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More Inventory Content
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More Inventory Content
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Inventory is the lifeblood of a business. And the business needs to maintain its inventory for a spontaneous supply of goods to meet customers’ demands. A company’s inventory can include goods, raw materials, or other products procured by the company for selling to its customers. The goods in the inventory are part of the company’s assets, and the business’s profitability is closely associated with its inventory.
Therefore, a business needs an efficient and convenient inventory valuation method to improve its inventory management. Let’s go through a detailed understanding of the inventory accounting process and how it works for the benefit of the business.
What is Inventory Accounting?
Inventory accounting is the part of accounting that deals with the values and accounts of inventoried assets yet to be sold to customers. Proper accounting for the inventory is as important as accounting for sales in a company. Every product in the stock has a basic cost value. The accounting for inventory covers determining the exact unit counts and their precise valuation.
Inventory is constantly recorded and reported on a company’s balance sheet at its cost. After the merchandise is sold, the company removes the cost entry from the inventory account and updates the sheet with new entries of the cost of goods sold and product revenue accounts. Too much inventory can negatively impact the company’s cash flow.
Similarly, a business can incur additional expenses due to storage costs, insurance costs, and transportation. A company must sell products in its inventory relatively quickly at a price higher than its cost to minimize the impact on the overall cash flow. The effective inventory accounting method ensures an accurate representation of the value of all assets and leads to increased profit margins for the company.
Fundamentals of Inventory Accounting
The basics of inventory accounting include:
Raw Materials
Raw materials are a business’s essential components in manufacturing its products. For example, in the case of a cheese factory, the raw materials enlisted would be milk, the primary ingredient for processing cheese. The cost of the raw materials contributes to the first step in inventory accounting.
Work In Progress (WIP) Products
Work in progress products are the end products being manufactured with raw materials and other necessary components.
Finished Products
Finished products are the end products of the business that are ready to be sold to its customers. Several subsection inventories like transit inventory, buffer inventory, cycle inventory, decoupling inventory, and anticipation inventory is associated with finished goods. Inventory accounting keeps accurate records for each step of the production adding value to the finished product.
MRO Management
MRO stands for Maintenance, Repair, and Operating Supplies. MRO management includes managing other components associated with producing finished goods but is not directly associated with it. MRO goods include equipment, janitorial supplies, lubricants, coolants
Resale / Return Products
Products that have been returned by the customers for various reasons and are in good condition for resale.
Key Features for Inventory Accounting
A practical inventory accounting focuses on two key terms mainly. They are:
Cost of Goods Sold (COGS) – The final and direct costs of the produced goods sold by the company.
Ending Inventory (EI) – The value of any unsold inventory at the end of an accounting period.
Cost of Goods Sold (COGS)
The Cost of Goods Sold is crucial in measuring a company’s inventory value and overall profitability. COGS calculates the total amount it costs a business to produce the final product, including the steps of production like materials, labor, equipment used, etc.
However, production processes like shipping, advertising, salesforce, etc., are not included in factoring costs. COGS primarily functions as the mode of valuation to determine the number of gross profits made in a single or multiple sales.
How COGS is Calculated
Following are the steps to calculate CGOS for an accounting period:
- Determining the total costs associated with the production process, including labor, raw materials, tools, etc.
- Evaluating the Beginning Inventory (BI) cost.
- Adding the cost of fresh purchased inventory during the accounting period.
- Substracting the leftover and unsolved inventory at the end of the accounting period.
Cost of Goods Sold = (Beginning Inventory Cost + Purchases Cost) - Ending Inventory
Ending Inventory (EI)
Ending Inventory (EI)
It is likely for a business not to sell the entire inventory at the end of each accounting period.
Therefore, the unsold stock is carried forward to the next period and must be evaluated and included in the financial reports.
How EI is Calculated
EI at the end of the accounting period is calculated as follows :
- Evaluate the beginning inventory (BI) and units carried over from the previous accounting period.
- Add fresh inventory.
- Subtract units sold
- Assess the final inventory figure.
Ending Inventory = (Beginning Inventory (BI) + Purchases) - Sales
Benefits of Inventory Accounting
A business can manage its inventory more comprehensively with complete control and cost-effective measures to save on operations through efficient inventory accounting. Inventory accounting helps a company balance its inventory for maximum efficiency, better financial prospects, and added value.
The benefits of inventory accounting are:
Improved Inventory Accuracy
Inventory accounting allows a company to keep track of its inventory and make purchases or transactions based on availability.
