If your business sells, resells or makes new products from purchased stock, then your inventory is probably your biggest asset. The right accounting tools can help you make sure that inventory maintains its value, as well as guide business decisions for maximum success.
Types of Inventory
First, determine what type of inventory you work with.
Items for reselling: The stock of a retail store, or the retail component of a service business such as a hair salon. (Drop shipped products don’t count if you never bought them from the supplier.)
Items for installing: Products sold by a service business as an essential part of the job, for example a computer repair company that sells spare parts.
Items for manufacturing: Materials you make into products for sale, for example fabric, beads, thread, etc. for making wedding gowns. For accounting purposes, they will be assigned to one of three categories:
• Raw materials
• Work in progress
• Finished goods
Basics of Inventory Accounting
In order to keep tight control of your inventory, set the right prices, properly insure the stock and do your taxes, you’ll need to track a number of variables. Your accounting software should be able to show you:
• Cost of goods
• Associated costs including storage, shipping and losses due to damage or age
• Stock on hand
• Selling price
• Profit (or loss)
• Items sold
• Sales patterns by item and season
You must also choose an inventory valuation method for your year end statement, which will affect both your profits and tax liability. The most common ones are:
LIFO (Last In, First Out): Assumes you sell your most recently acquired — therefore most expensive — items first, while leaving older/lower priced stock on the shelf.
• Advantage: Increases cost of good sold and lowers net income, reducing taxes.
• Disadvantage: May not correspond to actual flow of goods or replacement costs.
FIFO (First In, First Out): Assumes you have perishable or quickly outdated items, so you need to sell the oldest goods first. Also, if selling prices rise, this method will give you a lower cost of goods sold.
• Advantage: Makes bottom line look better to lenders and investors.
• Disadvantage: Higher profit results in higher taxes.
AVCO (Weighted Average Cost): Bases report on the average product cost and average selling price for the entire year.
• Advantage: Simpler to do, more accurately represents replacement costs.
• Disadvantage: Inaccurate when prices fluctuate severely up or down.
Benefits of Inventory Management
Now we get to the good stuff: how your accounting system can save money and help you make money, too.
- Avoid cash flow problems. With stock levels properly tracked, you’ll never tie up too much cash in unneeded inventory. Use that cash to pay other expenses or improve your business.
- Maximize sales. Know in advance when you’re running short of an item, so you’ll never have to turn customers away.
- Reduce storage costs. Know which items are slow selling, so you reorder less often or not at all.
- Maximize write-offs. Know exactly how much you’re losing to damage, theft and product expiration.
- Get bulk discounts. Know what’s selling fast, so you can place larger orders at a lower cost per unit.
- Get better marketing results. Use seasonal sales trends to build promotions.
- Optimize profit margins. Fully tracked costs let you see how much you’re really making and where adjustments could be made.
In short, the better your inventory management system, the more you’ll be empowered to take your business to the next level. If you have any questions about inventory accounting or valuation, please give us a call.