Inventory accounting: definition, methods and tips

Published Friday 20 March 2026

Table of contents

• What is inventory?
• What isn't inventory?
• What is inventory accounting?
• Benefits of inventory accounting
• Types of inventory
• Inventory accounting methods
• Periodic vs. perpetual inventory systems
• How to do inventory accounting
• Take control of your inventory accounting
• FAQs on inventory accounting

Key takeaways

• Choose FIFO (First-In, First-Out) as your inventory accounting method since it's simple, matches how goods typically move through your business, and is accepted under all major accounting standards.
• Upgrade from spreadsheets to inventory software when you spend more than a few hours per week on manual tracking or struggle to keep records accurate, as automated systems provide real-time updates and reduce costly mistakes.
• Conduct regular stock takes monthly or quarterly to verify your records match physical inventory, helping you catch discrepancies early and maintain accurate balance sheet values.
• Track inventory movements in real time by recording every sale, return, damage, and adjustment to maintain accurate records that help you identify fast and slow movers for better purchasing decisions.

What is inventory?

Inventory is the goods your business has bought to sell to customers. These items may be resold as-is, or combined into a new product. A retailer's inventory might include clothing on shelves, while a manufacturer's inventory includes raw materials and finished goods ready for sale.

What isn't inventory?

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

• Business equipment and supplies: Tools, vehicles, and stationery are recorded as expenses, not inventory
• Dropshipped goods: If a third party ships products directly to your customer, you don't hold inventory
• Items you don't own: You must own goods for them to qualify as inventory on your balance sheet

What is inventory accounting?

Inventory accounting is the process of tracking the value and costs of your stock. Since inventory is listed as an asset on your balance sheet, you need accurate records to understand what it's worth at any point in time.

Inventory value can change quickly. Stock loses value when it gets old, damaged, or when market prices drop. Storage also adds ongoing costs.

Accurate inventory accounting helps you:

• set profitable prices
• get appropriate insurance coverage
• budget effectively
• calculate taxes correctly
• value your business for sale
• identify your most profitable products

Benefits of inventory accounting

Inventory accounting helps you save money and make smarter decisions. Here's how it improves your profits.

Improve cash flow and reduce costs

• Free up cash: Avoid tying money up in slow-moving stock so you can pay down debt or invest in growth
• Cut storage costs: Order fewer slow-moving items to reduce warehousing and write-off expenses
• Time purchases strategically: Control when you buy stock to manage tax timing and due dates

Prevent stockouts and overstocking

• Keep fast sellers in stock: Track what's selling so you never miss a sale
• Reduce excess inventory: Identify slow movers before they become dead stock
• Plan for seasonal demand: Spot sales trends to order the right quantities at the right time

Make better business decisions

• Know your true margins: Track actual stock costs to see which products are most profitable
• Negotiate better deals: Identify high-volume items and shop for bulk discounts
• Plan effective promotions: Use sales data to time marketing campaigns around demand patterns

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

Types of inventory

Understanding the different types of inventory helps you track and value stock accurately. Most small businesses work with one or more of these categories.

• Raw materials: Components and ingredients used to manufacture products, such as fabric for a clothing maker or timber for a furniture builder
• Work-in-progress (WIP): Partially completed goods still moving through production, like a half-assembled piece of furniture
• Finished goods: Completed products ready to sell to customers
• Maintenance, repair, and operating (MRO) supplies: Items that support production but aren't sold directly, such as cleaning supplies or machine parts
• Dead stock: Unsold inventory that's unlikely to sell due to damage, obsolescence, or lack of demand

Retailers typically hold finished goods, while manufacturers manage raw materials, WIP, and finished goods. Knowing your inventory types helps you choose the right accounting method and tracking system.

Inventory accounting methods

Inventory accounting methods determine how you calculate the cost of goods sold and the value of remaining stock. The method you choose affects your reported profits and tax obligations, as different rules may apply based on your business size. In New Zealand, for instance, the Inland Revenue Department (IRD) defines a low-turnover trader as a business with sales under $3 million for the year, which can open up different valuation options.