Cost-Cutting
The inventory is the core of a supply chain process. And stocks are an asset until sold. The other physical factors like storage, handling, insurance, shipping, and transportation add to the overall cost of the final product. Proper inventory accounting allows a company to properly analyze the needs and curb the unnecessary expenses trapped in unnecessary inventory operations.
Avoiding Over-Hoarding Of Stock
Efficient inventory accounting aids a firm in better planning and controlling the inventory and avoids unnecessary stock purchases and stockouts.
Improve Vendor/Supplier Terms
Inventory accounting analyses and reveals the individual costs of the products stored in inventory, providing better insight into additional or unnecessary cost interruptions. A better understanding of the financial accounts allows a business to evaluate and bargain with suppliers for better terms and rates.
Promotes Healthy And Steady Cash Flows
Proper analysis of inventory accounts helps a company organize inventory functions for a steady cash flow.
Reduce Storage Costs
Identification of slow-moving goods in the supply chain process helps reduce additional storage costs.
Maximize Profitability
Improved inventory accounting results in proper inventory turnover contributing to more significant revenue generation.
Increase In Sales
Proper inventory accounting helps better calculate reordering levels, improving inventory turnover visibility and allowing a business to maintain their inventory for better customer service.
Facilitates Better Decision Making
Accurate inventory accounting helps with accurate financial and revenue projections, helping a business make sound decisions.
Types of Inventory Accounting
Inventory accounting primarily focuses on analyzing the needs and requirements of a company concerning its inventory levels. Inventory accounting allows a company to use the extracted data to target high sales and improve profitability. The best common types of inventory accounting are as follows:
Economic Order Quantity (EOQ)
A business often has some additional and hidden expenses adhered to basic inventory operations such as ordering and inventory carrying costs. Unprepared planning leads to a significant escalation of the hidden costs. Economic order quantity (EOQ) looks forward to eliminating additional yet wasteful expenditure in basic inventory operations like inventory orders and replenishment. EOQ is the responsible factor for reducing carrying costs and other additional costs of inventory orders to an acceptable range.
Just In Time (JIT)
Just in time (JIT) is an inventory management system primarily focused on inventory functions like cost-cutting and optimal order time. JIT allows a business only to place orders so that the inventory arrives only when required. JIT helps the company monitor storage costs by placing orders only when the inventory levels are low significantly. JIT helps efficient inventory management with reduced inventory waste, improved management, and spontaneous cash flows.
ABC Analysis
ABC analysis allows the business to rank its products in the inventory according to their importance to the company. The products are divided into A, B, and C groups based on various inventory metrics, including demand, cost, expiration, etc., to determine the product rank. ABC analysis allows the business to improve its inventory turnover rate, boost sales, and cut unnecessary storage expenses.
Fast, Slow And Non-Moving
Fast, slow, and non-moving is a method primarily focused on the movement of goods in an inventory. The inventory is divided into fast, slow, and non-moving sections based on the market demand for the products. The fast-moving products require frequent replenishment, whereas the non-moving goods need occasional ordering to repeat further orders.
Inventory Accounting Methods
The management of inventory turnover and inventory control needs to follow the Generally Accepted Accounting Principles (GAAP) rules. It requires all inventory to be properly accounted for using either the cost or market value method, using the inventory as an asset to rule out depreciability.
A business must adhere to a specific method for inventory accounting for accurate, consistent, and, most importantly, legally acceptable financial documents.
The three main inventory valuation methods are:
First In First Out (FIFO
FIFO is not only used in handling stock in a warehouse but also as a method of valuing unsold inventory. It follows the principle that merchandise that was purchased first needs to be sold first. All products received and sold are recorded individually in this FIFO accounting method. However, there’s a possibility of underestimating or overestimating inventory value due to the future ever-changing market pattern.
Last In First Out (LIFO)
The LIFO method assumes that the products added to the inventory most recently are to be sold first. LIFO works best for businesses specializing in nonperishable items. It can also increase COGS and diminish the gross profit margins due to the cost difference in the products’ recent and old market prices.
Weighted Average Accounting Method
Average Cost inventory accounting method is primarily based on the average cost of items throughout an accounting period of a company. It is different from the above two methods and does not track the cost per inventory unit for each separate purchase or delivery. The weighted average can be derived by simply dividing the overall cost of products for sale by the total inventory available.
