What do manufacturers, distributors, wholesalers and retailers have in common? They all deal with inventory. Whether your client is a manufacturer or a retailer that purchases products for resale, they both need to account for inventory accurately.
With accurate inventory accounting, your clients can better analyze their stock and identify areas to cut costs and maximize profits. It also aids in creating financial projections, which can help business owners in decision-making.
Here, we cover inventory accounting and the core concepts associated with it.
What is inventory accounting?
Inventory accounting determines how an organization shows inventory in its Balance Sheet and P&L statements. Inventory accounting is all about being able to accurately value inventory so that it is appropriately documented in financial statements.
The cost and valuation of inventory depends on how inventory is accounted for. On-hand inventory, despite not being sold, should be treated as an asset because it can be used to generate revenue. It is extremely important to correctly value inventory because any fluctuation in its value affects a business's overall profitability.
Essential terms for inventory accounting
Essential Term No. 1: Cost of goods sold (COGS)
The cost of goods sold is the cost that a business incurs to make or acquire the products that it sells. COGS includes everything from materials used to labor cost. But it only includes costs that are directly related to the production process.
Thus, shipping and marketing costs are not included in COGS. Inventory accounting is primarily used to determine cost and inventory value at the end of each accounting period. Here’s the formula to calculate the COGS:
Cost of Goods Sold = Beginning Inventory + Purchases - Ending inventory
To better understand COGS, here is an example. At the beginning of the financial year, your client’s inventory was valued at $4,000. Throughout the year, they purchased inventory valued at $3,500, and at the end of the year, their inventory value was $2,000.
The cost of goods sold is $4,000 + $3,500 - $2,000 = $5,500.
COGS can be calculated weekly, monthly, quarterly, or annually. It is an important measure of a business' inventory value and profitability. Using the cost of goods sold, your client can calculate their gross profit.
Essential Term No. 2: Ending inventory
It is unlikely that your client will sell all their inventory by the end of an accounting period. However, unsold inventory is not a liability because it can be sold next year.
Therefore, any leftover inventory should be treated as an asset in financial statements. This unsold inventory is commonly referred to as the “ending inventory.” In fact, the ending inventory becomes the “beginning inventory” for the next year.
Here’s how to calculate ending inventory:
Ending Inventory = Beginning Inventory + Purchases - Cost of Goods Sold (COGS)
You will notice that the ending inventory is derived from the COGS that we discussed earlier. Here’s a real-life example of calculating the ending inventory.
Your client’s beginning inventory is valued at $5,000, and their purchased inventory valued at $2,000 throughout the year. Their cost of goods sold (COGS) is $5,500.
The ending inventory is $5,000 + $2,000 - $5,500 = $1,500
Estimating ending inventory is not as easy as it seems. The real challenge is assigning a specific monetary value to unsold inventory. This can be difficult to calculate. In an accounting period, numerous purchases of raw materials and new inventory are made.
However, each purchase can come at a different cost per unit. Furthermore, if all stock is stored together, it can be very difficult to identify what unit was acquired at what cost. To add to the confusion, inventory is constantly moving due to ongoing sales.
How is it possible to determine the value of ending inventory when there is so much influx and movement within an accounting period? The solution lies in using inventory valuation, which we'll discuss next.
Essential Term No. 3: Inventory valuation
The value of the inventory is highly dependent on how an organization tracks its stock. As inventory is sold and replenished, its price fluctuates; therefore, it is ideal to value inventory at cost.
Now that we’re clear about valuing inventory at cost, it is important to determine the best valuation method. Sticking to a specific valuation method is crucial to maintaining accurate, consistent, and legally acceptable financial records.
There are four commonly used inventory valuation methods.
- First in, first out (FIFO)
- Last in, first out (LIFO)
- Weighted average cost method
- Specific identification method
First in, first out (FIFO)
FIFO is used to manage inventory in warehouses; however, it can also be used to value unsold inventory. The premise of the FIFO method is that stock acquired first must also be sold first. So when an order is received, the oldest on-hand inventory is used for fulfillment.
FIFO can be extremely useful for perishable goods including fruits, vegetables, medications, and beverages—as prioritizing older inventory reduces the risk of food going bad before it’s sold. Plus, it also ensures that customers always receive the freshest items.
At the time of valuation, the FIFO method yields a lower cost of goods sold, higher ending inventory value, and a higher gross profit.
If you use FIFO for accounting, all items received or sold must be recorded individually. In addition, delivery details should also be recorded including both date and price.
Considering market changes, it is possible that your client may under- or overestimate inventory value. The FIFO method may also evaluate cost inaccurately if there are frequent price increases.
