What is inventory accounting?

Published Monday 15 June 2026

Table of contents

• What is inventory?
• What falls outside inventory?
• Types of inventory
• What is inventory accounting?
• Benefits of inventory accounting
• Inventory accounting systems
• Inventory accounting methods
• What is cost of goods sold (COGS)?
• How to record inventory in your accounts
• How to do inventory accounting
• Inventory shrinkage and write-offs
• Inventory turnover: measuring stock performance
• What is stocktaking?
• Inventory tracking alternatives to manual stocktaking
• Take control of your inventory accounting
• FAQs on inventory accounting

Key takeaways

• Perpetual inventory systems update stock records in real time, while periodic systems rely on scheduled counts. Choosing the right system for your business affects how accurately you track costs day to day.
• Your inventory accounting method (FIFO or weighted average cost) determines your cost of goods sold, which flows directly into your reported profit and tax bill.
• Inventory shrinkage from theft, spoilage or damage reduces your stock value and must be recorded as a loss. Regular stocktakes help you catch discrepancies early.
• Inventory turnover shows how quickly you sell through stock. A higher ratio generally means less cash tied up in unsold goods.

What is inventory?

Inventory refers to the goods your business holds for sale to customers. In accounting terms, inventory is a current asset on your balance sheet that represents the value of stock you own and intend to sell. These items may be resold as-is or combined into a new product.

What falls outside inventory?

Some business purchases are classified differently from inventory. Here are the main exclusions to keep in mind:

• Business equipment and supplies: work tools, vehicles and stationery are recorded as expenses or fixed assets, not inventory.
• Dropshipped goods: a third party ships these directly to your customer, so they remain outside your inventory records.
• Consignment stock: goods held on behalf of another business stay off your books, as ownership remains with the original supplier. You must hold title to goods before counting them as inventory.

Types of inventory

Businesses typically hold 3 main types of inventory. Understanding which categories apply to your business 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 tells you what your inventory is worth at any point in time and how much it costs to produce or purchase the goods you sell.

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 are the practical benefits for your business:

• Maximise sales by tracking what's selling and when to reorder, so you avoid stockouts.
• Lower storage costs by ordering fewer slow-moving items and reducing warehouse expenses.
• Negotiate better deals by identifying high-volume products and shopping for bulk discounts.
• Understand true margins by tracking actual stock costs to see which products are most profitable.
• Plan smarter promotions by spotting seasonal trends and timing your marketing accordingly.
• Control tax timing by managing 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 also connects directly to your financial statements. As a current asset, it appears on your balance sheet and affects your business's net worth. When you sell stock, its cost transfers to cost of goods sold (COGS) on your income statement, which reduces your reported profit. Keeping inventory records accurate means your financial statements reflect what your business is actually worth.

Inventory accounting systems

Before choosing a costing method, you'll need to decide how to track inventory movements. There are 2 main systems, and each handles record-keeping differently.

Perpetual inventory system

A perpetual system updates your stock records in real time every time a purchase or sale occurs. Modern point-of-sale systems and inventory management software typically use this approach.

The main benefits of a perpetual system are:

• You always know your current stock levels.
• You can spot shrinkage faster because records are continuously updated.
• You reduce the need for full physical counts.

For example, a retailer using a cloud-based point-of-sale (POS) system that syncs with their accounting software will see inventory update automatically with each sale.

Periodic inventory system

A periodic system updates stock records at set intervals, typically at the end of a month, quarter or financial year. Between counts, the business estimates inventory based on purchases and sales.

This approach works for smaller businesses or those with lower transaction volumes. It requires a stocktake to establish closing inventory before COGS can be calculated. For example, a tradie or small manufacturer might do a stocktake at financial year end to finalise their records.

Most accounting software now supports perpetual tracking, which reduces reliance on manual counts.

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 2 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.

Last in, first out method (LIFO)

LIFO assumes the most recently purchased stock is sold first. This method is used in some countries, particularly the United States, because it can reduce taxable profit when prices are rising.

LIFO is not an approved method under Australian Accounting Standards Board (AASB) 102. Australian businesses must use either FIFO or weighted average cost. LIFO is included here for awareness only, in case you've encountered the term elsewhere.

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 because it directly affects your reported profit.

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

COGS = Opening inventory + Purchases − Closing inventory

Opening inventory is the value of stock you held at the start of the period. Closing inventory is what remains unsold at the end. According to the Australian Taxation Office (ATO), 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.

COGS vs operating expenses

COGS and operating expenses are both costs your business incurs, but they cover different things. COGS includes the direct costs of producing or purchasing what you sell: materials, manufacturing labour and freight in.

Operating expenses cover the costs of running your business that are not directly tied to production: rent, marketing, administration and salaries for non-production staff. The distinction matters because COGS is subtracted from revenue to calculate gross profit, while operating expenses come out of gross profit to determine net profit.

If you're unsure how to classify an expense, ask your accountant.

How your inventory method affects tax

Your choice of inventory accounting method (FIFO vs weighted average) affects your COGS figure, which in turn affects your taxable profit. When prices are rising, FIFO typically produces a higher profit figure (and a higher tax bill) because it assigns older, lower costs to goods sold. Choosing the method that best reflects your business activity is worth discussing with your accountant.

How to record inventory in your accounts

Recording inventory involves debits and credits, but the logic is straightforward once you understand what each transaction represents. Here are the 3 most common inventory transactions.

1. Purchasing inventory

When you buy stock, your inventory asset increases and your bank balance decreases (or your accounts payable increases if you're buying on credit). In accounting terms, you debit Inventory and credit Bank or Accounts Payable. You've traded cash, or a promise to pay, for stock.