How to Account for Inventory
Accurate inventory accounting determines the correct unit counts, including ending inventory and assigning a value to each unit. The resulting costs are recorded as an ending inventory value and the cost of goods sold for the accounting period. The steps involved in inventory accounting are expanded upon as follows:
Determine Ending Unit Counts
Companies maintain their inventory either through a periodic or perpetual inventory system. However, the periodic inventory method relies on manual inventory keeping at regular intervals, whereas a perpetual inventory system uses automation to track the inventory. The majority of the companies prefer to use the perpetual inventory method for more accurate and in-depth information about the current inventory levels. The perpetual inventory method uses technology and automation to track real-time updates of the inventory records to arrive at the same goal in much lesser time and increased productivity.
Improve Record Accuracy
The perpetual inventory method leads to accurate inventory transactions in a much more convenient manner. Companies tend to use the perpetual inventory method to monitor real-time inventory records for better decisions. This system helps the companies to account for all the products they have in the inventory and track their movement and usage for a significant inventory insight.
Conduct Physical Counts
Companies maintain their inventory either through a periodic or perpetual inventory system. However, the periodic inventory method relies on manual inventory keeping at regular intervals, whereas a perpetual inventory system uses automation to track the inventory. The majority of the companies prefer to use the perpetual inventory method for more accurate and in-depth information about the current inventory levels. The perpetual inventory method uses technology and automation to track real-time updates of the inventory records to arrive at the same goal in much lesser time and increased productivity.
Estimate Ending Inventory
A business may face certain situations where performing a physical count to determine the ending inventory balance is nearly impossible. In these cases, the company can use the retail inventory method or gross profit method to derive the approximate inventory ending balance.
Assign Costs to Inventory
Every month, an accountant is responsible for allocating costs to inventory unit counts. The cost layering procedure, which monitors tranches of inventory expenses, involves the FIFO layering method and the LIFO method. The LIFO approach is one example of assigning a set cost to each inventory item rather than assigning its historical cost.
Allocate Inventory to Overhead
Each of the facilities related to the supply chain consists of a significant amount of additional overhead costs, which need to be identified and allocated to the specific units concerned.
How to Do Inventory Accounting With the FIFO Method
The term First In First Out pertains to the fact that the inventory items purchased first need to be sold first. This is the most common inventory valuation method used by the majority of businesses.
Here is an example to understand how the FIFO accounting method is implemented in a business.
On January 2, 2022, a company called ABC purchased 100 hats from a regular supplier at $5 each. And on January 17, the same company needed to buy an additional 100 hats, but unfortunately, the regular supplier raised the price to $7 for each product.
When the supply began to run low in late January, ABC turned to another supplier, who offered them a price of $6 per hat. On January 31, ABC purchases an additional 100 hats from the new supplier at the new cost.
Now, to track ABC’s total inventory costs and the value of the remaining inventory at the end of the accounting period, the company needs to track the pricing and sales of all three levels. Since the account for inventory pricing directly affects the cost of goods sold and the total inventory value.
Let’s break this down for better understanding:
- 2/01/2022: 100 hats @ $5 each = $500
- 17/01/2022: 100 hats @ $7 each = $700
- 31/01/2022: 100 hats @ $6 each = $600
Now, in addition to purchasing the hats in January, ABC had two large customer orders; one on January 20 for 125 hats and one on January 31 for 140 hats.
So, Here is how ABC would value the inventory that was purchased on 20/01/2022 using the FIFO method:
- 100 hats @ $5 each = $500
- 25 hats @ $7 each = $175
- Total cost of inventory = $675
Now, as the company uses the FIFO method, their order includes the first hats placed in stock, which were $7 each. The remaining hats in the order were taken from the second group of hats purchased, which were $6 eac
calculating for inventory tax and expenses
Therefore,the next purchase, completed on 31/01/2022 would look like:
- 75 hats @ $7 each = $525
- 65 hats @ $6 each = $390
- Total cost of inventory = $915
With this order, the oldest hats in stock, $7 each, were sold first, along with 65 hats from the most recent purchase.
After the completion of both the orders, the company ABC was left with 35 hats in stock, all valued at $6 each for a total value of $210.Thus,
The cost of goods sold for the month of January (with Beginning Inventory = $0) using the FIFO accounting method for ABC is:
$0 + $1,800 – $210 = $1,590
Valuing Inventory with the LIFO method
LIFO, Last In First Out, calculates the inventory value based on the assumption that the last purchased inventory items are the first ones to be sold.
Now, with the same transactions in the above example,
here’s how the company ABC calculates its inventory totals using the LIFO valuation method.
