Inventory Accounting for Businesses- Key Terms & Valuation Methods
Inventory accounting is the key to assessing the value of a company's inventory. This allows businesses to determine profitability, product pricing, and tax liabilities.
For any company, on-hand inventory is a major asset and a major expense. It represents more than just unsold stock but is also a business possession that needs to be valued accurately for both record-keeping purposes and legal compliance.
Even before a business does anything with its stock, these goods already hold value - hence why they are listed as assets on a balance sheet. However, stock can also quickly lose value, especially when the items become old, damaged, or out of date. Even the act of holding inventory will cost money - up to 20% to 30% of total inventory costs.
It is for these reasons that businesses with any kind of physical inventory need to stay on top of these numbers. This is where inventory accounting comes in.
What Is Inventory Accounting?
Inventory accounting is the process of determining the value and cost of inventoried assets. It involves calculating the value of stock in every phase of the production process - raw goods, goods-in-progress, and finished goods.
Inventory accounting is the underlying function for other crucial business processes, such as pricing products and services, insuring these assets, budgeting, business forecasting, and calculating taxes.
Accurate inventory accounting also protects a company from fluctuations in the value of its inventory. This can happen due to damage, deterioration, and obsolescence. Changes in the market can also cause goods to depreciate, or worse, become entirely obsolete. Conversely, changes in consumer demand and decreased market supply from competitors can increase the value of a company's stock.
Whatever the case, an accurate inventory accounting system enables the business to keep track of changes in stock value throughout the entire production process. This is also necessary to comply with GAAP (Generally Accepted Accounting Principles), which requires inventory to be accounted for under specific guidelines.
For starters, any on-hand and unsold inventory must be listed as assets in the company's end-of-year financial statement. Inventory accounting allows the business to track the cost of all inventory sold and place an accurate value for unsold inventory at the end of every accounting period. This rule reduces the potential of overstating profits by understating inventory value, which, in turn, prevents the company from overvaluing or undervaluing itself.
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The Different Types of Inventory
Inventory refers to any merchandise or goods that a company has on hand. Naturally, depending on the type of business, these products can come in various shapes and sizes. While there are different ways of categorizing inventory, most will fall into 3 broad types-
1. Manufactured Goods
The manufacturing and production process can be broken down into three phases, each one handling a different type of manufacturing inventory-
- Raw Goods - Also known as raw materials, feedstock, or primary commodities, raw goods are the basic materials used to create products.
- Goods-in-Process - Also known as work-in-progress, these are products that are partially completed but not ready to be sold to customers.
- Finished Goods - These are goods that are ready for final sale.
2. Merchandise to Be Resold
This is often the type of stock the average person thinks of when they hear the word inventory. Retail stores, supermarkets, online marketplaces, and distributors buy finished goods from manufacturers and resell them to customers. Inventory comes in the form of fast-moving consumer goods (FCMG), fashion and apparel, medicines, and consumer electronics among others.
3. Products to Be Installed
Service businesses like car dealerships, beauty salons, computer repair stores, and dentists typically keep small amounts of products that they sell along with their services. For example, a franchise dealership may keep OEM car parts like cabin filters, CV joints, spark plugs, and tires as part of their repair services.
Important Inventory Accounting Terms
At the heart of inventory accounting are two key terms that manufacturers and resellers should be aware of-
1. Cost of Goods Sold
The cost of goods sold (COGS) is the core metric that measures the company's inventory value and profitability. This refers to the direct costs of developing and manufacturing any goods sold by a company. It also includes all resources that directly went into producing the products, from materials and labor to tools and machinery. Indirect production costs, such as shipping, marketing, and advertising are excluded from this figure.
COGS Steps and Formula-
- Take the value of the company's beginning inventory. This is the recorded dollar value of a company's on-hand stock at the beginning of an accounting period.
- Next, add the value of any new inventory purchased during the accounting period.
- Finally, subtract the value of any unsold inventory at the end of the accounting period.
From here, we can use the following formula-
COGS = (Beginning Inventory + Purchases) - Ending Inventory
2. Ending inventory
It is rare for companies to completely sell out their inventory by the end of a business year. Any unsold stock at the end of the accounting period automatically turns into assets that have to be valued and listed on the company's financial statement. These goods are known as ending inventory (EI).
EI Steps and Formula-
- Take the value of the beginning inventory.
- Add the value of any new inventory purchased during the accounting period.
- Finally, subtract the total cost of goods sold during the accounting period.
From here, simply use the formula-
EI = (Beginning Inventory + Purchases) - COGS
However, the business must still assign a dollar value to any unsold inventory at the end of the accounting period. This is easier said than done as there can be multiple purchases of raw goods and/or inventory throughout the accounting period. Not to mention, each purchase may have a different cost per unit.
