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How To Use 3 Inventory Accounting Methods

how-to-use-3-inventory-accounting-methods
How To Use 3 Inventory Accounting Methods

Inventory accounting is a critical part of financial management for any business. Proper inventory accounting facilitates accurate financial reporting, efficient operations, and your ability to meet customer demand. Delve into the mechanics of inventory accounting, what assets are included, the advantages it offers, and its various valuation methods.

What is inventory accounting?

Inventory accounting refers to the systematic recording, tracking, and valuation of a company’s inventory—that is, a complete list of merchandise and materials held by a business for selling in the market and earning a profit. Tracking inventory is essential to get an accurate picture of a business’s financial health and ensure it has enough stock to meet customer demand without overstocking or incurring unnecessary stock costs.

Proper inventory accounting is required by generally accepted accounting principles (GAAP), a regulated set of accounting rules that limit the potential for misleading a company’s performance and financial health. Applying GAAP to inventory accounting is necessary, as it prevents businesses from underreporting the value of inventory, thereby inflating profits.

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How inventory accounting works

Inventory accounting works by assigning costs to inventory items as they move through the production process and are eventually sold to customers. These costs are determined under either the cost method or market value method.

Under the cost method, you assign costs to inventory goods based on how much you were charged to acquire the goods (typically purchase price and shipping). Under the market value method, you assign cost based on a good’s current market value, which can rise and fall over time. In either case, it’s important to note that inventory is considered a current asset under GAAP, which means it is not depreciable, unlike a company vehicle or equipment. 

How inventory accounting affects COGS and inventory valuation

Cost of goods sold (COGS) and inventory valuation—two critical financial management metrics—depend on properly accounted inventory. When determining COGS, the formula is:

COGS = beginning inventory balance + purchases – ending inventory balance

If your inventory at the beginning of an accounting period (such as a month) is valued at $5,000, and you purchase $3,000 in additional inventory and end the same period with an inventory value of $2,500, here’s how you would calculate your COGS:

COGS = $5,000 + $3,000 – $2,500

COGS = $5,500

Inventory valuation is calculated by assigning specific values to products that remain in inventory at the end of the accounting period, either based on the cost of acquisition or fair market value. 

What is included in inventory accounting?

Businesses typically include the following when conducting inventory accounting:

  • Materials. These might include raw materials (wood, cotton, etc.) and components (screws, microchips, zippers, etc.) that go into manufacturing a product.
  • Work-in-progress goods. These are goods that are in the process of being manufactured. For example, a clothing company might include half-finished dresses in its inventory accounting.
  • Finished goods. These are goods that a business is ready to sell to customers.
  • MRO supplies. Maintenance, repair, and operations supplies include materials that are used up in the production process but not included in the final product. They can include personal protective equipment, cleaning supplies, office supplies, and tech equipment.
  • Resale goods. These are products that customers returned but are of sufficient quality to sell again.

Advantages of inventory accounting

The benefits of good inventory accounting all feed into determining an accurate picture of a company’s financial positioning. Some advantages include:

Accurate financial reporting

Implementing proper inventory accounting ensures that a company’s balance sheet reflects the accurate value of its inventory assets. This accuracy extends to financial statements, providing stakeholders (or potential investors) with reliable information for decision-making.

Efficient inventory management

Inventory accounting allows businesses to manage inventory levels (known as inventory control) and ensure they aren’t stocking too much inventory or overspending on storage costs. By understanding which items are fast-moving and which may be obsolete inventory, businesses can make informed decisions to avoid these risks.

Meeting customer demand

With accurate tracking of inventory levels and sales patterns, businesses can ensure they have enough stock to meet customer demand (which might fluctuate seasonally). This not only enhances customer satisfaction by ensuring product availability on a ready schedule, it also helps maintain a positive cash flow.

Tax compliance

Proper inventory accounting is critical for tax purposes. It enables businesses to accurately calculate taxable income, ensuring compliance with tax regulations and avoiding penalties.

Inventory accounting methods

There are three commonly used inventory accounting methods: FIFO (first in, first out), LIFO (last in, first out), and weighted average. Here’s how they operate in inventory accounting:

FIFO

First in, first out, or FIFO, is arguably the most common method for inventory valuation. It assumes that the first items added to the inventory are the first to be sold. What this means is that COGS is calculated using the cost of the oldest inventory, while the ending inventory is valued at the cost of the most recently purchased items.

