What is inventory? Understanding and applying inventory accounting is essential on two fronts. On one hand, inventory accounting is integral to your tax and reporting responsibilities. On the other hand, it also acts as a key indicator of how well you’re running your business.
If your small business purchases, holds and sells inventory of any description, you need to come to terms with how inventory works and how to manage, report and account for it through sound inventory accounting.
What is inventory accounting?
Inventory accounting is a way to declare, calculate and report upon the value of your business’s inventory.
In basic terms, inventory accounting assists you to understand:
- how much inventory your business has
- how much your inventory cost you
- what your inventory can sell for.
We frame inventory in accounting terms as your inventory is both an asset and an expense.
As such, inventory accounting helps you understand the value of your business and how well you’re balancing stock, sales, expenses and cashflow.
If you nail your inventory accounting, you’ll receive a far broader and more accurate overview of how well managed your business is.
Is inventory an asset or expense?
For accounting purposes, inventory is understood as both an asset and an expense.
Inventory is an asset as it holds material value and potential sales are associated with it. But inventory is also classified as an expense because it cost your business capital to purchase it.
For a better understanding, read about COGS or ‘cost of goods sold’ here.
How do you record inventory in accounting?
So how does one record inventory in their accounting? In basic terms, when your busines purchases inventory, such as beans for a café, you’ll record your beans as both an expense and an asset in your software or spreadsheet.
When you eventually sell those beans, you’ll record this as income and concurrently remove the items from your ledger of assets.
There’s also an alternative method. You can record the inventory you bought solely as an asset and then only record the cost simultaneously with the sales income when you sell your inventory.
How do value stock in accounts?
So how do you value stock in your accounts? What if you paid various amounts for inventory over your reporting period?
With the prices of inventory often fluctuating, a cost disparity between orders is highly possible. As such, you’ll need a method for simplifying and accounting for the varying cost of your goods.
There are several methods for working out how to value inventory or stocks over a period of time. These are the most common and useful methods of valuing stock or inventory:
1) AVCO (weighted average cost method)
As the name suggests, this method averages the price of your purchased inventory. For each item type you bought, you simply find the average price across the period.
By multiplying the average price of a product line by the quantity of items sold, you’ll have the value of your inventory.
However, this method becomes rather inexact, particularly if you have large price changes. Your actual inventory value might in fact be above or below this result.
By using the AVCO method of inventory accounting, you can miss out on valuable data relating to specific profit margins and how the price of your inventory changed over time.
2) FIFO (first in, first out method)
Another method of inventory accounting you can use to calculate the value of your inventory is FIFO accounting.
For this method, you specifically assign the actual cost to each inventory item in a line of producers. This method functions on the assumption you sell older stock first (not necessary in action).
Upon making a sale, you record the sale price at the same time you cross off the oldest item in your inventory.
The FIFO method, although more intricate, gives you a better understanding of your profit while shining a light on the real cost of goods.
As with almost any accounting tasks, inventory accounting is best served by investing in time with a business advisor to recommend the best methods of inventory accounting for your business. By coupling this advice with some industry leading software to take the leg work out of daily operations, you’ll have a perfect solution to your inventory accounting needs.
