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chapter four of six

Inventory accounting

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Inventory can be a big expense, and a big earner, so it pays to stay on top of the numbers. Besides, you need to report it on your tax return. So let’s look at the basics of inventory accounting.

What is inventory accounting?

Inventory accounting helps you figure out how much inventory you have, what it cost you, and what it’s worth to your business. It will help you see if your business is performing as well as it could.

How to do inventory accounting

Inventory accounting when buying.

When you buy an inventory item, it is recorded as a cost and an asset. It’s an asset because you can sell it.

Inventory accounting when selling.

When you sell that item, it is recorded as income. You also remove it from your list of assets.

This isn’t the only way to account for your inventory. Other methods may better suit your business. One alternative is to record your inventory as an asset when you buy it, and only record the cost (along with the income) when you sell it.

Simple, but there’s a catch

It can be tricky keeping tabs of what you paid for things when prices change all the time. Accountants have two methods for working around this.

1. Weighted average cost method (AVCO)

For each product line, you can simply use the average cost per item.

AVCO inventory valuation formula.

Multiplying this average cost by the number of items you have will tell you the rough value of your inventory. AVCO is a straightforward method, but it leaves out some detail and doesn’t work very well when there are big price fluctuations.

2. First in, first out method (FIFO)

You can assign a specific value to each item in your inventory using FIFO accounting.

FIFO inventory valuation formula.

You assume you sell your oldest items first (although that doesn’t have to happen in practice). FIFO gives you a more detailed view of the value of inventory in stock. It also gives you a better view of your profit margin and how it changes over time.

What about cost of goods sold?

It’s important to know the value of the inventory you’re holding in stock. But it’s also important to know the value of the inventory you’ve sold. That information will help you get a sense for how much money the business is making.

That’s where cost of goods sold (COGS) comes in.

COGS = beginning inventory + purchases - ending inventory

This formula tells you how much inventory you had to buy in order to earn your sales revenue. Most businesses use this simple COGS formula for inventory accounting. When it comes to working out your profit, you can dig into more detail by factoring in things like storage and handling costs. See more on COGS in our guide to starting a business.

What is stocktaking?

Stocktaking is used to double-check the numbers in your financial records. You do this by physically counting every item of inventory in your possession.

Compare that number to what you have on your balance sheet. They won’t often match up. Generally there will be less in reality than on the books. That missing inventory is generally assumed to have been damaged and dumped, or stolen.

Why is stocktaking important?

You may be required to do a stocktake before submitting your business tax return. Besides that, it’s a really good way to check and correct your financial numbers.

How often should I do a stocktake?

Tax authorities may require you to do a stocktake at the end of the financial year. Some businesses do it far more often than that. For example:

  • retail businesses may do it quarterly (if they sell seasonal goods)

  • hospitality businesses often do it once a month

  • manufacturers of perishable foods may do it even more frequently

Alternatives to stocktaking

If the numbers of a physical stocktake closely match the numbers in your financial records, you may be able to wait longer till your next one.

Computerised inventory systems can sometimes deliver this level of accuracy. They automatically count inventory as you order it, and subtract it when you sell it. You can complement this technology with cycle counts, where you do a physical count of a few random product lines to check that your book records reflect reality.

Chapter 5: Inventory management systems

Different businesses need different inventory management systems. What’s the best option for your business?

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