The first customer purchase, made on January 20 would be:
- 100 hats @ $6 each = $600
- 25 hats @ $7 each = $175
- Total cost of inventory = $775
As the LIFO method is used, the $6 hats were the last inventory items added before the customer’s purchase on January 20, thus they are the first ones to be sold.
The next purchase, completed on January 31, would be:
- 100 hats @ $7 each = $700
- 40 hats @ $5 each = $200
- Total cost of inventory = $900
After these purchases, the company was left with 35 hats in stock, all valued at $6 each for a total value of $210.
Since using the LIFO method, both $5 hats and $7 hats were sold first, leaving only the $6 hats in stock.
Therefore, The cost of goods sold using the LIFO method for the month of January (with Beginning Inventory = $0):
$0 + $1,800 – $210 = $1,590.
Valuing Inventory Using Weighted Average Method
The Weighted Average Method measures the total cost of the inventory sold divided by the total number of units available at the beginning of the accounting period.
Using the exact same transactions in the first example, the inventory accounting average for the company ABC for the month of January stands at:
- 100 hats @ $5 each = $500
- 100 hats @ $7 each = $700
- 100 hats @ $6 each = $600
The total inventory count for January is 300. Therefore, the Weighted Average for the inventory is, $1,800 ÷ 300 = $6.
Important Inventory Accounting Reports
Inventory valuation allows a company to manage and evaluate its inventory levels in the best possible way. Among the most critical inventory accounting reports are :
- Stock Movement Analysis – The constant monitoring of the flow of goods down the supply chain helps a business understand the factor that helps achieve the desired level of sales and profit margins. Stock Movement Analysis allows a company to understand which products are fast-moving and which are not and plan the inventory operations for effective implementation and further management.
- Reordering – Inventory Turnover and Replenishment are two essential aspects of inventory management in a supply chain system. Hence, proper insight into when and what to order is indispensable in the company. Overstocking results in product wastage, additional storage and maintenance costs, and cash blockage. On the other hand, an insufficient stock may result in risking order fulfillment. Thus, Reordering allows the business to replenish its inventory promptly and effectively.
- Product Ageing Analysis – Any product lying in the storage for an extended period is never a positive sign for a business. Using efficient stock movement analytics, a company can gather essential information about the aging analysis of the remaining goods.
- Stock Summary – The Stock Summary report comprehensively provides all the inventory details. The Stock Summary report contains real-time information about the inventory quantity, rate, beginning values, closing values, and end inventory report of a company.
Inventory Accounting Issues
In addition to the essential accounting aspects, certain factors need equal attention while evaluating the inventory. Some of the concern areas in inventory accounting are :
- Obsolete Inventory
- Inaccurate Physical Counts
- Excessive Market
- Fluctuations
- Spoilage, Rework and Scrap items
- Joint Products and By-Products
- Financial statement disclosures
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FAQs
Inventory accounting is the valuation of the inventory products available for sale. A typical inventory involves goods in three stages of production, mainly :
- Raw Goods
- Work in Progress Goods
- Finished Goods
Inventory accounting assigns specific values to the items in each of the three
processes to evaluate and record them as assets for the company for precise valuation.
The fundamental way of formulating the cost of goods sold in an accounting period is the sum of the beginning inventory and the total amount of purchases minus the ending inventory of a business. However, the challenge for most product-based enterprises is assigning value to inventory on hand instead of stock sold. Since the prices of identical goods fluctuate over time, several methods are customizable to suit a company’s needs.
A few advantages of inventory accounting include:
- To determine the current value of the unsold stock
- Derive the cost of goods sold
- To know the accurate profitability
- The stock statement with values is one of the essential collaterals for getting approval for bank loans.
- Assists in projecting future revenues and aids in business decisions.
The main accounting methods used by businesses are:
- Periodic Inventory Accounting
- Cost of Sales Inventory Accounting
- FIFO
- LIFO
- Weighted Average Method
- Specific Identification Method
Inventory accounting can be time-intensive and complex to be carried out Manually. Some reliable software programs help a company digitize and automate its inventory management system to extract accurate data that are beneficial for future use.
Some of the accounting software programs are :
- Xero
- Bookkeeper
- FreshBooks
- Wave
Inventories are the most significant current asset and an essential working capital component of a business. It usually determines the specific values of assets at each stage of their development and production. An accurate inventory accounting method ensures an accurate presentation of the values leading to increased profit margins for the company. A company can adjust the variables keeping the product value the same while increasing the profitability and decreasing expenses.