Managing inventory properly is a critical function for retail-based businesses, as well as for service-based businesses, like plumbers and electricians, who may sell products along with the services. This is because inventory costs reflect affect actual profit, and inventory in stock affects is considered an asset for balance sheet, business valuation and taxation purposes.
If a business sold only one item, managing the inventory could be as simple as counting the stock on hand, and reordering more when that stock hit a certain threshold. However, if the age of the product may affect their value (such as if they are perishable or subject to devaluation over time), the business may need to have a policy of selling older stock first. Likewise, if the wholesale cost of the products changes, the business must decide whether to sell the more or less costly items first, and whether that cost difference should be reflected in the retail price. It’s important to note that not only retailers and some service professionals need to track inventory. It is equally important to manufacturers who need to track raw materials, components, various parts and finished products.
Those two examples are issues that a business could face even if it had only a single product for sale. As the product offerings grow more diverse, the accounting required to manage that inventory grows more complex. For instance, if the business sells clothing, each specific style, color, size and material of shirt may be tracked as separate inventory items. By tracking such information at very specific levels such as this, the business can better analyze their sales, better prepare for seasonal trends, and more accurately identify products that are profitable and those that are not.
Most cloud-based accounting systems offer basic inventory functionality that include tracking stock quantities and costs, with the ability to drill down into best-selling products. More advanced inventory management systems also offer greater control and insight on stock valuations, import capabilities, integration with sales for invoices and estimates, and additional integration with ordering functions when inventories need to be replenished.
There are also numerous add-on programs that provide more extensive inventory management functions, such as inventory forecasting, packing/shipping solutions, management of multiple warehouse locations, RFID tracking, barcode systems, point of sale, tools for manufacturers, and remote access to management and reporting options. The more advanced systems also integrate with sales and ecommerce systems to keep real-time inventory data that is always up-to-date, while less sophisticated (and more manual) options are available for businesses with less dynamic sales.
Types of Inventory
As noted previously, many different types of businesses have inventory that must be accounted for properly in order for the business or its financial advisors to accurately assess cashflow and business finances. There are a variety of types of inventory, generally depending on the type of business.
Merchandise
When most people think of inventory, they think of merchandise. Items on the shelf at a store that are for sale, and additional boxes of that item back in the stockroom or in a warehouse. These are generally retail goods that the retailer sells for a profit, so tracking the costs of the goods is important to determining actual profitability. Contractors and service providers, such as plumbers and auto mechanics also frequently maintain small inventories of products that they sell along with their labor, such as gaskets, appliances, and filters.
Merchandise inventory is goods that the company owns, and is therefore an asset included on balance sheets. Items being sold on consignment or other method, in which the product is not owned by the business, are not considered inventory.
Manufacturing
Manufacturing inventory can be a little more complex, because of the several phases of the manufacturing process.
Raw Materials inventory are those goods which will be used to produce the finished product. This can include wood for ship building, raw dairy products to be made into retail products, metal used in fabrication, and paint used for finishing products.
Works in Progress inventory items are not yet finished, and therefore not available for sale. They are, however, still an asset for accounting purposes, and should be tracked. As the title implies, these are most commonly items that are not yet complete and ready for sale as merchandise, but also have progressed beyond the raw material stage.
When manufacturing is complete, the raw materials have been combined, transformed or consumed to produce Finished Goods inventory, which are ready to sell either at retail or wholesale.
eCommerce Inventories
While the term inventory may be used by the ecommerce business for its internal workflow and management, it is often misapplied. Only merchandise owned by a business is considered inventory for accounting purposes. Many modern ecommerce systems do not require sellers to possess such inventories, as the seller acts are more of a middle man, with the transaction actually processing the sale directly from a wholesale provider, with a profit margin added.
Inventory Accounting Methods
The most central point of inventory accounting involves how to assign value to the items being sold. If a business has a supply of the same item that came in different deliveries, it’s important to segregate them if the items had different costs or if the newness of the product can affect sales. The most common inventory valuation methods are First In, First Out (FIFO), Last In, Last Out (LIFO), and Average or Weighted Cost (AVCO).
FIFO
The First In, First Out (FIFO) method is the most commonly used accounting system for periodic management of inventory. Through this system, the inventory on-hand the longest is to be sold first. This keeps a smooth chain of inventory without allowing items to become too aged, since as new supplies of the items come in, they are set to the back of the sales queue. However, some accountants note that this method may over or underestimate the value of future inventory, because there may be fluctuations due to inflation or price changes. As such, it does not necessarily provide the most accurate assessment of inventory value.
LIFO
The Last In, First Out method may seem counter intuitive to some, but it has its applications. Specifically, if more recent inventory purchase costs have been higher due to inflation or trending issues, selling the most recent (higher cost) inventory items first can help the business decrease the book value of their inventory. Additionally, if the more recently acquired stock is of higher cost but sold for the same retail price, it would result in less taxable profit. There are regulations on how and when this method can be applied, however.
AVCO
Using an Average or Weighted Cost method, the cost of goods are averaged, making it a simpler, however less accurate, method of valuation.
How to Account for Inventory
Periodic Inventory Management
Still commonly used in brick and mortar retail businesses, periodic inventory systems do not automatically update along with sales or inventory purchases. Instead, the inventories are audited once or twice per year (or other period), and then reconciled against sales and purchases, and any discrepancies written off as losses.
Dynamic Inventory Management
With a dynamic, or perpetual, inventory method, inventory is a much more fluid part of the business’ accounting. This requires accounting for cost of goods sold (COGS), which is debited when sales transactions are made, reflecting actual cost of inventory instead of being averaged.
Source: ISAAC M. O’BANNON