The Basics of Inventory Accounting (Updated 2021)Time to read: 3 minutes
Inventory is one of the essential facets of the global economy. Contrary to popular belief, inventory isn’t merely the items that a company has on hand and are ready to be sold. It is a form of a business asset that can affect cash flow, production cost, and overall profitability.
Inventory accounting is a useful skill, especially for people who run eCommerce businesses. Inventory accounting isn’t the most straightforward practice to perfect. If you or your business partners are getting into the eCommerce trade, this article will explain inventory basics and what it does for a company.
What is Inventory? What isn’t Inventory?
At its core, inventory is an item a business has acquired to resell. It includes raw materials, what is currently in production, and finished products ready to be sold.
Consequently, inventory doesn’t include the equipment and tools used for production; these, instead, are recorded as expenses.
What is Inventory Accounting?
Inventory accounting determines the value of the inventory that is currently owned by a business. This accounting practice tracks the changes with inventoried assets that can be affected by several factors. These factors include the number of stock items, the price at which the merchants sell these products, and supplier pricing changes.
Key Inventory Accounting Terms
Dealing with inventory accounting involves two key terms: Cost of Goods Sold, otherwise known as COGS, and EI, aka Ending Inventory.
Cost of Goods Sold
As the name suggests, the cost of goods sold refers to the amount a business spends to produce the products they intend to sell. It includes labor, raw materials, as well as the use of tools. Ideally, COGS doesn’t account for expenses that aren’t directly involved in creating the product. It doesn’t include shipping costs and advertising.
Taking note of COGS is important in inventory accounting because it shows its profit every time it sells a specific product.
Regardless of the success of a business, it is unlikely that the entire inventory will sell out. The items that are left on-hand are considered assets. They should be valued and included in financial statements.
Inventory Valuation Methods
There are several types of inventory valuation methods. FIFO (First In, First Out), LIFO (Last In First Out), Specific Identification Method, and Weighted Average are four of the most popular options.
There isn’t a “best” method, and the decision usually depends on what the seller’s requirements are. Nevertheless, it is crucial to stick to a specific process to ensure that financial statements are accurate and consistent.
First In, First Out
First In, First Out is pretty straightforward. With this valuation method, the first items to be purchased are the first ones sent out to buyers.
FIFO is the most popular valuation method. For businesses that sell perishable goods, the First In, First Out process is the best fit since it prevents items from degrading as new supplies come in.
Last In, First Out
Consequently, Last In Last Out is another inventory valuation method that businesses can consider. Again, as the name suggests, this method involves the last inventory items purchased to be the first ones sold. It can be an excellent option for merchants that sell non-perishable goods. It is important to note that LIFO is legal only across the United States.
Unlike the first two valuation options, weighted average doesn’t necessarily consider the cost per unit. Instead, this method accounts for the inventory value based on the average price of items throughout a specific amount of time.
Specific Identification Method
Specific Identification Method is widely considered the most accurate valuation method. In this process, a seller manages individual items through various identification means, including serial numbers, RFIDs, or SKU barcodes. However, businesses rarely use this method because it can be tedious and expensive. It is best suited for companies that stock rare items in their inventory.
Inventory accounting isn’t simple, nor is it easy, especially for business owners without an accounting degree.
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