× FreshBooks App Logo
FreshBooks
Official App
Free - Google Play
Get it
You're currently on our US site. Select your regional site here:

Curent Assets

  1. Work-In-Progress
  2. Inventory Accounting
  3. Marketable Securities
  4. Business Asset
  5. Financial Risk
  6. Zero Balance Account
  7. Current Assets
  8. Lower Of Cost Or Market

Save Time Billing and Get Paid 2x Faster With FreshBooks

Try It Free ➝

Inventory Accounting Definition & How It Works

Updated: February 23, 2023

It’s crucial for a company to be aware of the inventory on hand at all times. It’s also a key metric alongside your profit margins.

This is where inventory accounting comes in. It helps business owners track what they have, how much it’s worth, and when it needs to be replaced. Inventory accounting is an important concept to understand for business owners and managers.

This article will discuss what inventory accounting is and how it works. Other topics will include pros and cons, cost of sale explanation, inventory accounting methods, and more.

List IconTable of Contents


    KEY TAKEAWAYS

    • Inventories are an important part of many businesses.
    • There are two main methods for accounting for inventory: periodic and cost of sales.
    • There are pros and cons to inventory accounting.
    • FIFO and LIFO are the two types of inventory valuation methods.

    What is Inventory Accounting?

    Inventory accounting is a system for tracking the value and quantity of a company’s inventory. By keeping tabs on stock, business owners can better plan for future needs and avoid running out of products. It reflects the cost of inventory. As well as purchasing and storing goods. It also shows the costs involved in selling those goods.

    Inventory accounting provides key information. Including how much inventory should still be on hand (as opposed to having been sold). It also details the value of that inventory and how much the inventory is worth on the current market.

    Inventory accounting is often used in certain industries such as retail and manufacturing. These types of businesses need to keep track of their inventory so that they can stay profitable.

    Automated Stress Free Accounting

    The Basics of Inventory Accounting

    Inventory accounting can be done in a number of ways. Businesses can use periodic inventory accounting or cost-of-sales inventory accounting. These will be discussed in more detail later in the article. Basically, inventory accounting is a way of keeping track of the inventory that a business has on hand. This information can be used to make better business decisions.

    Cost of Sale / Cost of Goods Sold

    When it comes to inventory accounting, it’s important to understand the concepts of cost of sale and cost of goods sold. Cost of sale is the total amount of money that was spent on acquiring and storing the inventory. This includes the purchase price and all associated costs. These would include shipping and handling as well.

    Cost of goods sold (COGS) is the total amount of money that was spent to produce the goods that were sold. These include the cost of materials, labor, and any other associated costs. COGS is deducted from the revenue of a company to determine how much profit was made on the sale of goods.

    Let’s look at an example of this in action:

    Suppose a company buys inventory for $100. The shipping and handling costs are $10. The company has to pay a sales tax of $5. The total cost of the inventory would be $115. That company sells that same inventory for $150 after marketing and labor costs of $20 (COGS). The total cost would be $135. $135 subtracted from $150 leaves a profit of $15.

    Pros and Cons of Inventory Accounting

    There are both pros and cons to using inventory accounting.

    Pros

    • It allows businesses to track their inventory more closely. This can help a company stay on top of its stock and make sure that it is not overstocked or running low on certain inventory items.
    • Inventory accounting can help a business determine the cost of goods sold. This information can be used to make better decisions about pricing and production.
    • Inventory accounting can help a business keep tabs on its profits and losses. This information can be used to make changes in how the business is run. 
    • Inventory accounting can be used to determine if a company is producing a profit or loss on individual inventory items.

    Cons

    • Inventory accounting can be time-consuming and difficult to keep track of. It requires regular updates and can be complex to understand.
    • Inventory accounting does not take into account the fact that some inventory may never be sold. This can lead to inaccurate information.

    Inventory Accounting Methods

    There are a few different ways that businesses can do inventory accounting. The two most common methods are periodic and cost of sales. Determining which method to use can be tricky. It depends on several factors, such as the size of the business and the type of inventory it sells.

    Method 1: Periodic Inventory Accounting

    Periodic inventory accounting is an accounting method. It’s where businesses track their inventory at fixed intervals. This could be done monthly, quarterly, or even yearly. At each interval, the business will calculate the cost of sale and the value of its inventory.

    This method is fairly simple to use. It can be helpful for businesses that have a lot of inventory and that change their stock frequently. It is not as helpful for businesses that have a smaller inventory or that sell the same items over and over again.

    Method 2: Cost of Sales Inventory Accounting

    Cost of sales inventory accounting is a method where businesses track their inventory as it is sold. This means that the business updates its inventory count after every sale.

    This method is more complicated to use than periodic inventory accounting. It can be helpful for businesses that have a smaller inventory.

    Save 6 Hours A Month On Accounting

    Inventory Valuation

    FIFO and LIFO Methods

    There are two different basic concepts that businesses can use to track the cost of their inventory.

