Q & A: The Basics of Inventory Accounting

The accurate accounting of inventory is a crucial operation for any business. It demands discipline, focus, and above all, honesty.

Inventory is rightly viewed as money in a different form, and should be treated as such. However, accounting for inventory is not quite as simple as just knowing what you have, where it is located, and in the correct quantities (inventory visbility).

Rather, inventory accounting involves correctly valuing what you have. 

A multitude of different factors can impact that valuation and several methods can be used to derive it. 

At SkuNexus, we understand the critical importance of thorough inventory accounting as a tool for managing cash flow, keeping accurate financial statements, and maintaining inventory control.

Here, we would like to go through a series of useful questions and answers to give you a helpful introduction to the basics of inventory accounting.

Is Inventory an Asset?

Yes. The company has invested in products it plans to resell and 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. 

Is Inventory a Current Asset?

That depends. 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.

What is Holding Cost?

Holding cost (or cost of holding) includes warehousing costs (rent, utilities, salaries), opportunity cost, and other costs related to things like depreciation, perishability, shrinkage, and insurance.

What is Inventory Rule?

This is also referred to as the 80/20 rule. It is derived from a management consulting principle which states that 80% of effects come from 20% of causes (aka the “vital few”). 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 can increase focus on reorder points, lead times and safety stocks, create a more efficient use of capital, and improve inventory turnover.

What’s The Difference Between Periodic and Perpetual Inventory Systems?

A periodic inventory system uses an occasional physical count to measure inventory sales, levels, and the cost of goods sold. A perpetual system continuously keeps track of inventory balances and updates automatically upon receipt or sale of a product.

Which System Should We Be Using?

There is no blanket answer for this. 

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.

What is Inventory Costing?

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).

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.

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.

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.

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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