Let’s break it down with an example: Say you own and operate a company that sells graphic-printed hoodies. On November 1, 2023, you purchase 100 blank cotton hoodies for $8 each. On November 15, 2023, you purchase an additional 100 hoodies, but your regular supplier has raised its price to $10 each. You purchase 100 hoodies at this new price.

Let’s also say that your supply dips in late November. On November 30, you buy 100 additional hoodies from another supplier who prices the goods at $9 each.

To properly track inventory costs and ending inventory, you need to incorporate all three prices into your inventory accounting, as these will directly impact your COGs and inventory’s overall value. You would record the inventory purchases as follows:

  • 11-01-2023: 100 hoodies x $8 = $800
  • 11-15-2023: 100 hoodies x $10 = $1,000
  • 11-30-2023: 100 hoodies x $9 = $900

Aside from making these inventory purchases, you received two significant customer orders on November 17 for 125 hoodies and another on November 30 for 150 hoodies. Here’s how you would value inventory purchased on November 17 using the FIFO accounting method:

  • 100 hoodies x $8 = $800
  • 25 hoodies x $10 = $250
  • Total cost of inventory = $1,050

Under the FIFO method, the above includes the first hoodies taken into stock at $8 each. The remaining hoodies in the order were accounted for under the second price offered by your regular supplier, at $10 each.

The next order, completed on November 28, would be recorded as:

  • 75 hoodies x $10 = $750
  • 75 hoodies x $9 = $675
  • Total cost of inventory = $1,425

Here, the oldest hoodies in stock, which were $10 each, sold first. Once those were exhausted, the additional 75 hoodies were valued at the most recent cost of $9 each. After both of the above orders were completed, you were left with 25 hoodies in stock, all valued at the most recent cost of $9, or $225 in total.

The COGS for the month of November 2023 under FIFO, taking into account all of the above, would be:

COGS = $0 + $2,700 – $225

COGS = $2,475

LIFO

Last in, first out, or LIFO, evaluates inventory based on the assumption that the last items purchased in your inventory will be the first to be sold. Using the same example as above, here’s how your inventory totals would be determined under LIFO:

The first order on November 17 would be:

  • 100 hoodies x $10 = $1,000
  • 25 hoodies x $8 = $200
  • Total cost of inventory = $1,000

Under LIFO, because the $10 hoodies were the last inventory items added before the November 17 order, they are the first to be sold.

The next order, completed on November 30, would be:

  • 100 hoodies x $9 = $900
  • 50 hoodies x $8 = $400
  • Total cost of inventory = $1,300

After both orders are completed, you are left with 25 hoodies all valued at $8 each, or $200.

Your COGS using the LIFO method for November 2023 would be:

COGS = $0 + $2,700 – $200

COGS = $2,500

Weighted average

The weighted average method takes the average of the total cost of your inventory. Using the hoodie example, you would add up the cost of all three inventory purchases for the month of November:

$800 + $1,000 + $900 = $2,700

You would then divide your total monthly inventory cost by your total inventory count for the same period:

$2,700 / 300 = $9

Using the weighted average method, your ending inventory valuation would be:

$9 x 25 = $225

And that would leave you with a COGS of:

COGS = $0 + $2,700 – $225

COGS = $2,475

Inventory accounting FAQ

Why is inventory accounting important?

Inventory accounting is important because it provides an accurate reflection of a business’s financial health by properly recording inventory values on financial statements and balance sheets. Inventory accounting facilitates reliable financial reporting for stakeholders and potential investors. It also promotes optimal stock levels, prevents overstocking or stockouts, and ensures the business can meet demand.

How is inventory classified in accounting?

Inventory is classified as a current asset. This means it is expected to be converted into cash or used up in the near future, usually within an operating cycle (typically a year). This classification is important because it distinguishes between short-term and long-term assets, providing insights into a company’s immediate liquidity and ability to meet short-term obligations.

Do you have to report inventory?

Yes, businesses are generally required to report inventory as part of their financial statements. In the US, inventory reporting rules come from the US Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS), as well as state tax authorities.

This originally appeared on the Shopify Retail Blog and is available here for discovery.
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