Here’s an example of calculating inventory value using the FIFO method:
On Jan. 1, your client purchases 10 bottles for $20 each. They buy 10 more bottles at $30 each on Jan. 5. Then, on Jan. 31, they sell 10 bottles. Since we’re using the FIFO method, the $20 bottles would be sold first. Now, 10 $30 bottles remain. The inventory value would be $300.
Here’s the calculation, broken down by step:
- Jan. 1: Bought 10 bottles at $20 each = $200
- Jan. 5: Bought 10 bottles at $30 each = $300
- Jan. 31: Sold 10 bottles acquired first (10 x $20) = $200
- Remaining inventory value: 10 bottles at $30 each = $300
Last in, first out (LIFO)
Contrary to the FIFO method, the LIFO method means the most recently acquired products must be sold first.
This method works well for businesses that specialize in selling non-perishable goods with a lower risk for obsolescence. If recently acquired inventory is expensive, then LIFO can increase overall COGS and reduce net profit. This reduces annual tax liability, and it’s discouraged by many countries. There also is a risk that your client may stockpile obsolete inventory.
The US is the only country where LIFO is considered to be an acceptable inventory accounting method. A business that wishes to switch from FIFO to LIFO accounting needs to file a form 970 to the IRS.
Here’s how to calculate the same inventory example using LIFO.
On Jan. 1, your client purchases 10 bottles for $20 each. They buy 10 more bottles at $30 each on Jan. 5. Then, on Jan. 31, they sell 10 bottles. Since we’re using LIFO, the more recently acquired $30 bottles would be sold first, so they’d be left with the older $20 bottles. Thus, their inventory value would be $200.
Here’s the calculation:
- Jan. 1: Bought 10 bottles at $20 each = $200
- Jan. 5: Bought 10 bottles at $30 each = $300
- Jan. 31: Sold 10 bottles recently acquired (10 x $30) = $300
- Remaining inventory value: 10 bottles at $20 each = $200
The inventory value was $300 using FIFO, and $200 using LIFO. If the most recently purchased inventory costs more than the older inventory, the LIFO method reduces overall inventory cost.
Weighted average cost method
The weighted average is best for organizations that do not want to use either FIFO or LIFO for inventory accounting. Using the weighted average inventory cost, businesses can adjust the cost of new purchases based on the cost of existing inventory.
This way, they will calculate a new weighted average cost, which is readjusted every time new inventory is added.
In this method, the weighted average is used to determine the cost of goods sold. It is best to use this method when product units are indistinguishable from each other or challenging to track individually—for example, gasoline.
Here’s the weighted average cost formula:
Weighted Average Cost = Total Cost of Inventory / Total Inventory Units
Continuing with the same scenario from above, your client purchased the first 10 bottles at $20 each, and the additional 10 bottles at $30 each.
- 10 bottles at $20 each = $200
- 10 bottles at $30 each = $300
- Total bottle units = 20 bottles (10 + 10)
- Total cost of bottles = $500 ($200 + $300)
The weighted average cost is $500 / 20 = $25. When your client sells 10 bottles out of 20 total, 10 bottles are left. Inventory value will be $250 (10 bottles x $25).
Specific identification method
In this method, each unit is tracked individually until it gets sold. The specific identification method is primarily used for large items that can be easily identified. Rather than grouping items together, this method individually tracks the items, and the cost is also individually assigned.
Such extensive tracking can be done using RFID tags. RFID tracking can be expensive, so this tracking method is only used for highly valuable or rare items.
Essential Term No. 4: Obsolete inventory
Obsolete inventory is inventory that lies at the end of its product cycle and has not been sold for a long period.
Due to a lack of demand, such inventory is not expected to be sold in the future. Therefore obsolete inventory is often called "deadstock." While accounting for the dead stock, it should be either “written down” or “written off.”
A write down occurs when the inventory's market value is lower than the cost recorded in financial records. A write off occurs when, due to perceived lack of value, a business decides to eliminate the inventory from their accounting books altogether.
Essential Term No. 5: Accounting standards
When performing accounting for inventory, it’s essential that you keep the method of accounting consistent across businesses. That is why the Financial Accounting Standards Board (FASB) issues Generally Accepted Accounting Principles (GAAP).
GAAP are commonly used procedures and principles for accounting that businesses must comply with. For example, GAAP mandates that businesses must create an inventory reserve account for obsolete inventory in their balance sheet. As obsolete inventory is written off, a debit to the expense account should be made, which in turn reduces profit.
In this article, we learned the five key terms clients with inventory should know. They are: cost of goods sold, ending inventory, obsolete inventory, and accounting standards. We also explored the four commonly used inventory valuation methods: first in, first out (FIFO), last in, first out (LIFO), weighted average cost method, and specific identification method.
With accurate inventory accounting, your clients can better analyze their current stock in real-time and improve their ability to forecast future purchasing.
Mark Leach is the Manager of Content/Web Enablement for Product Marketing at Cin7.
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