The three main methods are:

• First-In, First-Out (FIFO): Assumes your oldest stock sells first. This method often results in higher reported profits when prices are rising, since older, cheaper inventory is counted as sold.
• Last-In, First-Out (LIFO): Assumes your newest stock sells first. This can lower taxable income when prices rise, but isn't permitted under some accounting standards.
• Weighted average: Calculates an average cost across all units in stock. This smooths out price fluctuations and simplifies record-keeping.

Most small businesses use FIFO because it matches how goods typically move through a business and is accepted under all major accounting standards. Your accountant can help you choose the method that best suits your industry and tax situation.

Periodic vs. perpetual inventory systems

You can track inventory using two main approaches: periodic counting or real-time tracking. The right choice depends on your business size and complexity.

• Periodic system: You count inventory at set intervals, such as monthly, quarterly, or annually. Between counts, you estimate stock levels based on purchases and sales. This approach works for small businesses with limited product lines but can miss theft, damage, or errors until the next count. New Zealand's tax authority allows businesses with sales under $1.3 million and closing stock under $10,000 to use a simplified valuation method.
• Perpetual system: You update inventory records with every sale and purchase in real time. This gives you accurate stock levels at any moment and helps you spot problems quickly. Cloud accounting software makes perpetual tracking affordable for small businesses.

Most businesses that outgrow spreadsheets move to a perpetual system. The upfront setup takes more effort, but ongoing accuracy saves time and reduces costly mistakes.

How to do inventory accounting

Getting started with inventory accounting means tracking three key things: how much stock you have, what it costs, and what you sell it for. Here's how to set up a system that works.

1. Set up your tracking system: Choose between spreadsheets for very simple needs or inventory software for automated tracking. Software connects to your accounting and updates in real time.
2. Record inventory purchases: Track what you buy, when you buy it, and the cost per unit. Include shipping and handling in your cost calculations.
3. Choose your valuation method: Select FIFO, LIFO, or weighted average based on your business type. Your accountant can help you decide which method suits your situation.
4. Track inventory movements: Record every sale, return, damage, and adjustment. This keeps your records accurate and your balance sheet current.
5. Conduct regular stock takes: Count physical inventory periodically to verify your records match reality. Monthly or quarterly counts catch discrepancies early.
6. Review and analyse: Use reports to identify fast and slow movers, calculate profitability by product, and set reorder points.

Learn more in our guide to inventory.

Take control of your inventory accounting

Good inventory accounting shows you what's selling, what's sitting, and where your money is tied up. Instead of guessing what to order or discovering problems at tax time, you'll have up-to-date information to make confident decisions.

The result is better cash flow, fewer stockouts, and clearer profitability. Whether you're tracking a handful of products or hundreds, the right system makes inventory management simpler.

Simplify how you track inventory. Get one month free when you purchase any Xero plan. See how inventory software takes the manual work out of stock management.

FAQs on inventory accounting

Here are answers to common questions about managing inventory in your accounting system.

What are the four types of inventory?

The four main types are raw materials, work-in-progress (WIP), finished goods, and maintenance, repair, and operating (MRO) supplies. Depending on your business, you might hold one or several of these types.

How do you record inventory in accounting?

Record inventory purchases as an asset on your balance sheet. When you sell items, reduce inventory and record cost of goods sold (COGS) as an expense on your profit and loss statement.

What inventory accounting method should I use?

Most small businesses use First-In, First-Out (FIFO) because it's simple and matches how goods typically move through a business. Your accountant can help you choose the best method based on your industry and tax situation.

When should I upgrade from spreadsheets to inventory software?

Consider upgrading when you spend more than a few hours per week on manual tracking or struggle to keep records accurate. It's also time to upgrade if you run out of stock unexpectedly or grow beyond a handful of products.

Reaching certain financial milestones can also be a trigger, as tax obligations can change. For example, New Zealand's Inland Revenue has special rules for retailers with a turnover exceeding $1 million. Software like Xero automates tracking and integrates with your accounting.