The transformation cycle: When accounting entries become real money
Before analyzing calculation methods, I would like to share my view of a company: as an organism that transforms money (liquidity) into matter, and then that matter into more money.
This operating cycle is a loop where value changes form. At the start, gross cash is available in the bank account: this money is "inert."
To create wealth, it is used to buy stock. At that exact moment, the money disappears from the bank but instantly reappears in what the company owns (the balance sheet) as an asset.
The net worth does not change; it simply changes its nature and form.
Everything is at stake during the resale. The decision made "on paper", the choice of method to calculate the value of what leaves the warehouse, acts like a faucet on available cash. If a method is chosen that artificially reduces the purchase cost to show a larger profit, it isn't just a number to look good: it is the basis upon which the State will calculate taxes.
Consequently, a theoretical decision on a calculation method triggers a very real outflow of money to the tax authorities. The more a chosen method "values" the company, the more it can "impoverish" the bank account in the short term. Managing stock therefore consists of finding a balance: should you appear wealthy and solid at the risk of having less cash available, or appear more modest but keep your money to reinvest?
1. Inventory on the balance sheet: An owned asset, not a loss of money
When purchasing goods, the company does not become poorer. It transforms a cash resource into a material resource. This operation is neutral for the company's net worth.
1A. The purchase:
Entry into assets
Upon receiving the purchase invoice, we record the increase in what we own (inventory) and the increase in what we owe (debt to the supplier).
We debit the account Nr 37, Merchandise Inventory: 10 000 €
We credit the account Nr 401, Suppliers: 10 000 €
The stock is here in the Assets (account 37): it is a promise of future income. We do not yet consider this purchase as an expense that reduces profit.
1B. The resale:
The moment the expense is recognized
To calculate real profit, we must match the selling price and the purchase price at the same time. We then move the value of the stock out of the assets and into the calculation of the result.
Step 1:
Recording the sale (Income)
We debit the account Nr 411, Customers: 15 000 €
We credit the account Nr 707, Sales of Goods: 15 000 €
Step 2:
Recording the Cost of what was sold
We debit the account Nr 607, Purchase of Goods (Variation): 10 000 €
We credit the account Nr 37, Merchandise Inventory: 10 000 €
The net profit is then 5 000 € (15 000 - 10 000).
2. The paradox between image and wallet
The choice of calculation method creates a trade-off between the image projected to third parties and the reality of what remains in the bank account.
2A. The "First-In, First-Out" (FIFO) method
It is assumed that the first items purchased are the first ones sold. In a period of rising prices, old (and therefore lower) costs are deducted. The company appears very wealthy on the balance sheet, but the tax to be paid is higher because the reported profit is mechanically inflated.
2B. The "Average Cost" Method: The art of smoothing
Here, old and new prices are mixed to obtain an average.
Calculation example:
- Beginning stock: 100 units at 10 € (Value: 1 000 €).
- New purchase: 100 units at 20 € (Value: 2 000 €).
- Average: (1 000 + 2 000) / 200 units = 15 €.
Impact when selling 100 units at 30 €:
- Calculated cost: 100 units x 15 € = 1 500 €.
- Profit: 1 500 €.
- Tax (e.g., 25%): 375 €.
With the FIFO method, the tax would have been 500 € (because it would be based on the initial cost of 10 €). Average Cost therefore allows you to keep 125 € more in your bank account.
2C. Standard Cost: Stability above all
Unlike other methods, here we do not track the actual purchase price. The company sets a "theoretical" price (the standard) that it estimates to be fair for the year.
If the standard is set at 12 €, but the item is bought for 15 €, the stock will still enter the balance sheet at 12 €. The difference of 3 € is immediately sent to a special account called "Purchase Price Variance."
This is the preferred method for manufacturing plants. It allows for the judgment of commercial performance without being polluted by supplier price variations. We know exactly what we "should" be earning.
The profit is very stable, but the discrepancies (the famous "variances") must be monitored closely, as they reveal if the company is buying at a higher price than expected.
The entry in the case of a purchase higher than the standard cost:
We debit the account Nr 37, Merchandise Inventory (Standard Value): 100 €
We debit the account Nr 6037, Purchase Price Variance (The excess): 10 €
We credit the account Nr 401, Supplier (Actual Debt): 110 €
2D. Specific cost: Surgical precision
This is the method most faithful to physical reality, often used for high-value products or those with serial numbers (jewelry, cars, machinery).
Each item is tracked individually. If two identical watches are bought, one at 5 000 € and the other at 5 500 €, the system knows exactly which one was sold.
There is no longer an average calculation or a theoretical outflow. The cost that leaves the balance sheet is exactly what was paid for the specific unit leaving the warehouse.
This requires absolute data entry discipline (scanning every serial number at every movement). This is the price to pay for total transparency on margins.
💡 The "Zero Balance" Rule
In manual management, cost calculation can be a headache. If the method is poorly mastered, there is a risk of ending up with a residual value on the balance sheet even though the warehouse is empty.
In such a case, the accountant must intervene to regularize the balance by writing it off as a loss to clean the balance sheet.
Conversely, they must ensure they do not remove more value than the stock contains, which would create an impossible negative asset value.
Rest assured, Business Central eases this responsibility. The system has a mathematical safety feature: when a sale brings the quantity down to zero, the ERP ignores the theoretical calculation and allocates the entire remaining balance sheet value to the income statement. Whether the discrepancy comes from rounding or a late fee, the system guarantees that: Zero Quantity = Zero Value. The software handles this cleanup on its own, ensuring perfect consistency.
3. The legal framework: Freedom under supervision
The reason Business Central offers such a variety of methods is that it is global software used in very different contexts. However, the choice of a method is not just a matter of management preference: it is also a matter of compliance with the law.
3A. The consistency rule
Tax authorities and accounting standards (the General Accounting Plan in France) allow the company to choose its method, but they impose the principle of consistency. You cannot change the calculation method every year based on inflation to reduce taxes. If you switch from FIFO to Average Cost, you must be able to justify it with a real change in business activity and explain it in the notes to the balance sheet.
3B. Global harmony... with major exceptions
Calculation methods are generally the same across the planet, but their legality varies by geographic area:
In France and Europe (IFRS Standards): FIFO and Average Cost are king. LIFO (Last-In, First-Out) is strictly forbidden. Why? Because in times of rising prices, LIFO would allow expenses to be disproportionately inflated to pay less tax.
Authorities consider this a distortion of reality.
In the United States (US GAAP Standards): This is the notable exception. LIFO is authorized there, allowing American companies to optimize their taxes much more aggressively than their European counterparts.
Standard Cost: It is accepted everywhere, provided it does not deviate too far from reality. If at the end of the year, the discrepancies (variances) are massive, the accountant will have to rectify the situation so that the balance sheet value is not entirely imaginary.
4. Finding the right balance: The choice depends on strategic priority
- Wanting to Reassure (Banks or Investors): A method that highly values stock on the balance sheet (like FIFO) is often chosen to show a solid structure, even if it means paying more tax.
- Wanting to Grow (Cash Flow): Smoothing costs is preferred to reduce taxable profit and keep as much money available as possible to restock.
- Management Focus (Manufacturing): Standard Cost is chosen to avoid surprises regarding margins and to analyze purchasing errors.
- Traceability Focus (Luxury / High Tech): Specific Cost is chosen to match the physical reality of each product, regardless of the price.