Inventory accounting guide: FIFO, AVCO, COGS explained

Published Friday 20 March 2026

Table of contents

• What is inventory?
• What isn't inventory?
• Types of inventory
• What is inventory accounting?
• Benefits of inventory accounting
• Inventory accounting methods
• What is cost of goods sold (COGS)?
• How to do inventory accounting
• What is stocktaking?
• Inventory tracking alternatives to manual stocktaking
• Take control of your inventory accounting
• FAQs on inventory accounting

Key takeaways

• Choose the right inventory accounting method for your business by selecting FIFO if your stock moves in order (like food retail) or weighted average cost if your products are similar with fluctuating prices.
• Track your cost of goods sold using the formula: opening inventory plus purchases minus closing inventory to understand your true product costs and set profitable prices.
• Conduct regular stocktakes to identify theft, damage or errors early, with frequency depending on your business size and inventory value - from annual counts for small businesses to monthly for high-value stock.
• Implement inventory tracking software or barcode systems to automate stock management and reduce manual counting errors, especially as your business grows beyond basic spreadsheet tracking.

What is inventory?

Inventory refers to the goods your business holds for sale to customers. These items may be resold as-is or combined into a new product.

What isn't inventory?

Not everything you buy counts as inventory. Here's what falls outside the definition:

• Business equipment and supplies: Record work tools, vehicles and stationery as expenses, not inventory.
• Dropshipped goods: Exclude goods that a third party ships directly to your customer.
• Items you don't own: Own the goods before counting them as inventory.

Types of inventory

Businesses typically hold three main types of inventory. Understanding which categories apply to you helps you set up the right accounting approach.

Raw materials

Raw materials are the basic inputs you use to create your products. For a furniture maker, this includes timber, screws and fabric. For a bakery, it's flour, sugar and eggs.

These materials haven't been processed yet, so their value is based on purchase cost.

Work in progress (WIP)

Work in progress refers to items that are partially complete. A half-assembled chair or an unbaked batch of bread dough are examples.

WIP is trickier to value because you've added labour and overhead costs but don't yet have a finished product to sell.

Finished goods

Finished goods are products ready for sale to customers. This is the inventory most retailers and ecommerce businesses hold.

The value of finished goods includes all costs to get them sale-ready: raw materials, labour, packaging and any other production expenses.

What is inventory accounting?

Inventory accounting is the process of tracking the value and costs of your stock. It helps you understand what your inventory is worth at any point in time.

Inventory appears as an asset on your balance sheet, but its value can drop quickly. Stock may become outdated, damaged or lose market value. Storage adds ongoing costs too.

Accurate inventory accounting matters for:

• setting profitable prices
• arranging proper insurance coverage
• budgeting and cash flow planning
• calculating tax obligations
• valuing your business for sale or investment

Benefits of inventory accounting

Good inventory accounting helps you save money and make money. Here's how:

• Maximise sales: Avoid stockouts by tracking what's selling and when to reorder.
• Lower storage costs: Reduce warehouse expenses by ordering fewer slow-moving items.
• Negotiate better deals: Identify high-volume products and shop for bulk discounts.
• Understand true margins: Track actual stock costs to see which products are most profitable.
• Plan smarter promotions: Spot seasonal trends and time your marketing accordingly.
• Control tax timing: Manage when you order to influence your tax obligations.

Inventory accounting also improves your cash flow. Rather than tying up money in slow-moving stock, you can keep more cash available for paying down debt or growing your business.

Inventory accounting methods

Different businesses use different methods to value their inventory. The method you choose affects your reported profits and tax obligations, so it's worth understanding your options.

In Australia, the official accounting standards specify two main methods for assigning cost to inventory: first-in, first-out (FIFO) or the weighted average cost formula.

Weighted average cost method (AVCO)

Weighted average cost calculates the average price of all units in stock. Each time you buy more inventory, the average updates.

This method works well when your products are similar and prices fluctuate. It smooths out cost variations and simplifies record-keeping.

Example: You buy 100 units at $10 and 100 units at $12. Your weighted average cost is $11 per unit.

First in, first out method (FIFO)

FIFO assumes you sell your oldest stock first. The cost of goods sold reflects the price of your earliest purchases, while remaining inventory is valued at more recent prices.

This method suits businesses where stock actually moves in order, like food retailers or fashion. It typically results in higher reported profits when prices are rising.

Example: You buy 100 units at $10, then 100 units at $12. When you sell 50 units, the cost is based on the $10 batch.

Your accountant can help you choose the right method for your business type and goals.

What is cost of goods sold (COGS)?

Cost of goods sold (COGS) is the direct cost of producing or purchasing the items you've sold during a period. It's one of the most important numbers in your financial statements.

