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
When you buy an inventory item, it is recorded as a cost and an asset. It’s an asset because you can sell it.
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 three methods for working around this.
1. Weighted average cost method (AVCO)
For each product line, you can simply use the average cost per item.
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.
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.
3. Last in, first out method (LIFO)
LIFO accounting also gives you a specific value for each item of inventory. But it goes about it in a different way.
- Record the cost of each new item as it comes in (the price will change over time).
- When you make a sale, record what you were paid.
- Delete the newest cost from the list.
In this scenario, you assume you sell your newest items first. Under some circumstances, this can help lower business income taxes. However there are a lot of rules around LIFO, so always speak to an accountant before choosing it.
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 an inventory count?
An inventory count 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 inventory counting important?
You may be required to do an inventory count 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 an inventory count?
The IRS may require you to do an inventory count 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 inventory counting
If the numbers of a physical inventory count closely match the numbers in your financial records, you may be able to wait longer till your next one.
Computerized 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.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
Guide to inventory
Inventory management is more than just knowing what’s been sold and what you’ve ordered. Find out what else is involved.
- What is inventory?
Your inventory is one of the most important purchases you’ll make. It’s the reason you’re in business.
- Types of inventory
Inventory comes in many forms. Understanding the types will help you identify it for valuation and management.
- Inventory management
A complete overview of your inventory will help your business run smoothly and profitably, so where do you start?
- Inventory accounting
Inventory can be a big expense, and a big earner, so it pays to stay on top of the numbers.
- Inventory management systems
You know inventory is vital to a healthy business. So let’s look at some systems for efficient inventory management.
- Inventory management software
Inventory management software may give you the extra time you need, or the ability to take things to the next level.
- Tools and guides for your business
Now that you’re in business, you want to stay there. Xero’s got resources and solutions to help.
Download the guide to inventory
Learn the strategies and techniques behind successful inventory management. Fill out the form to receive our inventory guide as a PDF.
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