Inventory accounting is essential for managing cash flow, ensuring accurate financial statements, and maintaining inventory control. Mastering that accounting is a critical component of optimized inventory management.
It must be recognized that accounting for inventory is not just a matter of knowing what you have, where it is located, and in the correct quantities (aka inventory visibility). It also involves assessing the value of what you have, which can be affected by a number of factors and determined through a variety of methods.
At SkuNexus, we understand the crucial importance of thorough inventory accounting and in this article, we would like to go through a series of key components to give you a helpful introduction to the basics.
What is Inventory Accounting?
Before we discuss how to optimize your accounting of inventory, it’s important to define our terms.
Inventory accounting is the practice of tracking and recording a company's purchases and sales of inventory items, and involves all other costs related to inventory (storage, insurance, shrinkage/loss, etc.). The goal is to provide the most accurate possible record of a business’s inventory for the purposes of valuation, financial reporting, and the proper management of the business.
Benefits of Proper Inventory Accounting
Inventory is a repository of vast amounts of data re: the health of a business, and accounting for it informs cash flow management, reduces unnecessary expenditures, and helps businesses accurately forecast and plan for future sales.
Proper accounting also aids in the tracking of inventory, yielding more efficient management, improved productivity, and lower operating costs.
From a customer service perspective, keeping accurate inventory records ensures that businesses have in stock the products their shoppers need, when they need them.
Understand that Inventory is an Asset (That can Become a Liability)
Whether inventory is an asset or a liability is easily misunderstood. When a company has invested in products it plans to resell, those items are listed as assets on the balance sheet.
It should be noted, however, that while inventory is a literal asset, too much on hand can turn it into a figurative liability. Meaning, the cost of holding inventory over a long time frame can become so significant that it seemingly outweighs the value of the items themselves.
Evaluating Inventory as a Current Asset
Current assets are defined as those which can be converted into cash within one year. As such, the liquidity of the inventory in question plays a large role in determining its status. Seasonality, price points, industry sector, and many other factors can all impact whether or not inventory will still be here a year from now.
Accounting for Inventory Holding Costs
Inventory holding costs are the costs associated with keeping stock on hand, and proper accounting demands that they all be noted and incorporated. These costs include storage, insurance, taxes, and the cost of capital tied up in the inventory (opportunity costs). Businesses typically account for inventory holding costs by allocating them to the cost of goods sold (COGS) and/or inventory accounts on their balance sheet. It’s crucial to monitor inventory levels and keep them in balance with demand as they can add up very quickly.
Be Mindful of the 80/20 Inventory Rule
The 80/20 inventory rule is derived from a management consulting principle which states that 80% of effects come from 20% of causes (aka the “vital few”). As applied to inventory, this rule means roughly 80% of profits will come from 20% of items in inventory and that those 20% should be prioritized. Prioritization of this 20% will increase focus on reorder points, lead times and safety stocks, create a more efficient use of capital, and improve inventory turnover.
Understand the Difference Between Periodic and Perpetual Inventory Systems
Periodic inventory systems record inventory transactions only at the end of an accounting period. This system relies on physical counts of inventory to determine the amount of inventory on hand.
Perpetual inventory systems, on the other hand, record inventory transactions in real time as they occur, generally through the use of electronic scanners, bar codes, and other technology..
Beyond the difference between the two models in the frequency of inventory counts, they can also differ significantly in terms of inventory accuracy - perpetual systems are much more accurate. However, that accuracy can come at a large upfront cost. The cost of implementing a perpetual system will involve an investment in technology, whereas periodic systems require more labor to conduct physical counts.
Large businesses with expansive inventory would of course find it extremely difficult if not physically impossible to count every item in their warehouses once a month. Likewise, many small businesses would most likely have neither the need nor resources to invest in a point-of-sale system for use in a perpetual inventory system.
Most businesses will fall somewhere in the middle and should simply choose the model that best suits their needs and capacities.
Exploring the Different Inventory Costing Strategies
Inventory costing, often called inventory cost accounting, is the process businesses use to assign costs to the items they have in inventory.
This has important tax implications. Businesses calculate how much it costs to sell their products and deduct those costs from their taxes. As such, the accurate assessment of these costs is critical.
There are 4 main methods used to compute the cost of goods sold (COGS).
FIFO Method (First In, First Out)
Just as it sounds, this method assumes that the cost of inventory purchased first will be recognized first. Because It aligns current inventory costs with the actual flow of products out of a business, FIFO provides the most accurate picture of real-time inventory cost.
EXAMPLE: A company bought 1000 units of a product for $6 each, later purchased 1000 more units for $8 each, and sold 600 items. Using the FIFO method, the cost of goods sold for each of the 600 items is $6/per because the first goods purchased are the first units sold.
With 1400 remaining items in inventory, the value of 400 items is $6/per and the value of 1000 items is $8/per.
If another 600 units are sold, the COGS is 400 at $6, 200 at $8, and the remaining inventory is 800 units at $8/per.
The FIFO technique is based on the idea that in order to prevent obsolescence, a business should sell its oldest inventory products first and keep its newest ones on hand. A merchant must be able to explain why it chose to adopt a specific inventory valuation technique, even though the actual method used does not have to correspond to the actual inventory.
LIFO Method (Last In, First Out)This mirror-image of FIFO, this COGS model assumes that the most recent items placed into your inventory are the first items sold. Working under the inflationary idea that recently-purchased items will cost more than older ones, LIFO may lower profits, but can also minimize taxable income.
Most online retailers would avoid LIFO as there’s generally no justification to selling recent items before older, outdated inventory.
WAC Method (Weighted Average Costing)
This accounting method does not differentiate between different items. The total cost of all inventory is simply divided by the number of units. This is the simplest approach to use and is best employed by merchants with high volume and inventory turnover.
Special Identification Method
The specific identification method assigns costs individually vs. grouping items together. It is used by businesses with high-value products (automobiles, collectibles, luxury goods), although it can also be very useful to any company that wants highly-specific data and has the capacity to track each item (serial numbers, RFID tags, etc.)
Understanding the financial benefits and implications of inventory accounting makes clear the importance of proper inventory management in providing accuracy, insight, and control. At SkuNexus, our software solutions provide merchants with real-time inventory visibility across all channels and locations.
If you would like to get a closer look at what our systems can do for your business, please schedule a demo.
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