2. Selling inventory

Selling stock requires 2 entries. First, record the sale: debit Bank or Accounts Receivable, credit Sales Revenue. Second, move the cost of the stock from inventory to COGS: debit Cost of Goods Sold, credit Inventory. The stock is no longer an asset; its cost is now an expense matched against the sale revenue.

3. Writing off damaged or stolen stock

When inventory is lost, damaged or stolen, you reduce the inventory asset and record a loss. Debit Inventory Write-off Expense, credit Inventory. The stock is gone and its cost becomes a business expense.

Accounting software handles most of these entries automatically when you record purchases and sales, but understanding the logic helps you spot errors.

How to do inventory accounting

Inventory accounting starts with tracking 3 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. This gives you an accurate starting point for your records.

2. Record purchase costs

Track what you pay for each item, including freight and handling. Accurate purchase records are the foundation of reliable inventory accounting.

3. Choose a costing method

Select FIFO or weighted average cost to value your inventory consistently. Stick with the same method from period to period so your records are comparable.

4. Calculate cost of goods sold

Work out the cost of items you've sold during each period using the COGS formula. This figure flows directly into your financial statements.

5. Update your records

Reconcile your inventory counts with your accounting records regularly. The more often you do this, the fewer surprises you'll find at year end.

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 the guide to inventory.

Inventory shrinkage and write-offs

Inventory rarely matches your records perfectly. Shrinkage is the difference between your recorded inventory and what you actually have on hand, and it directly reduces your stock value.

The 4 main causes of shrinkage are:

• Theft, both internal (employee) and external (shoplifting).
• Spoilage or expiry, especially common in food, cosmetics and pharmaceutical businesses.
• Damage during storage or transit.
• Administrative errors, including miscounts and data entry mistakes.

Even small losses add up over time and erode your margins. For retail, hospitality and food businesses, shrinkage can be a significant ongoing cost.

When stock is unsellable (damaged beyond repair, expired or obsolete), you write it off. This means removing it from your inventory records and recording it as an expense. The write-off reduces your asset value on the balance sheet and increases expenses on your income statement.

The ATO allows businesses to write down or write off trading stock that is damaged, lost or worth less than its cost. Small businesses may also qualify for the simplified trading stock rules if their stock value changed by no more than $5,000 during the year.

Regular stocktakes and inventory software that flags discrepancies early are the most effective tools for keeping shrinkage under control.

Inventory turnover: measuring stock performance

Inventory turnover is a ratio that measures how quickly your business sells and replaces its stock over a period. It's one of the most useful indicators of how efficiently you're managing inventory.

The formula is:

Inventory turnover = COGS ÷ Average inventory

Average inventory = (Opening inventory + Closing inventory) ÷ 2

For example, if your COGS for the year was $120,000 and your average inventory was $30,000, your inventory turnover ratio is 4. That means you sold and replaced your entire stock 4 times during the year.

Here's what the ratio tells you in practice:

• A higher ratio means stock moves quickly, which generally means less cash tied up in unsold goods and lower storage costs.
• A lower ratio may indicate slow-moving stock, overstocking or weak demand.
• What counts as a "good" ratio varies by industry. A grocer will have a much higher turnover than a jeweller.

Tracking turnover over time (month to month or year to year) is more useful than comparing to industry averages. If your ratio is falling, investigate whether you're over-ordering or whether certain product lines are slowing down.

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. It's how you confirm that your records match reality.

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 by spotting theft, damage or administrative errors early.
• Maintain accurate accounts so your balance sheet reflects true asset values.
• Improve ordering by basing purchasing decisions on actual stock levels, not guesses.
• Meet compliance requirements by satisfying 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: the minimum for most businesses, often done at financial year end. 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.

Dealing with stock discrepancies

Discrepancies occur when your physical count doesn't match your records. Here's how to handle them:

1. Recount the item before making any adjustments to confirm the discrepancy is real.
2. Investigate the cause: check for unrecorded purchases or sales, damaged goods that weren't written off, or data entry errors.
3. Adjust your records to match the physical count. Record the adjustment as a shrinkage or write-off expense if stock is genuinely missing or damaged.
4. Note large or recurring discrepancies as a signal to review your ordering, storage or data entry processes.

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 speeds up counts and reduces errors by scanning items rather than writing them down.
• Cloud-based inventory software lets you 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 frequently asked questions about inventory accounting.

What is the difference between perpetual and periodic inventory systems?

A perpetual system updates your stock records in real time with every purchase and sale, giving you an accurate count at any point. A periodic system updates records at set intervals, such as monthly or at financial year end, and relies on a physical stocktake to establish closing inventory.

What is inventory shrinkage?

Inventory shrinkage is the difference between your recorded stock levels and the actual stock you have on hand. It's caused by theft, spoilage, damage or administrative errors, and must be recorded as a loss in your accounts.

How does inventory accounting affect my tax return?

Your inventory accounting method affects your cost of goods sold (COGS), which reduces your taxable profit. Choosing between FIFO and weighted average cost changes which stock costs you recognise first, so the method you select can influence how much tax you pay in a given year.

What is inventory turnover and why does it matter?

Inventory turnover is a ratio that measures how many times you sell and replace your stock over a period, calculated as COGS divided by average inventory. A higher ratio generally means you're selling efficiently with less cash tied up in unsold stock.

What is the difference between COGS and operating expenses?

COGS covers the direct costs of producing or purchasing the goods you sell, such as materials, manufacturing labour and freight in. Operating expenses are the costs of running your business that aren't tied directly to production, including rent, marketing and administration.