Inventory accounting follows and marks the changes in inventory assets. This allows businesses to track how much inventory they have, what it is worth, and when it needs to be replaced.
It helps businesses avoid overstocking or undersupplying products, which can lead to financial losses. In this article, we will guide you through the advantages of this type of accounting and show you how it can lead to a more successful business.
What is Inventory Accounting?
Simply put, this is the process of tracking and reporting the value of a company’s inventory. The goods that make up the inventory are placed in one of three categories: raw materials,
work-in-progress, and finished goods.
This is important to know, as your inventory can go from one category to the next until it is sold. Keeping track of all three categories is part of good business practices as it makes it much easier to calculate your profits at the end of an accounting period.
It’s a vital tool for businesses of all sizes because it provides essential information about your company’s assets and can also help improve decision-making, increase efficiency, and boost profits.
Inventory Accounting Terms You Need to Know
Before choosing the most suitable accounting method, it would be beneficial to get acquainted with two key terms – cost of goods sold (COGS) and ending inventory (EI)
- Cost of goods sold (COGS) can include materials, labor, and shipping. COGS is a key figure in many financial calculations, such as gross margin and operating expenses.
There are several different methods for calculating COGS, but the most common is to use beginning inventory plus purchases minus ending inventory. This method gives the company a good idea of the actual cost of its goods and allows for more accurate financial planning.
- Ending inventory (EI) is the merchandise that a company has on hand at the end of an accounting period. The ending inventory is essential for keeping a steady inventory balance because it represents the merchandise that will be used to generate sales in the next accounting period.
Accordingly, companies must carefully manage their ending inventory levels to ensure they have enough merchandise to meet customer demand.
Different Methods of Accounting for Inventory Management
There are several different inventory valuation methods used by businesses to determine the cost of their inventory.
The most common ones are the first-in, first-out (FIFO) method and the last-in, first-out (LIFO) method.
The FIFO method assumes that the first items purchased are also the first items sold, while with LIFO, the assumption is that the last items purchased will get sold first.
Other less common inventory accounting methods include the weighted average and specific identification methods.
The weighted average method calculates the cost of inventory based on the average price of all units in stock, while the specific identification method tracks each item individually from the moment it enters the supply to when it is sold on.
We’ll get into each of these methods more to bring you the complete picture of their advantages and disadvantages.
But no matter which inventory accounting policy is used, accurate inventory records are essential for proper financial reporting.
The Right Method for Your Business
The choice of valuation method can have a significant impact on a company’s bottom line.
As a result, accountants and financial managers must understand each method’s pros and cons before choosing one for reporting purposes.
The FIFO accounting method, or “first in, first out,” is a method used to calculate the cost of the inventory on hand. The assumption with FIFO is that the first items acquired will be removed from the stock before the others.
It is most often used in manufacturing and retail environments where products have a shelf life or expiration date. When using FIFO, the first inventory purchases are assumed to be sold first and are therefore charged to the cost of goods sold.
This method can help to prevent spoilage since older items are more likely to go bad before newer items.
While the FIFO inventory accounting method is not always the most efficient way to determine the cumulative inventory value, it can be a helpful tool for keeping track of stock levels and ensuring that materials are used in a timely manner.
It can help businesses avoid obsolescence, as older items are less likely to be sold if they can’t compete with newer items in stock.
For example, stocking older iPhones isn’t likely to be profitable as the new model will be much more desirable than its previous generation.
The FIFO method is all about efficiency – by ensuring that the items sitting around the longest are used first, we can avoid waste and ensure everyone gets what they need.
LIFO stands for “last in, first out.” It’s a method of accounting for inventory management in which the most recent products added to inventory are the first ones sold.
The main advantage of LIFO is that it closely resembles the real-world flow of inventory, which can give business owners a more accurate picture of their actual profits and losses.
LIFO can help businesses maximize their profits by selling goods that are likely in high demand. In some cases, LIFO can also help to improve customer service levels by ensuring that the most recently received items are the ones that are shipped out first.
This method can also have some disadvantages, however. For example, if prices rise, businesses using LIFO will report higher costs of goods sold and lower profits than those using other methods. As a result, LIFO is not always the best choice for businesses.
Also, LIFO inventory accounting can lead to difficulties in managing inventory levels, as businesses may find themselves with a surplus of older items that are no longer in demand.
Weighted Average Method
The weighted average accounting method uses the average cost of a company’s goods sold during a period to determine the value of its ending inventory.
The weighted average cost is calculated by taking the total cost of goods available for sale and dividing it by the total number of units available for sale.
This method is a lot simpler than both FIFO and LIFO methods. It doesn’t offer the same level of accuracy as those two, but it does represent an efficient way to calculate your overall profit over a certain fiscal period.
Specific Identification Method
This method is best used when accounting for stock comprising a small number of high-priced items like cars, machines, or jewelry.
That’s because this method assigns a specific cost to each unit of inventory rather than averaging the cost across all of them.
The process is generally done by tracking inventory from the time it is purchased until the time it is sold, which requires additional resources, and, therefore, isn’t for businesses with a high number of different items that need to be tracked.
How to Manage Your Accounting
A company’s inventory is one of its most important assets. It represents the raw materials, finished goods, and work in progress that a company has on hand to support its operations.
As such, it is essential to have an accurate valuation of inventory in financial reporting.
While many businesses choose to outsource their inventory accounting, there are several benefits to doing it in-house.
The most important benefit is that you’ll have complete control over your data. This means you can customize your reports to fit your specific needs and ensure that the information is always accurate.
With good inventory management software and POS system providers that permit third-party interfacing with accounting software, you will be able to track inventory items as they move through the system. If you can find affordable accounting software, you’ll also save money by avoiding the fees associated with outsourcing.
Ultimately, accounting inventory by yourself can give your business a valuable competitive advantage.
Whichever way you manage your accounting, doing so will offer several advantages. It can:
- Help keep track of inventory levels and value,
- Enable better detection of obsolete inventory,
- Help avoid overstocking or undersupplying products,
- Provide useful information for financial reporting,
- Help save money on inventory costs.
In our inventory accounting guide, we showed you why this is such an essential tool for small businesses and how to use it to your advantage.
This type of accounting allows businesses to track their inventory levels, value their inventory, and make informed decisions about purchasing and selling merchandise.
It can also help businesses to manage their cash flow and provide information about when inventory levels are low and need to be replenished.
Overall, inventory accounting is a valuable tool that can help small businesses to run more effectively and efficiently.