Pillar: Inventory Accounting Guide for Small Business Owners

August 16, 2024

Inventory accounting is a big topic with many nuances. Inventory accounting professionals possess a lot of specific knowledge, however understanding the fundamental principles and implementing them in your inventory management practices is possible and has many benefits for everyone engaged with inventory. Building inventory management with accounting in mind will help both accuracy of your records and avoiding common tax mistakes. Reconciling your inventory with financial data will also be easy and hustle-free when the fundamentals of inventory accounting are understood by all participants.

Below are some key concepts and practices that will help you manage your inventory.

1. Use a Consistent Inventory System

Inventory system is the first pillar of Inventory Accounting. It determines how you record changes to your inventory. There are two approaches: perpetual and periodic.

• Perpetual Inventory System updates inventory records with each purchase or sale. It means that the inventory records should match what’s physically present at a warehouse at any given moment. Using Inventory Management Software and QR codes makes it easier to implement perpetual systems. The main benefit is accurate data supporting timely decisions.

• Periodic Inventory System updates inventory at specific intervals, such as monthly or quarterly and therefore changes are recorded post-factum. It means that most of the time there is no exact match between your records and the actual inventory at a warehouse. This can lead to less accurate data between counts and potential issues with stock levels and reordering. On the other hand, the periodic inventory system is less resource-intensive. This is the main benefit.

Which system you should choose depends on the size of your business, how fast your inventory changes, and how much control you want over your inventory.

Whichever method you choose, you should be using the same inventory accounting method from one period to another. This will keep you accurate and in good standing with inventory accounting principles.

2. Understand what goes into Cost of Goods Sold (COGS) and keep proper records

Cost Of Goods Sold is the second pillar and a critical concept in inventory accounting. COGS includes direct costs related to your inventory item, starting from the price paid to the supplier and including transportation, so all such data must be carefully recorded. Knowing COGS is necessary for setting prices, calculating Gross Profit and understanding your overall business performance. COGS is used for calculating such important efficiency indicators as Inventory Turnover Ratio and Days Sales of Inventory. In the manufacturing process COGS includes expenses like raw materials, labor, and overhead. Learn more about COGS.

3. Implement Inventory Valuation Methods

Inventory valuation is the process of determining the value of inventory on hand, or COGS. The value changes each time some inventory is sold or added. There are four methods for managing such situations, and each affects financial statements differently. Inventory accounting principles demand every business to select and use one method consistently.

First-In, First-Out (FIFO)

The FIFO method (first in first out) means the oldest inventory items are sold first. If purchase prices are increasing, this will lead to more inventory value being reported in your financial statements and higher profits, compared with the other methods.

Last-In, First-Out (LIFO)

LIFO assumes that recently acquired inventory is sold first.

If inflation is high, using this method results in lower value of inventory in your financial statements because you sell the most expensive items first. At the same time the cost of your sold inventory is higher compared to using FIFO, so the taxable income is lower.

Weighted Average Cost

The weighted average cost method takes price fluctuation into consideration by averaging the costs of each type of inventory item you have on hand. This method provides a middle-ground approach, balancing the effects of price changes on your sales reports and inventory valuation.

Specific Identification

Specific identification method assigns a specific cost to each item of inventory individually. This method is great for businesses dealing with unique, high-value items, such as custom furniture or artwork. It provides precise cost tracking but doesn't add value for businesses with large inventories of similar items.

4. Maintain Accurate Records

Keeping accurate, detailed and timely records for every purchase or sale of inventory is the critical pillar for both Financial Reporting and Inventory Control. Records can be kept on paper or using a computer, with or without special software. A simple row entry system can be effective, as long as it shows quantities, cost and dates.

Protecting records from loss or accidental changes is important. Don’t forget about making copies of your file or paper journal and keeping them separate from the main register, so that if something happens to it, you can still have your inventory records. If you are working with inventory software, it's best to use a cloud system, where your data is protected from accidental loss.

5. Perform regular Inventory count

Making physical counts of your inventory on a regular basis is very important, even if you use a perpetual system to update the data after each transaction. The best practice in inventory counts is to use a combination of cycle count and physical count for ensuring data accuracy and quality of the inventory management process.

A cycle count is counting a subset of your inventory on a rotating basis. You may choose to do such “partial” counts daily, weekly or monthly, keeping in mind that a full cycle count of all of your inventory should be done at least once a quarter. Some businesses do daily counts of strategic sections. A benefit of cycle count is that it helps maintain inventory accuracy and timely fix any discrepancies without a disruption to your business operations.

A physical count means counting your entire inventory in a single push. This is required at least once a year to confirm the value reported in financial statements. Businesses with high inventory turnover and a diverse product range may need to do physical counts more frequently. Some businesses need to do physical counts every 6 months or every quarter to be compliant with regulatory standards. The benefit of physical count is comprehensive verification of all inventory records.

6. Use Inventory Management Software

Inventory software levels up inventory management in many ways. It simplifies keeping records, saves a lot of time and allows both real time updates and instant access to all data. It also supports quality Inventory Accounting. Here are some of benefits of Inventory Software for accounting:

• Enhanced accuracy. Using Inventory software helps to reduce errors, because data is easy to verify and analyze. That is crucial to proper financial analysis and reporting.

• Automated data sharing. Good Inventory Software can be configured to share data with an accounting program automatically. This eliminates both extra work of putting it in and errors which may occur.

• Real-Time Financial Insights. The software provides real-time updates on inventory levels, cost of goods sold (COGS), and other key metrics. These financial insights help accountants to monitor and manage cash flow more effectively, ensuring that the business remains agile and responsive to market changes.

Conclusion

For inventory managers, a solid understanding of inventory accounting is invaluable. It enables you to interpret financial reports more effectively, manage inventory more efficiently, and contribute to your company's profitability. By leveraging inventory accounting knowledge, you can optimize stock levels, reduce carrying costs, and ensure that your business is well-positioned to respond to market changes.