Inventory Accounting Definition & How It Works
It’s crucial for a company to be aware of the inventory on hand at all times. It’s also a key metric alongside your profit margins.
This is where inventory accounting comes in. It helps business owners track what they have, how much it’s worth, and when it needs to be replaced. Inventory accounting is an important concept to understand for business owners and managers.
This article will discuss what inventory accounting is and how it works. Other topics will include pros and cons, cost of sale explanation, inventory accounting methods, and more.
Table of Contents
- Inventories are an important part of many businesses.
- There are two main methods for accounting for inventory: periodic and cost of sales.
- There are pros and cons to inventory accounting.
- FIFO and LIFO are the two types of inventory valuation methods.
What is Inventory Accounting?
Inventory accounting is a system for tracking the value and quantity of a company’s inventory. By keeping tabs on stock, business owners can better plan for future needs and avoid running out of products. It reflects the cost of inventory. As well as purchasing and storing goods. It also shows the costs involved in selling those goods.
Inventory accounting provides key information. Including how much inventory should still be on hand (as opposed to having been sold). It also details the value of that inventory and how much the inventory is worth on the current market.
Inventory accounting is often used in certain industries such as retail and manufacturing. These types of businesses need to keep track of their inventory so that they can stay profitable.
The Basics of Inventory Accounting
Inventory accounting can be done in a number of ways. Businesses can use periodic inventory accounting or cost-of-sales inventory accounting. These will be discussed in more detail later in the article. Basically, inventory accounting is a way of keeping track of the inventory that a business has on hand. This information can be used to make better business decisions.
Cost of Sale / Cost of Goods Sold
When it comes to inventory accounting, it’s important to understand the concepts of cost of sale and cost of goods sold. Cost of sale is the total amount of money that was spent on acquiring and storing the inventory. This includes the purchase price and all associated costs. These would include shipping and handling as well.
Cost of goods sold (COGS) is the total amount of money that was spent to produce the goods that were sold. These include the cost of materials, labor, and any other associated costs. COGS is deducted from the revenue of a company to determine how much profit was made on the sale of goods.
Let’s look at an example of this in action:
Suppose a company buys inventory for $100. The shipping and handling costs are $10. The company has to pay a sales tax of $5. The total cost of the inventory would be $115. That company sells that same inventory for $150 after marketing and labor costs of $20 (COGS). The total cost would be $135. $135 subtracted from $150 leaves a profit of $15.
Pros and Cons of Inventory Accounting
There are both pros and cons to using inventory accounting.
- It allows businesses to track their inventory more closely. This can help a company stay on top of its stock and make sure that it is not overstocked or running low on certain inventory items.
- Inventory accounting can help a business determine the cost of goods sold. This information can be used to make better decisions about pricing and production.
- Inventory accounting can help a business keep tabs on its profits and losses. This information can be used to make changes in how the business is run.
- Inventory accounting can be used to determine if a company is producing a profit or loss on individual inventory items.
- Inventory accounting can be time-consuming and difficult to keep track of. It requires regular updates and can be complex to understand.
- Inventory accounting does not take into account the fact that some inventory may never be sold. This can lead to inaccurate information.
Inventory Accounting Methods
There are a few different ways that businesses can do inventory accounting. The two most common methods are periodic and cost of sales. Determining which method to use can be tricky. It depends on several factors, such as the size of the business and the type of inventory it sells.
Method 1: Periodic Inventory Accounting
Periodic inventory accounting is an accounting method. It’s where businesses track their inventory at fixed intervals. This could be done monthly, quarterly, or even yearly. At each interval, the business will calculate the cost of sale and the value of its inventory.
This method is fairly simple to use. It can be helpful for businesses that have a lot of inventory and that change their stock frequently. It is not as helpful for businesses that have a smaller inventory or that sell the same items over and over again.
Method 2: Cost of Sales Inventory Accounting
Cost of sales inventory accounting is a method where businesses track their inventory as it is sold. This means that the business updates its inventory count after every sale.
This method is more complicated to use than periodic inventory accounting. It can be helpful for businesses that have a smaller inventory.
FIFO and LIFO Methods
There are two different basic concepts that businesses can use to track the cost of their inventory.
First in, FIrst Out
The first is the FIFO method. Under this method, the oldest items in the inventory are expected to sell first.
FIFO is typically easier for accounting purposes. This is because FIFO assumes that older stock will be moved quickly.
Last in, First Out
The second method is the LIFO method. Under this method, the newest items in the inventory are expected to sell first.
Choosing between the FIFO method and the LIFO method can have important consequences. Especially when it comes to taxable income and profitability. Be sure to consult an accounting professional to decide which method is best for your company.
How to Value Inventory using the Weighted Average Method
Another way to value inventory is by using the weighted average method. This takes into account the cost of inventory, not just the oldest or newest.
This method can be helpful for businesses that have a variety of items in their inventory. It is also helpful for businesses that sell items at different prices.
The weighted average method is not as common as the FIFO and LIFO methods. It can be more complicated to use. The weighted average method can be used to assign a cost to two different factors. Those are the ending inventory and the COGS.
Here is a summary for calculating your weight average.
- You divide the COGS your company has available for sale by the number of units that are currently available for sale.
- This gives you the weighted-average cost per unit.
- The cost of goods available for sale is the sum of the beginning inventory value and net purchases.
- The number of units available for sale is the sum of ending inventory units and net sales units.
As a small business owner, it’s vital that you keep track of your inventory costs and profit margins. Being able to have a constant awareness of how much inventory in stock you have is key to running your business properly. Especially when it comes to your inventory balance to ensure you don’t overorder or run out after an inventory transaction. Utilizing good accounting software can hugely help with this process.
FAQs on Inventory Accounting
When a company values its inventory, it directly affects its cost of goods sold (COGS). It also affects gross income and the value of the remaining inventory at the end of an accounting period. It, therefore, makes your inventory accounting a key metric for the profitability of your business.
The days sales of inventory is a financial ratio. It shows the average amount of time taken for a company to convert its inventory into sales. This is measured in days and includes goods that aren’t finished.
Inventory is classed as an asset. This means that it will show up on the balance sheet of a company. When inventory increases, it is recorded as a debit. A reduction in the inventory account would be signified by a credit.
Manufacturing inventory refers to the raw materials and components that are used to produce a product. These items are considered part of the inventory until they are used in the production process. Once they are used, they become part of the cost of goods sold.
Inventory is made up of products that a company has purchased or manufactured. Inventory is typically ready for sale. Accounts receivable refers to money that is owed to a company by its customers. This could be for products that have already been sold or for services that have been provided.
Inventory in the service industry refers to the work that has been completed but has not yet been billed. This could be work that has been done by employees or contractors. It could include materials and supplies that have been used in the course of providing services.
The inventory process refers to the steps that a company takes to track and manage its inventory. This includes recording what items are in stock and calculating the cost of those items. It also includes determining how much money the inventory is worth. This process is made easier by accounting software.
Inventory count is the process of counting the items in a company’s inventory. This is typically done regularly throughout an accounting period to ensure that the inventory is accurate.
Inventory typically goes to the company’s creditors when it goes out of business. This includes suppliers, lenders, and other creditors. The inventory is used to pay off the company’s debts.
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