3 Inventory Valuation Methods
The 3 primary inventory valuation methods are First-In, First-Out (FIFO), Last-In, Last-Out (LIFO), and Average Cost. Regardless of the method used, a business must stick to one approach to ensure consistent and legally accurate financial statements at the end of each accounting period.
This inventory valuation method assumes that stock items purchased first are also sold first. This ensures that the flow of costs also matches the natural flow of goods. Consider the following scenario.
- A retailer purchases 100 boxes of milk at $10 a box on March 5.
- It sells 80 boxes of milk at $10 a box on March 7.
- It purchases another 100 boxes at $12.49 a box on March 9.
- The company sells 25 boxes of milk on March 12.
Given this scenario, the formula for FIFO can be expressed as-
- 100 boxes at $10 per unit = $1,000.00
- 5 boxes at $12.49 per unit = $62.45
- Total sold equals 105 units
- COGS = $1,062.45
- 95 boxes at $12.49 = $1,186.55
- Ending Inventory Value = $1,186.55
The last-in-last out (LIFO) method is the exact opposite of FIFO - the most recent inventory additions are the first ones to be sold. This method is ideal for businesses dealing with non-perishable goods that want to fight the effect of inflation. By selling its most recent and highest priced items first, a company can reduce its short-term profits and tax liabilities. For instance-
- A retailer purchases 100 boxes of toilet paper at $5 a box on March 5.
- It purchases another 100 boxes at $7 a box on April 5
- It sells 80 boxes of toilet paper on April 15
With these variables, the formula for LIFO can be expressed as-
- 80 boxes of toilet paper at $7 per unit = $560.00
- Total sold equals 80 units
- COGS = $560.00
- 20 boxes at $7 = $140.00
- 100 boxes at $5 = $500.00
- Ending Inventory Value = $640.00
3. Weighted Average Cost
The Weighted Average Cost method is ideal for businesses that don't track their cost per inventory unit for each purchase. Instead, inventory valuation is based on the average cost of all items procured during the accounting period. For example-
- A store procures 10 sacks of rice at $20
- It procures 10 sacks of flour at $30
- It sells 2 sacks of rice and 3 sacks of flour
Based on the WAC formula-
WAC = Total Cost of Goods for Sale / Total Number of Units Sold
If the total cost of goods for sale is $50 (i.e., 2 sacks of rice at $20 and 3 sacks of flour at $30) and the total number of sacks sold is 5, the weighted average cost is $10.
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Why Bother with Inventory Accounting and Management?
While inventory accounting and management are crucial for compliance purposes, they also have several business benefits.
- Optimized Sales - An accurate method of tracking inventory costs and movement ensures the business never runs out of stock.
- Lower Inventory Carrying Costs - Inventory accounting reduces the potential of ordering/producing slow-moving products.
- Optimized Supply Chain - Inventory accounting can help reduce write-offs caused by damage, expiry, and depreciation.
- Better Visibility of Profits - Tracking inventory costs gives the business a better view of each product and the product category's profit margins.
- Better Marketing and Advertising - Tracking inventory movement makes for better forecasting of seasonal demand and appropriate marketing promotions.
Inventory Management Systems Promote Accurate Accounting
The globalization of supply chains has made inventory management and accounting more complicated than ever. Fortunately, many companies provide inventory management systems (IMS) specifically designed to track inventory spending, movement, and sales.
An IMS is a software tool that gives enterprise owners both a bird's eye and granular view of goods across the entire supply chain. With inventory software, stock tracking can be digitized by using barcode and scanner tools. Additionally, IMS solutions come with automation features that reduce the amount of time spent on repetitive tasks and the potential for human error.
Other key features of IMS solutions include-
- Real-Time Reports - An IMS typically provides a real-time count of stock figures across all sales channels and warehouses. Inventory managers can also drill down into specific reports to discover insights on sales, suppliers, warehousing activities, and shipments.
- Inventory Forecasting - An IMS can scour past historical data to automatically detect patterns in seasonal demand, helping the business plan for future inventory requirements.
- Supplier and Vendor Dashboard - All records of transactions with suppliers and vendors are housed in one system. Suppliers and vendors can also have self-service portals where they can process purchase orders and invoices, as well as update their company information.
- Automated Reordering and Replenishments - Users can set a minimum and maximum stock level plan to automate reordering and maintain adequate inventory levels at all times.
- Barcode Scanning - IMS solutions can also be compatible with barcode scanning systems, eliminating the problem of data silos through each stage of the supply chain.
Ultimately, any system that allows a company to perform inventory accounting will go a long way towards providing an accurate representation of a company's financial state and profitability. Accurate inventory valuation is also a legal obligation and the key to remaining competitive.
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