COGS connects directly to your inventory accounting. Here's the basic formula:

COGS = Opening inventory + Purchases − Closing inventory

According to the Australian Taxation Office, the closing stock value from one income year automatically becomes its opening value for the next, ensuring continuity in your calculations.

When you sell a product, its cost moves from your inventory (an asset) to COGS (an expense). This reduces your reported profit and your tax bill.

Understanding COGS helps you:

• Calculate gross profit: Revenue minus COGS shows what you keep before paying overhead.
• Set prices: Knowing your true product costs helps you price for profit.
• Spot problems: Rising COGS without rising prices squeezes your margins.

The inventory accounting method you choose (FIFO, weighted average) directly affects your COGS calculation and, in turn, your reported profits.

How to do inventory accounting

Inventory accounting starts with tracking three things: how much stock you have, what it costs and what you sell it for.

Here's how to get started:

1. Count your stock: Conduct a physical stocktake or use inventory software to establish your baseline quantities.
2. Record purchase costs: Track what you pay for each item, including freight and handling.
3. Choose a costing method: Select FIFO, weighted average or another method to value your inventory consistently.
4. Calculate cost of goods sold: Work out the cost of items you've sold during each period.
5. Update your records: Reconcile your inventory counts with your accounting records regularly.

The level of detail depends on your business. A small retailer might use simple estimates, while a manufacturer may need precise tracking across raw materials, work in progress and finished goods.

Learn more in our guide to inventory.

What is stocktaking?

Stocktaking is the process of physically counting your inventory, comparing it to your accounting records, and valuing each item according to an approved method.

Even with good systems, discrepancies happen. Stock gets damaged, lost, stolen or miscounted. Regular stocktakes catch these issues before they become bigger problems.

Why is stocktaking important?

Accurate inventory records affect your financial statements, tax calculations and business decisions. Stocktaking helps you:

• Identify shrinkage: Spot theft, damage or administrative errors early.
• Maintain accurate accounts: Ensure your balance sheet reflects true asset values.
• Improve ordering: Base purchasing decisions on actual stock levels, not guesses.
• Meet compliance requirements: Satisfy auditors and tax authorities with verified records.

How often should you do a stocktake?

The right frequency depends on your business size and inventory turnover:

• Annual stocktake: Minimum for most businesses, often done at financial year end. However, some small businesses may not need a formal stocktake if their stock's value changed by no more than $5,000 during the year.
• Quarterly or monthly: Better for businesses with high-value or fast-moving stock.
• Cycle counting: Count a portion of inventory each week to spread the workload.

High-value items may warrant more frequent counts than low-value stock.

Inventory tracking alternatives to manual stocktaking

Manual stocktakes are time-consuming and prone to error. Modern inventory systems offer automated alternatives that keep your records accurate with less effort.

Here are the main options:

• Perpetual inventory systems: Track stock levels in real time as items are bought and sold, reducing the need for full physical counts.
• Barcode scanning: Speed up counts and reduce errors by scanning items rather than writing them down.
• Cloud-based inventory software: Access stock levels from anywhere and sync automatically with your accounting records.
• Integrated point-of-sale systems: Update inventory automatically each time you make a sale.

The right approach depends on your business size and complexity. A small retailer might start with basic software, while a manufacturer may need barcode scanning across multiple locations.

Take control of your inventory accounting

Good inventory accounting gives you visibility into one of your biggest business costs. You'll know what your stock is worth, which products make you money and where cash is tied up.

Start with the basics: count your inventory, choose a costing method and track your cost of goods sold. As your business grows, consider software that automates the manual work.

Inventory accounting software like Xero can help you track what's selling and what's not. Get one month free and see how managing your stock can be easier than you think.

FAQs on inventory accounting

Here are answers to common questions about inventory accounting.

Which inventory accounting method should I use for my business?

The best method depends on your business type. FIFO suits businesses where stock moves in order, like food retail. Weighted average works well when products are similar and prices fluctuate. Your accountant can help you choose.

How does inventory accounting affect my tax bill?

Your inventory method affects your cost of goods sold, which in turn affects your taxable profit. FIFO typically shows higher profits (and higher tax) when prices are rising. Weighted average smooths out fluctuations.

Can I change my inventory accounting method once I've started?

You can change methods, but it requires careful adjustment to your records and may need approval from tax authorities. Consult your accountant before switching, as it can affect your financial statements and tax position.

Do I need special software to do inventory accounting?

Small businesses can start with spreadsheets, but dedicated inventory software saves time and reduces errors. Cloud-based accounting software with built-in inventory tracking lets you manage stock and finances in one place.

What's the difference between inventory accounting and inventory management?

Inventory accounting focuses on valuing your stock and recording it in your financial statements. Inventory management is broader, covering ordering, storage, tracking and optimising stock levels. Both work together to control costs and improve cash flow.