    First in, FIrst Out

    The first is the FIFO method. Under this method, the oldest items in the inventory are expected to sell first.

    FIFO is typically easier for accounting purposes. This is because FIFO assumes that older stock will be moved quickly.

    Last in, First Out

    The second method is the LIFO method. Under this method, the newest items in the inventory are expected to sell first.

    Choosing between the FIFO method and the LIFO method can have important consequences. Especially when it comes to taxable income and profitability. Be sure to consult an accounting professional to decide which method is best for your company.

    How to Value Inventory using the Weighted Average Method

    Another way to value inventory is by using the weighted average method. This takes into account the cost of inventory, not just the oldest or newest.

    This method can be helpful for businesses that have a variety of items in their inventory. It is also helpful for businesses that sell items at different prices.

    The weighted average method is not as common as the FIFO and LIFO methods. It can be more complicated to use. The weighted average method can be used to assign a cost to two different factors. Those are the ending inventory and the COGS.

    Here is a summary for calculating your weight average.

    • You divide the COGS your company has available for sale by the number of units that are currently available for sale.
    • This gives you the weighted-average cost per unit.
    • The cost of goods available for sale is the sum of the beginning inventory value and net purchases.
    • The number of units available for sale is the sum of ending inventory units and net sales units.

    Summary

    As a small business owner, it’s vital that you keep track of your inventory costs and profit margins. Being able to have a constant awareness of how much inventory in stock you have is key to running your business properly. Especially when it comes to your inventory balance to ensure you don’t overorder or run out after an inventory transaction. Utilizing good accounting software can hugely help with this process.

    Let FreshBooks Crunch The Numbers For You

    Grant Gullekson is a CPA with over a decade of experience working with small owner/operated corporations, entrepreneurs, and tradespeople. He specializes in transitioning traditional bookkeeping into an efficient online platform that makes preparing financial statements and filing tax returns a breeze. In his freetime, you’ll find Grant hiking and sailing in beautiful British Columbia. Learn more about Grant’s services at viccityaccountant.com.

    Grant Gullekson headshot

    Written by Grant Gullekson

    Grant Gullekson is a CPA with over a decade of experience working with small owner/operated corporations, entrepreneurs, and tradespeople. He specializes in transitioning traditional bookkeeping into an efficient online platform that makes preparing financial statements and filing tax returns a breeze. In his freetime, you’ll find Grant hiking and sailing in beautiful British Columbia. Learn more about Grant’s services at viccityaccountant.com.

    FAQs on Inventory Accounting

    Why Is Inventory Accounting Important?

    When a company values its inventory, it directly affects its cost of goods sold (COGS). It also affects gross income and the value of the remaining inventory at the end of an accounting period. It, therefore, makes your inventory accounting a key metric for the profitability of your business.

    What Is the Days Sales (DSI) of Inventory?

    The days sales of inventory is a financial ratio. It shows the average amount of time taken for a company to convert its inventory into sales. This is measured in days and includes goods that aren’t finished.

    What Type of Account Is Inventory Sales?

    Inventory is classed as an asset. This means that it will show up on the balance sheet of a company. When inventory increases, it is recorded as a debit. A reduction in the inventory account would be signified by a credit.

    What Is Manufacturing Inventory?

    Manufacturing inventory refers to the raw materials and components that are used to produce a product. These items are considered part of the inventory until they are used in the production process. Once they are used, they become part of the cost of goods sold.

    What Is the Difference Between Inventory and Accounts Receivable?

    Inventory is made up of products that a company has purchased or manufactured. Inventory is typically ready for sale. Accounts receivable refers to money that is owed to a company by its customers. This could be for products that have already been sold or for services that have been provided.

    What Does Inventory in the Service Industry Mean?

    Inventory in the service industry refers to the work that has been completed but has not yet been billed. This could be work that has been done by employees or contractors. It could include materials and supplies that have been used in the course of providing services.

    What Is Inventory Process?

    The inventory process refers to the steps that a company takes to track and manage its inventory. This includes recording what items are in stock and calculating the cost of those items. It also includes determining how much money the inventory is worth. This process is made easier by accounting software.

    What Is Inventory Count?

    Inventory count is the process of counting the items in a company’s inventory.  This is typically done regularly throughout an accounting period to ensure that the inventory is accurate.

    What Happens to Inventory When a Company Goes out of Business?

    Inventory typically goes to the company’s creditors when it goes out of business. This includes suppliers, lenders, and other creditors. The inventory is used to pay off the company’s debts.

    WHY BUSINESS OWNERS LOVE FRESHBOOKS

    553 HRS

    SAVE UP TO 553 HOURS EACH YEAR BY USING FRESHBOOKS

    $ 7000

    SAVE UP TO $7000 IN BILLABLE HOURS EVERY YEAR

    30M+

    OVER 30 MILLION PEOPLE HAVE USED FRESHBOOKS WORLDWIDE

    Try It Free for 30 Days. No credit card required. Cancel anytime.