Bookkeeping 101: How to Master Your Inventory Accounting

If you have a small business, you probably have inventory. This is an obvious statement for those who sell end-use products such as skateboards or alarm clocks, but it also relates to manufacturers that supply other businesses.

What Is Inventory Accounting?

Inventory accounting is how you account for and value the inventory in your business. Raw goods, work-in-progress products, and finished items all need to be counted as inventory. The two most common ways of calculating inventory costs are First-In, First-Out (FIFO) and Last-in, First-Out (LIFO).

“A company’s inventory consists of all the goods it offers for sale,” explains small business expert Rosemary Carlson. “For example, a company may buy wholesale items, such as clothing or gift items, and resell them. Its entire inventory is made up of finished goods. Manufacturing companies have an inventory made up of raw goods, or various product components, works in progress, and finished items […] All of these units qualify as inventory and are recorded in inventory and work-in-progress accounts that show up as assets on the company’s balance sheet.”

Your inventory is your lifeblood, so it’s essential you manage it accordingly. When you don’t sell enough products, your days might be numbered. When you sell a lot but aren’t able to restock, you will also take a financial hit.

A big part of successful inventory management is accounting. Let’s look at some of the ways you can keep tabs on your inventory and accurately represent it all on your balance sheet.

How to Calculate Inventory

Whether your inventory falls at the beginning of the production process or is end-use, you’ll employ the same calculation to create a manageable number. Here’s how you break it out:

BI + NP − COGS = EI

The acronyms used in this calculation are beginning inventory (BI), net purchases (NP), cost of goods sold (COGS), and ending inventory (EI).

How to Calculate Inventory Costs

There are multiple ways to calculate your inventory costs. Let’s look at 2 of the most common: First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). In addition to being really fun to say out loud, these 2 terms represent accounting methods that can help you get a better idea of what’s happening in your inventory.

The FIFO method is used for situations where the first units of your inventory are often the first ones sold. As an example, you have a clock factory and make 50 clocks on a Monday and the cost is $7 per unit. The next day, you make 50 more clocks, though the cost goes down to just $6 each. If you were to sell 50 clocks on Wednesday, you would put the COGS as $7 per unit on the income statement.

As you might imagine, LIFO takes the opposite approach. So if your factory makes 50 clocks for $7 per unit on Monday and 50 more for $6 per unit on Tuesday, then sells 50 clocks on Wednesday, you would put the COGS as $6 a pair on the income statement.

A third method to consider is Average Cost. Rather than look at the cost of individual batches of units, you simply average the cost for the chosen accounting period. Going back to the clock factory example, you would end up with a COGS of $6.50 for the clocks you made on Monday and Tuesday.

There are various scenarios where these 3 methods might work best. For example, if you own a fruit distribution company, you’ll be an advocate of the FIFO approach. The longer your inventory sits on shelves, the higher the chances that it will go rotten. The clock factory example is likely different because clocks won’t spoil if they sit on a shelf for a month. So the owners of the factory would have more options to choose from.

Accounting for Variation

The clock factory example given above is helpful as far as the numbers go, but it also presents things in a much too precise manner. As we all know, running a small business isn’t clockwork. There are ebbs and flows, starts and stops. Nothing is guaranteed.

Here are some of the inventory variations you could encounter:

• Variation in quantity
• Variation in production line
• Variation in delivery time
• Variation in demand
• Variation in performance

Managing your inventory as carefully as possible helps to smooth out these snags and forecast the future.

How to Manage Your Inventory for Better Accounting

There was a time when tracking and managing inventory was done with a clipboard and a ballpoint pen. Luckily, technology has now automated many of these manual tasks. Not only does inventory management software make things easier, but it reduces errors, syncs with your other systems, and securely stores your data.

Here are 9 inventory tech products to consider:

1. FlowTrac
2. SKULabs
3. Lead Commerce
4. MarginPoint Mobile Inventory
5. Finale Inventory
6. Fishbowl Inventory
7. Chondrion Inventory Management
8. eTurns
9. Infoplus

Choosing the best inventory management software for your business is like choosing the best car for your high school-age child. You’ll need to carefully do your research, test drive a couple of top contenders, then choose an option that is reliable and easy to use.

Aided by top-notch software, you’ll be able to stay closer to the details of your inventory. This enables you to navigate challenges and improve your efficiency. There’s no doubt that the more accurate you can make your accounting, the more you will set yourself up for success in the future.