To calculate the worth of the company’s inventory assets, any company that keeps inventory must have an effective inventory accounting procedure in place. Because inventory movement has an impact on your business’s cash flow, cost of products sold, and even profit, it is crucial to account for it correctly. Businesses use a number of standard inventory accounting methods to value their goods, keep track of the inventory turnover ratio and ensure accurate record-keeping.
In this post, we’re providing an answer to the question “What is inventory accounting?”, and share strategies for managing inventory, as well as different inventory accounting methods you can use.
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What is Inventory Accounting?
Inventory is a term that refers to the items that your company has purchased with the goal of reselling them to customers. Since it has a value, inventory is recorded as a company asset on your balance sheet. But if it becomes outdated, damaged, or the market price for that kind of goods declines, it might quickly lose its worth.
Inventory accounting can help you determine the cost of inventory and its value. This is crucial when determining selling prices, obtaining insurance, creating a budget, calculating taxes, or selling your business. You can also use it to determine where in your company you are making the most money. Proper management and accounting of inventory can make a huge difference to your profitability and the overall business.
How Inventory Accounting Works
In the States, public enterprises must adhere to GAAP (Generally Accepted Accounting Principles), a set of rules established by the Financial Accounting Standards Board (FASB).
GAAP requires companies to accurately record inventory following a strict set of guidelines. It forbids companies from both overstating or understating the value of their inventory because doing so could result in an inflated valuation for the business. Inventory counts as a business asset, so overstating its worth may give the appearance that a company has more assets than it actually does.
Fashion retailers, manufacturers, and wholesalers all need to use inventory accounting as an essential business strategy. Since the price of identical products might fluctuate over time, many of these enterprises struggle to assign a value to inventory that is currently in stock as opposed to inventory that has already been sold.
Companies are required to choose an accounting inventory method in their first year of operation, and while changing the method later on is possible, doing so can be very difficult. For this reason, business owners should carefully compare inventory accounting policies to decide which is best for them not only now but also in the future as their business (and the inventory amount) expands.
Benefits of Inventory Accounting
Inventory accounting improves the financial picture of a company, and this is probably its most significant benefit. Here are some ways in which inventory analysis, proper inventory management and accounting can help you earn as well as save money:
- Avoid cash flow issues. If your stock levels are properly tracked and managed, you’ll never have too much money locked up in surplus inventory. You’ll be able to spend that money on other expenses or expanding your business.
- Maximize sales. Be aware of when you are running out on a certain inventory item in order to prevent ever having to turn away customers.
- Reduce expenses. Lower storage (and write-off) expenses by ordering fewer of your slow-moving items of inventory.
- Better decision-making. Inventory accounting helps in the preparation of financial and revenue estimates, thus enabling the business owner to make wise decisions when it comes to inventory purchases.
- Get better deals. Knowing which are your best-selling products can enable you to place larger orders at a lower cost per unit.
- Determine where you make a profit. By accurately tracking stock costs, you’ll be able to determine the true margin that products earn you.
- Do more effective marketing. You can better prepare for promotions by recognizing seasonal sales trends.
Inventory Accounting Methods
There are three main inventory accounting methods that companies use: LIFO (Last In, First Out), FIFO (First In, First Out), and WAC (Weighted Average Cost).
1. LIFO
The last in, first out method is based on the idea that the items of inventory you’ve added most recently would be the ones to sell off first. This approach works well for retail businesses that specialize in non-perishable types of inventory or those with a low risk of obsolete inventory.
It can also result in a rise in COGS (cost of products sold) and a decrease in net profit if more recently purchased items of inventory are more expensive.
2. FIFO
First in, first out is an accounting inventory method that assumes that goods that were purchased first will likewise be sold first. Therefore, the oldest available on-hand inventory will be used to fulfill orders. It is a practical method to employ while managing the merchandise in your warehouse but it’s also good for valuing unsold stock.
The FIFO approach offers a lot of advantages. Businesses that offer perishable commodities (such as food and drinks) generally run a lower risk of having their products spoil or go past the best-before date. They can contribute to improved supply chain management to guarantee that their customers get the freshest stock possible.
3. WAC
The weighted average method differs entirely from the first two methods. It is applicable to companies who decide not to keep track of the cost per inventory unit for each unique purchase and delivery. Instead, the value of inventory is calculated using the average cost of products during the relevant time period.
You can determine the weighted average cost by simply dividing the total cost of items in inventory for sale by the number of items in the inventory.
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Which Accounting Inventory Method Should You Choose?
There is no simple response to this question. Your company’s financial objectives and the state of the market will both influence how you value your inventory. Select an accounting inventory method that fits your company’s requirements to optimize revenue potential and efficiently manage inventory records for tax calculation purposes.
Here are a few situations that can help you decide which inventory accounting method is ideal for your company.
Saving taxes
Your inventory valuation method can be useful if you’re looking for solutions to reduce your tax liability.
Assuming there’s inflation, a LIFO method will result in cost savings. When using the FIFO approach, you can observe that the tax due is highest because the profit is likewise the largest. Because of the decreased profit margin under LIFO, the liability is lower. However, you should bear in mind that we’re assuming price increases over the year. The outcome of this scenario might change if there is depression.
Attracting investors
A business with a large profit margin can attract many potential investors and retain its current stockholders. So FIFO valuation will be advantageous in an inflationary market if you’re looking for fresh funding opportunities or if you want to delight your shareholders with good earnings. Similarly to this, when prices are declining, LIFO value will be a preferable option.
Applying for a loan
If you intend to apply for a loan, you’ll need to keep your inventory as collateral. In such circumstances, it is desirable for the stock’s worth to be high because a higher valuation will give the lender more assurance. A FIFO method will provide you with a better value for closing inventory if prices are rising year-round. On the other hand, if prices are falling, a LIFO approach will provide a larger value.
The method that provides you with the highest inventory value will be ideal for your business because financial institutions consider the value of the closing inventory in your balance sheet as one of the criteria before approving a business loan.
The Bottom Line
In general, inventory accounting determines the exact worth of assets at various phases of their creation and production. It helps to ensure that the value of all assets, which is reflected in the value of the company, is accurately represented. Businesses can boost their profit margins and improve financial health by carefully evaluating the values determined by inventory accounting.
Hopefully, this article has provided a clear answer to the question “what is inventory accounting?” and has given you deeper insight into the best inventory accounting practices.
Despite this, retail businesses may still find inventory accounting to be a complicated task. That is why it’s smart to rely on inventory management software. Running your business on a single cloud inventory management solution such as ApparelMagic, increases accuracy and efficiency while reducing headaches across the board (not just for inventory accounting). This ultimately allows you to concentrate on expanding and improving your business.
