Inventory accounting: definition, methods and benefits

Published Monday 30 March 2026

Table of contents

• What is inventory?
• Types of inventory
• What is inventory accounting?
• Inventory accounting methods
• How inventory affects your financial statements
• Benefits of inventory accounting
• How to do inventory accounting
• Simplify inventory accounting with Xero
• FAQs on inventory accounting

Key takeaways

• Choose the right inventory accounting method for your business by selecting FIFO for rising prices and higher profits, weighted average for similar items, or consulting your accountant about LIFO if tax reduction is a priority.
• Track inventory systematically by recording all purchases with dates and costs, updating records when items sell, and conducting regular physical counts to catch discrepancies between your books and actual stock.
• Recognise that inventory directly impacts your financial statements as a current asset on your balance sheet and through cost of goods sold on your profit and loss statement, affecting both cash flow and profitability calculations.
• Use inventory accounting to make smarter business decisions by identifying fast-selling products to avoid stockouts, reducing slow-moving inventory to lower storage costs, and understanding true product margins for better pricing strategies.

What is inventory?

Inventory is the goods your business holds to sell to customers. These items may be resold as-is or combined into new products.

Equipment, supplies, and tools you use to run your business aren't inventory. They're recorded as expenses. If you sell goods that ship directly from a third party to the customer, you don't have inventory either. You must own something for it to count as inventory.

Types of inventory

Businesses typically track four main types of inventory. Understanding each category helps you account for costs at every stage of production and sales.

• Raw materials: Items purchased for use in manufacturing, such as fabric, wood, or metal
• Work-in-progress (WIP): Partially completed goods still moving through production
• Finished goods: Completed products ready for sale to customers
• Maintenance, repair, and operations (MRO): Supplies used to support production, such as cleaning materials or spare parts

What is inventory accounting?

Inventory accounting is the process of tracking the value and costs of the goods you hold for sale. It helps you understand what your inventory is worth and how much it costs to store.

Inventory appears as an asset on your balance sheet, but its value can drop quickly as items become outdated, damaged, or lose market value. Because of this, accounting standards require inventory to be measured at the lower of cost and net realisable value. Storage also adds ongoing costs.

Accurate inventory accounting supports better decisions across your business:

• Pricing: Set prices based on true product costs
• Insurance: Ensure proper coverage for your stock
• Budgeting: Plan purchases and cash flow more effectively
• Taxes: Report inventory values correctly at tax time
• Profitability: Identify which products generate the most margin

Inventory accounting methods

The method you choose affects how you value inventory and calculate taxes. Here are the three most common approaches.

• First-in, first-out (FIFO): Assumes you sell the oldest inventory first. Works well when prices are rising because it reports lower cost of goods sold and higher profits.
• Last-in, first-out (LIFO): Assumes you sell the newest inventory first. Can reduce taxable income when prices rise, but it isn't accepted under all accounting standards; for example, IAS 2 prohibits LIFO because the method may not accurately represent inventory flows.
• Weighted average cost: Calculates an average cost for all units available during the period. Simplifies tracking when inventory items are similar or hard to distinguish.

Most small businesses use FIFO or weighted average because they're straightforward and widely accepted; for instance, among S&P 500 companies, an estimated 55% of companies use FIFO as their primary method. Talk to your accountant to choose the method that fits your business and tax situation.

How inventory affects your financial statements

Inventory accounting directly impacts two key financial reports: your balance sheet and your profit and loss statement.

Inventory on your balance sheet

Inventory appears as a current asset on your balance sheet. It represents the value of goods you hold for sale. As you sell items, their value moves from inventory to an expense called cost of goods sold.

Cost of goods sold on your profit and loss

Cost of goods sold (COGS) is the direct cost of producing or purchasing the items you sold during a period. It includes materials, labour, and other costs tied to those goods.

To calculate COGS:

1. Start with your beginning inventory value
2. Add purchases made during the period
3. Subtract your ending inventory value

The result shows what it cost to produce the goods you sold. Subtracting COGS from revenue gives you gross profit.

Impact on cash flow

Inventory ties up cash. Money spent on stock sits on your balance sheet until you sell those items. Tracking inventory accurately helps you avoid overstocking and frees up cash for other business needs.

Benefits of inventory accounting

Accurate inventory accounting helps you save money and make better decisions. Here's how it supports your business.

• Maximise sales: Avoid stockouts by tracking which products sell quickly
• Lower storage costs: Order fewer slow-moving items to reduce storage and write-off expenses
• Negotiate better deals: Identify high-volume items and shop for bulk discounts
• Understand true margins: Track actual product costs to see which items generate the most profit
• Plan smarter promotions: Spot seasonal trends to time your marketing effectively
• Manage tax timing: Control when you purchase inventory to affect your taxable income
• Improve cash flow: Free up cash by reducing money tied up in slow-moving stock

Inventory accounting software like Xero can help you track what's selling and what's not.

How to do inventory accounting

Inventory accounting involves consistent tracking and recording so you always know what you have, what it costs, and what it's worth. Follow these steps to set up a reliable system.

1. Choose your inventory accounting method: Decide whether to use FIFO, LIFO, or weighted average cost based on your business type and tax situation.
2. Set up your tracking system: Use accounting software like Xero to record purchases, sales, and current stock levels in one place.
3. Record inventory purchases: Enter each purchase with the date, quantity, unit cost, and supplier details.
4. Track inventory as you sell: Update records when items leave your inventory so your books reflect actual stock on hand.
5. Conduct regular physical counts: Compare physical inventory to your records periodically to catch discrepancies.
6. Reconcile and adjust as needed: Investigate differences between your records and physical counts, then make adjustments for damaged, lost, or obsolete items.

Learn more in our guide to Inventory.

Simplify inventory accounting with Xero

Managing inventory accounting is easier with the right tools. Xero helps you track stock, calculate costs, and see your financial position in real time.

With Xero, you can:

• Track inventory automatically: Record purchases and sales in one place
• Calculate COGS: See your cost of goods sold without manual calculations
• Monitor stock levels: Know what's selling and what's sitting on shelves
• Generate reports: View inventory value and margins whenever you need them
• Connect your systems: Integrate with apps for ecommerce, point of sale, and more

Ready to streamline your inventory accounting? Get one month free to try Xero's complete inventory features.

FAQs on inventory accounting

Here are answers to common questions about inventory accounting for small businesses.

What are the four types of inventory?

The four types are raw materials, work-in-progress (WIP), finished goods, and maintenance, repair, and operations (MRO) inventory. Each category represents a different stage in your production or sales process.

What's the difference between inventory and cost of goods sold?

Inventory is an asset on your balance sheet representing goods you hold for sale. Cost of goods sold (COGS) is an expense on your profit and loss statement representing the cost of items you've already sold.

Which inventory accounting method is best for small businesses?

Most small businesses use FIFO or weighted average cost because they're simple to apply and widely accepted. FIFO works well when prices change frequently, while weighted average suits businesses with similar, interchangeable items.

How often should I do physical inventory counts?

Count physical inventory at least once a year for accurate financial reporting. Businesses with high sales volume or shrinkage concerns may benefit from monthly or quarterly counts.

Do I need special software for inventory accounting?

You don't need separate software. Cloud accounting platforms like Xero include built-in inventory tracking that records purchases, calculates COGS, and syncs with your financial reports automatically.