Inventory accounting guide: methods, benefits and steps

Published Monday 30 March 2026

Table of contents

• What is inventory?
• What isn't inventory?
• Types of inventory
• What is inventory accounting?
• Inventory accounting methods
• Benefits of inventory management
• How to do inventory accounting
• Use Xero to streamline your inventory accounting
• FAQs on inventory accounting

Key takeaways

• Choose the right inventory accounting method for your business needs, with FIFO being the most widely accepted option that works well for perishable goods, while weighted average cost offers simplicity for businesses with similar inventory items.
• Track three core figures consistently to maintain accurate inventory records: how much stock you have through regular physical counts, what you paid for each item including shipping costs, and what you sell it for.
• Use inventory data to maximise profitability by avoiding stockouts on popular products, reducing storage costs on slow-moving items, and analysing product-level gross margins to make informed pricing decisions.
• Reconcile your inventory records regularly by comparing your documented stock levels to actual physical counts, which helps catch discrepancies early and maintains accurate financial reporting.

What is inventory?

Inventory refers to the goods your business buys with the intention of selling to customers. These items may be resold as-is or combined into a new product.

What isn't inventory?

Not everything your business buys counts as inventory. Here are common exclusions:

• Business equipment and supplies: Work tools and vehicles are generally recorded as property, plant, and equipment, and expensed over time through depreciation. Consumable supplies such as stationery are usually recognised as supplies or expenses as used, not as inventory.
• Dropshipped goods: In many dropshipping arrangements, you don't hold inventory because a third party fulfils the order directly to your customer. However, the accounting treatment depends on whether you control the goods before they're transferred.

Types of inventory

Businesses classify inventory into four main categories based on where items sit in the production and sales process. Understanding these types helps you track costs accurately and manage stock more effectively.

Raw materials

Raw materials are the basic inputs your business uses to create products. For a furniture maker, this includes wood, screws, and fabric. These items have value but require processing before you can sell them.

Work-in-progress (WIP)

Work-in-progress inventory includes items that are partially completed. These goods have moved past the raw material stage but aren't ready for sale yet. WIP inventory ties up labour and material costs until production finishes.

Finished goods

Finished goods are completed products ready for sale to customers. This is the inventory that generates revenue when sold. Tracking finished goods helps you avoid stockouts and overstocking.

Maintenance, repair, and operations (MRO)

MRO inventory includes supplies that support your production process but don't become part of the final product. Examples include cleaning supplies, safety equipment, and machine lubricants. While MRO items don't generate direct revenue, they keep your operations running.

What is inventory accounting?

Inventory accounting is the process of determining the value and costs of your stock. It helps you set prices, budget accurately, calculate taxes, and identify your most profitable products.

Inventory appears as an asset on your balance sheet, but its value can drop quickly. Stock can become outdated, damaged, or lose market value. Inventory can also create carrying costs, which may include storage, insurance, handling, and the risk of items becoming obsolete.

Tracking these factors through proper accounting helps you see what you need to make informed decisions.

Inventory accounting methods

Different businesses use different methods to assign costs to inventory. The method you choose affects your reported profits, tax obligations, and financial statements. Here are the four most common approaches.

First in, first out (FIFO)

FIFO assumes you sell your oldest inventory first. When prices rise, FIFO results in lower cost of goods sold and higher reported profits. Because the method is accepted under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), it's a reliable choice for businesses with perishable goods or products that can become obsolete.

Last in, first out (LIFO)

LIFO assumes you sell your newest inventory first. When prices rise, LIFO reports higher costs and lower taxable income. Note that the LIFO method is prohibited under IFRS (International Financial Reporting Standards), so it's mainly used in the United States where it is permitted by Generally Accepted Accounting Principles (GAAP).

Weighted average cost

Weighted average cost calculates the average cost of all inventory items available for sale during a period. This method smooths out price fluctuations and works well when inventory items are similar or interchangeable.

Specific identification

Specific identification tracks the actual cost of each individual item. This method suits businesses selling unique, high-value items like vehicles, artwork, or custom furniture. It provides the most accurate cost matching but requires detailed record-keeping.

Benefits of inventory management

Proper inventory accounting helps you save money and increase revenue. Reducing excess inventory can free up working capital that you may use to reduce debt, run operations, or invest.

Here's how inventory accounting supports your bottom line:

• Maximise sales: Avoid stockouts on popular products by tracking what sells.
• Lower storage costs: Order fewer slow-moving items to reduce carrying costs and the risk of write-downs or write-offs.
• Negotiate better deals: Use demand data to help negotiate purchasing terms, including volume discounts where available.
• Reveal true profit margins: Track stock costs accurately to analyse product-level gross margins.
• Plan smarter promotions: Use sales and inventory data to identify seasonal patterns that may inform promotion planning.
• Control tax timing: In some jurisdictions and under some accounting methods, inventory purchases and year-end stock levels can affect taxable income and the timing of tax liabilities.

How to do inventory accounting

Inventory accounting starts with tracking three core figures: how much stock you have, what you paid for it, and what you sell it for. It should be based on reliable records, physical counts, and recognised costing and valuation methods.

Follow these steps to set up your inventory accounting:

1. Count your stock: Conduct a physical inventory count or use software to track quantities in real time
2. Record purchase costs: Document what you pay for each item, including shipping and handling
3. Track sales prices: Log the price at which you sell each product
4. Choose an accounting method: Select FIFO, LIFO, weighted average, or specific identification based on your business needs
5. Reconcile regularly: Compare your records to actual stock levels to catch discrepancies early

Learn more in our guide to inventory.

Use Xero to streamline your inventory accounting

Good inventory accounting gives you control over costs, pricing, and profitability. But tracking stock manually or through spreadsheets takes time and leaves room for error.

With Xero's inventory tracking features, you can manage stock levels, monitor costs, and generate reports without the manual work. You can see what's selling, what's sitting, and where your margins are strongest.

Ready to simplify your inventory accounting? Get one month free when you try Xero today.

FAQs on inventory accounting

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

What is inventory in accounting?

Inventory refers to goods your business owns and intends to sell. In accounting, inventory is recorded as a current asset on your balance sheet until it's sold.

What are the 4 types of inventory?

The four types are raw materials, work-in-progress (WIP), finished goods, and maintenance, repair, and operations (MRO) supplies.

What inventory accounting method is best for small businesses?

FIFO works well for most small businesses because it's straightforward and accepted under all accounting standards. If your inventory items are similar, weighted average cost offers simplicity with less record-keeping.

How does inventory accounting affect my taxes?

Your inventory accounting method affects your cost of goods sold, which directly impacts taxable income. LIFO typically lowers taxes when prices rise, while FIFO may result in higher taxable profits.

Do I need inventory accounting software?

Software becomes valuable when you're tracking more than a handful of products or managing stock across multiple locations. It reduces errors, saves time, and lets you see stock levels and costs in real time. For example, one survey found 79% of finance leaders reduced month-end close time after implementing inventory management software.