standard costs and reivew them periodically. In Business Central, application still follows FIFO logic, but COGS reflects the standard—not actual—cost. Variances for purchase price, labor, overhead, etc., are posted separately.

Use the Standard Cost Worksheet to roll up and update costs across BOMs and Routings. Standard Costing is not supported per SKU.

We’ll do a deep dive on manufacturing costing coming soon in this series.

Specific Costing

Best for: High-value or regulated items that require traceability (e.g., medical devices, serialized parts).

How it works: The exact cost of a specific receipt is applied to a specific issue via fixed application.

What to expect:

Requires item tracking (serial numbers) on both receipts and issues. When properly configured, each outbound transaction reflects the actual cost of the linked inbound transaction.

Note: You can use item tracking without Specific Costing, but cost will follow the assumed flow of your selected costing method—not the specific lot/serial.

Troubleshooting Costing Method Issues in Business Central

Even with perfect setups, real-world use creates surprises. Here are five common problems and how to fix them:

1. Sales Entries Show Unexpected Costs

Check: Was the cost period crossed? Were receipts invoiced?

Fix: Run Adjust Cost – Item Entries and check Value Entries for actual cost alignment and assuring you’re properly using and closing Inventory Periods.

2. Cost Adjustments Appear Weeks After Shipment

Check: Were expected costs posted initially, then actual costs later?

Fix: Schedule recurring Adjust Cost jobs. Post final costs promptly.

3. COGS Varies Across Locations for the Same Item

Check: Average Cost Calc. Type may be set to “Item & Location”

Fix: Evaluate whether costing should be consistent across sites. Adjust config if needed.

4. Inventory Valuation Doesn’t Match the G/L

Check: Are cost adjustments posted to the G/L? Any timing mismatches?

Fix: Use the Inventory – G/L Reconciliation report. Confirm revaluations are properly posted.

5. Open Item Ledger Entries Aren’t Clearing

Check: Do you have un-applied or partially applied transactions?

Fix: Use the Item Application Worksheet and apply entries manually if needed.

Final Thoughts

Choosing the right costing method isn’t just an accounting decision—it’s a strategic one. It affects profitability, inventory valuation, tax obligations, and even how confidently your sales team quotes jobs. It’s critical to work closely with your Business Partner and your CPA to finalize the decision and setup properly.

Like this post? Subscribe to Dynamics Power Play for more Business Central hints, tips, and help.

Get caught up on the first two posts of this series here:

Part 1: Costing Fundamentals

Part 2: Inventory Posting Groups

I’d love it if you shared this post with others who might find it helpful—whether it’s your finance lead, ops manager, or fellow ERP warrior.

Let’s make your ERP work for you—not the other way around.