Accounting 101: How to Master Your Inventory Accounting

What is inventory accounting?

Inventory accounting is how you account for and value the inventory in your business.  The core tenet of most inventory accounting systems is that all costs incurred to produce or acquire goods that will be sold for a profit should:

1. Initially be recorded in the inventory account as an asset on the balance sheet and
2. Gradually move to the cost of goods sold account as an expense on the profit and loss statement as your business makes sales to customers.

If you own a merchandising business—for example, a shoe store that purchases shoes from manufacturers or wholesalers and sells these shoes to consumers—your inventory accounting system is somewhat straightforward.

When you purchase the shoes from a manufacturer or wholesaler, you:

• debit your inventory account and
• credit either your cash account or accounts payable account, depending on how you purchased the shoes.

And then when you sell shoes to your customers, you:

• debit your cash or accounts receivable account for the amount of the sale,
• credit your revenue account for the amount of the sale,
• credit your inventory account for the cost of the shoes that you just sold, and
• debit your cost of goods sold account for the cost of the shoes you just sold.

Of course, determining the cost of the shoes you just sold may require more complicated accounting processes than you may think. For example, what if you sold a pair of shoes—but your cost for these shoes recently increased significantly due to increased international shipping costs? Do you determine your cost of these shoes based on:

• the cost of the first pair of this type of shoes you bought (FIFO method),
• the cost of the last pair of this type of shoes you bought (LIFO method), or
• an average cost of all the pairs of this type of shoe you bought (average cost method)?

These are questions you have to answer as you set up your inventory accounting system.

And for businesses with complex production processes, inventory accounting can become much more involved and industry-specific.

For example, if you’re a manufacturing company such as a company that makes shoes to sell to shoe stores, your inventory exists in three different forms—raw goods, work-in-progress products, and finished items. These all need to be counted and tracked in your inventory accounting system.

And since you generally pay workers and maintain machines to manufacture the shoes, you will have to record not only the cost of your raw materials in your inventory, but also the cost of labor and machine maintenance and repairs. You may also need to store your shoes in warehouses before they are sold—this is a carrying cost that would be included in your inventory amounts.

Benefits of inventory accounting.

Here are three main benefits of inventory accounting:

1. Accurate financial statement presentation – Inventory accounting ensures that inventory is represented where it belongs on your financial statements—on the balance sheet. Unfortunately, some new businesses immediately expense their cost of goods upon purchase, which can cause large swings in the business’ profit and loss statement, depending on when they tend to purchase these goods.
2. Profit-driven decision making – A good inventory accounting system allows you to understand the profitability of each product you sell. This could inform business decisions to, say, expand highly profitable product lines or discontinue minimally profitable or unprofitable products.

Cost control – If your production process is complicated, establishing thorough inventory accounting procedures for each stage of production can help you pinpoint cost inefficiencies and develop solutions to correct them.

How to calculate inventory.

Whether your inventory falls at the beginning of the production process or is end-use, you’ll employ the same calculation to create a manageable number. Here’s how you break it out:

BI + NP − COGS = EI

The acronyms used in this calculation are beginning inventory (BI), net purchases (NP), cost of goods sold (COGS), and ending inventory (EI).

For example, let’s say that, at the end of last year, your inventory account was $1,000,000. During the year, you added an additional $500,000 of goods to inventory, and you sold $800,000 of goods, meaning that you are left with $700,000 of goods in your inventory at the end of this year. In this case:

Beginning Inventory (BI) of $1,000,000
+ Plus Net Purchases (NP) of $500,000
– Less Cost of Goods Sold (COGS) of $800,000
= Equals Ending inventory (EI) of $700,000Note that the $500,000 in net purchases is not the sales prices of the goods to your buyers—it’s your cost for the additional goods you added to inventory during the year, based on your cost accounting system.

How to calculate inventory costs.

There are multiple ways to calculate your inventory costs. Let’s look at two of the most common: First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). In addition to being really fun to say out loud, these two terms represent accounting methods that can help you get a better idea of what’s happening in your inventory.

FIFO

The FIFO method is used for situations where the first units of your inventory are often the first ones sold. As an example, you have a clock factory and make 50 clocks on a Monday, and the cost is $7 per unit. The next day, you make 50 more clocks, though the cost goes down to just $6 each. If you were to sell 50 clocks on Wednesday, you would put the COGS as $7 per unit on the income statement.

LIFO

As you might imagine, LIFO takes the opposite approach. So if your factory makes 50 clocks for $7 per unit on Monday and 50 more for $6 per unit on Tuesday, then sells 50 clocks on Wednesday, you would put the COGS as $6 a pair on the income statement.

Average cost

A third method to consider is Average Cost. Rather than look at the cost of individual batches of units, you simply average the cost for the chosen accounting period. Going back to the clock factory example, you would end up with a COGS of $6.50 for the clocks you made on Monday and Tuesday.

There are various scenarios where these three methods might work best. For example, if you own a fruit distribution company, you’ll be an advocate of the FIFO approach. The longer your inventory sits on shelves, the higher the chances that it will go rotten. The clock factory example is likely different because clocks won’t spoil if they sit on a shelf for a month. So the owners of the factory would have more options to choose from.

Accounting for variation.

The clock factory example given above is helpful as far as the numbers go, but it also presents things in a much too precise manner. As we all know, running a small business isn’t clockwork. There are ebbs and flows, starts and stops. Nothing is guaranteed.

Here are some of the inventory variations you could encounter:

• Variation in quantity
• Variation in production line
• Variation in delivery time
• Variation in demand
• Variation in performance

Managing your inventory as carefully as possible helps to smooth out these snags and forecast the future.

How to manage your inventory for better accounting.

There was a time when tracking and managing inventory was done with a clipboard and a ballpoint pen. Luckily, technology has now automated many of these manual tasks. Not only does inventory management software make things easier, but it reduces errors, syncs with your other systems, and securely stores your data.

Here are nine inventory tech products to consider:

1. FlowTrac
2. SKULabs
3. Lead Commerce
4. MarginPoint Mobile Inventory
5. Finale Inventory
6. Fishbowl Inventory
7. Chondrion Inventory Management
8. eTurns
9. Infoplus

Choosing the best inventory management software for your business is like choosing the best car for your high school-age child. You’ll need to carefully do your research, test drive a couple of top contenders, then choose an option that is reliable and easy to use.

Aided by top-notch software, you’ll be able to stay closer to the details of your inventory. This enables you to navigate challenges and improve your efficiency. There’s no doubt that the more accurate you can make your accounting, the more you will set yourself up for success in the future.

_{Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}