How Dynamics 365 Finance & Supply Chain Calculates Inventory Cost
In my experience supporting clients using Dynamics 365 Finance & Supply Chain Management for inventory management, there is often confusion around how inventory value is calculated and adjusted throughout the product lifecycle. This is especially true when costs change between physical and financial postings, or after inventory close processes run.
That lack of clarity can lead to frustration and, more importantly, a lack of trust in the system’s financial outputs. I chose this topic to break down those concepts for you in a practical way and help bridge that gap in understanding.
A Practical Look at Physical vs. Financial Postings in D365 Finance & Supply Chain
When it comes to inventory costing in Dynamics 365 inventory management, the inventory model you choose is only part of the story. The actual cost that gets assigned to inventory movements is also influenced by when transactions are physically updated, when they’re financially posted, and how inventory close or recalculation processes those transactions.
Because inventory valuation directly impacts things like cost of goods sold (COGS), margins, financial reporting, and even taxes, it’s important to understand how all of this works together. Understanding how D365 calculates inventory makes you better equipped to interpret fluctuations in inventory value and COGS.
Let’s start with one key idea: physical postings and financial postings are not the same.
Physical vs. Financial Transactions: What’s the Difference?
Understanding the distinction between physical and financial transactions and how inventory close finalizes cost helps ensure:
- More accurate and consistent financial reporting
- Fewer surprises during period-end close
- Improved confidence in system-generated inventory values
Every time inventory moves whether it’s a purchase receipt, sales shipment, production consumption, transfer, or return Dynamics 365 creates an inventory transaction.
- Physical transactions reflect the movement of goods.
- Financial transactions reflect the finalized accounting value of those movements.
For example:
- When you post a product receipt or packing slip, inventory is physically updated.
- When you post the vendor invoice, the transaction becomes financially updated.
The same idea applies on the outbound side inventory can leave physically before the financial impact is finalized.
Example of Physical and Financial Receipt Transactions
Example of Physical and Financial Issue Transactions
Why This Distinction Matters
In many cases, the cost assigned at the time of a transaction is not the final cost.
For periodic costing models in D365, issues are initially posted using a running average cost. The final cost is determined later during inventory close or recalculation, which adjusts transactions based on the item’s valuation method.
Another important setting here is “Include physical value.”
- Enabled: Both physical and financial transactions contribute to the running average during the period
- Disabled: Only financially updated transactions are included
However—and this is important—inventory close is always based on financially updated transactions, regardless of this setting (especially for weighted average methods).
This is why the cost you see during the month may not match the final cost after closing.
Ultimately, understanding this distinction allows you to make more informed decisions about costing strategies and ensures that your system is aligned with financial and operational goals.
How Each Costing Model Works in Practice
Moving Average: Cost Updates in Real Time
Moving average works differently from the other models. It’s a perpetual costing method, which means:
- Costs are updated continuously as transactions happen
- Inventory close does not adjust these items
- No settlements are created between transactions
When a purchase invoice comes in at a different price than the receipt:
- The difference is partially added to the remaining inventory
- Any leftover amount is posted to the price difference for moving average account
Example:
If you receive 2 units at $10, sell 1, and then invoice at $12:
- Only the remaining unit can absorb part of that $2 increase
- The rest is expensed as a price difference
Bottom line: With moving average, cost is finalized as you go—not at period end.
Weighted Average: Estimated During the Month, Finalized at Close
Weighted average is a periodic model, which means:
- Issues are posted during the month using a running average
- Final costs are calculated during inventory close
Even if “Include physical value” is turned on, only financially updated transactions are used to calculate the final weighted average.
Example:
Receipts at $10, $22, and $30 → issue posted at $16
After inventory close → adjusted to $20.67 (true weighted average)
Think of it in two stages:
- A temporary cost during the month
- A finalized cost after inventory close
FIFO: Final Cost Comes from the Oldest Financial Receipts
FIFO (First In, First Out) also follows a periodic pattern in D365:
- During the month, issues use a running average cost
- During inventory close, transactions are settled using the oldest financially updated receipts
So even though FIFO is the valuation method, you don’t see true FIFO costing until close runs.
Example:
Receipts at $10, $22, $30 → issue posted at $16
After close → adjusted to $10 (first receipt)
If “Include physical value” is enabled:
- It affects the running average during the month
- But final FIFO settlement still uses financial transactions
LIFO: Same Concept, Reversed Order
LIFO (Last In, First Out) works the same way as FIFO, but in reverse:
- Transactions are initially posted using a running average
- Inventory close settles issues against the most recent financially updated receipts
Standard Cost: Stability with Variance Tracking
Standard cost works differently from the other models:
- Each item has a predefined (standard) cost
- Transactions are always valued at that standard cost
- Differences between actual and standard are captured as variances
These variances can include:
- Purchase price variance
- Production variances (quantity, price, substitutions, etc.)
Example:
If standard cost = $10 and actual price = $12:
- Inventory is still valued at $10
- The $2 difference is recorded as a variance
Key benefit: Predictable costing, with separate visibility into cost deviations.
Final Thought on Inventory Cost in Dynamics 365
A simple way to think about inventory costing in D365 is this:
The cost you see during the month is often just an estimate. The final cost is determined at inventory close.
For weighted average, FIFO, and LIFO:
- Transactions are posted using a running average during the period
- Inventory close finalizes cost based on financially updated transactions
The “Include physical value” setting can influence the estimates during the month—but it doesn’t change how final costing is calculated.
Example of Inventory Transactions after Inventory Recalculation
Why a Clear Understanding of Inventory Cost Matters for Your Business
When clients see cost changes after inventory close, it can be confusing if they’re not expecting it and that confusion can lead to a lack of confidence in the numbers.
Understanding how Dynamics 365 calculates inventory cost helps:
- Avoid surprises during period-end close
- Improve consistency in financial reporting
- Build confidence in inventory valuation and COGS
Being aware of these behaviors helps set the right expectations and prevents misinterpretation of inventory and financial data.
It’s also useful at different stages:
- During implementation: to choose the right costing method for your business
- After go-live: to troubleshoot unexpected cost changes or refine processes
Getting costing right in D365 isn’t just a configuration decision it’s about understanding how the system behaves so you can trust the results and make more informed decisions. If you'd like to explore how these concepts apply to your organization, reach out to our team.
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