In the business world, precision is the secret sauce to success. It’s about getting your numbers right, understanding where your money is, and keeping your financial ship sailing smoothly.
That’s where inventory accounting comes in. It’s like your financial GPS, helping you keep track of what’s coming in and going out. Whether you’re a big retail store making sure your shelves are always stocked or a small shop trying to balance your books, inventory accounting is your trusted guide.
What is Inventory Accounting?
Accounting stands for the discipline of calculating, processing, as well as communicating financial information for individuals and businesses.
Inventory accounting, on the other hand, is a type of accounting that helps a business figure out how much inventory it has, what it costs and what it is worth to the business.
In simpler terms, it is said to be the practice of valuing as well as reporting on the physical inventory any business holds.
Day-to-day management of Accounts Payable and Accounts Receivable, along with the cost of goods accounts, are all included in inventory accounting. Besides these, it helps in the periodic reporting, which is essential for taxes, duties and insurance and valuing the firm for buying or selling.
Inventory accounting is an essential task for any company. Ideally, it should cover sold and unsold products as per when they come and go from the inventory and the bookkeeping records.
How Does Inventory Accounting Work?
Let us pay attention to how inventory accounting actually works.
It involves accurately depicting the financial health of a business as determined by its inventory. It deals with many variables, such as day-to-day fluctuations in quantity, the movement of stock, ageing inventory and headstock, and many more.
Choosing an inventory accounting system and method of cost valuation is essential for a company, and it needs to adhere to the guidelines to extract and calculate the needed financial information using fluctuating expenses and revenue.
In this accounting, the inventory costs are tracked, and the inventory assets are recorded. The overall value of the inventory initially and at the end of an accounting period are also recorded to determine the metrics of a business.
Periodic And Perpetual Inventory Accounting Systems
Businesses usually use two inventory accounting systems when it comes to accounting for inventory: periodic system and perpetual system.
Periodic Inventory Accounting System
In a periodic inventory system, a business takes inventory readings regularly and records them in its books. These readings are typically taken at the beginning and the end of accounting periods. Since there is no need for software or scanning, a lot of businesses prefer this periodic inventory system.
Perpetual Inventory Accounting System
In a perpetual inventory accounting system, a business keeps track of inventory by recording transactions as they take place. When compared to the periodic inventory accounting system, this system provides more accuracy and the information is also provided timely. Software tools can also automate this process.
Cost of goods sold
Cost of goods sold or COGS refers to the costs associated with the production process of a business, for example, the raw materials required to manufacture the goods.
It will include direct materials costs, manufacturing costs and labour costs. However, indirect expenses like distribution costs, marketing costs and taxes are not included.
Cost of goods sold is an essential metric that helps in understanding the gross profit associated with each product the business sells. It can provide valuable insights into production costs and can also be useful to see which products provide the most value for the business.
You can use the following formula to calculate the cost of goods sold:
Cost of goods sold = Beginning Inventory + Net Purchases + Production Costs – Ending Inventory
Beginning inventory, otherwise called opening inventory, is the total value of the inventory of a company at the beginning of each accounting period. This is equal to the ending inventory of the accounting period before the current period.
Ending inventory, or closing inventory, is the total value of a company’s inventory at the end of every accounting period. This is equal to the beginning inventory of the next accounting period.
Inventory turnover, or otherwise the inventory turnover ratio, is used to calculate the rate at which a company uses, sells and replaces its inventory.
It is extremely helpful for a business to determine whether it is carrying the optimal volume of stock relative to how fast it can be sold.
You can calculate the inventory turnover ratio using the following formula:
Inventory Turnover = Cost of goods sold / Average Value of inventory
The Main Inventory Accounting methods
When it comes to managing inventory, businesses have numerous methods to choose from. These methods determine how a company values its inventory and ultimately affect financial statements, taxes, and profitability.
Let’s take a closer look at the most common inventory accounting methods.
First-in, First-out (FIFO) Method
The FIFO (first-in, first-out) is like organising your closet – you use the oldest items first. In inventory accounting, it means that the items bought or produced first are the ones you consider as sold first.
This method is often preferred when inventory costs are rising because it results in a higher cost of goods sold (COGS), which can lower taxable income.
Last-in, first-out (LIFO) Method
The LIFO (last-in, first-out) method, on the other hand, is like grabbing the newest items from your closet. The most recently acquired or produced inventory items are the first to be counted as sold.
It’s advantageous when costs are rising because it can lower reported income and tax liabilities.
Specific Identification (SI)
This method is like knowing each item in your closet by name and price. It involves tracking the cost of each specific item individually.
It’s useful for businesses with unique or high-value items, like art galleries or specialty stores.
Weighted average cost (WAC)
This method blends all the costs from all your inventory purchases together. It’s like making a smoothie with various fruits. You don’t know which berry you’re sipping, but it’s a mix of all of them.
The weighted average cost method is straightforward and often chosen for simplicity and when inventory items are similar in nature and cost.
Benefits of Inventory Accounting
Inventory accounting is more than just a financial chore; it’s a powerful tool that offers numerous advantages to businesses across various industries. Let’s delve into the key benefits of implementing effective inventory accounting practices.
Avoid overstocks and stockouts.
When it comes to the inventory issues a business has to face, overstocks and stockouts are the two most common.
Businesses that do not pay attention to inventory management and tracking have a higher chance of either ending up with too much stock or too little.
Overstocks is when inventory levels are too high, which gives rise to unnecessary costs related to handling and storage. Stockout, on the other hand, occurs when the inventory levels are too low. Such levels may lead to missed sales opportunities.
Inventory accounting can help you avoid such problems by tracking stock levels and making sure that the inventory is ready whenever it is needed.
Enhance customer experience and satisfaction.
If you wish to strengthen customer confidence and satisfaction, keeping stock levels optimal is essential.
Customers desire a business to have what they need when they visit. When a business neglects inventory control, the products could drop below the minimum stock level. As a result, stockouts may occur, and it also leads to revenue losses. However, with inventory accounting, you can avoid this problem.
Cut costs and improve cash flow.
Through inventory accounting, you can identify the inventory that is no longer selling. This will save you from wasting money on stock that can’t be sold. Along with this, you can focus your effort on what is in demand and become more profitable. It can also help you identify capital your business could use to invest somewhere else.
Inventory accounting helps businesses figure out opportunities to reduce costs, for example, by using inventory control systems, sourcing from new suppliers and automating business processes.
Make better decisions and increase profits.
In order to make informed business decisions, you would require data that can be provided through inventory accounting.
You can do the following to make data-driven decisions about inventory sales:
- monitor inventory levels
- analyse sales patterns
- track inventory trends
You can increase profits by stocking in-demand inventory through this form of accounting and also get rid of unprofitable items.
You can reach out to an inventory accounting specialist or accountant to choose the right inventory accounting method for your business. Moreover, if you want to make your inventory tracking process more streamlined and decrease the probability of accounting errors, you should consider investing in inventory management software.
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