Inventory is a critical part of all businesses. The inventory asset can be assigned value in several ways, and it’s important to maintain proper record-keeping for the business so they know what their profits, or as importantly their losses are. A company might use one or many methods for this depending on how large their operation is – Inventory records should always be up to date. This is where a company requires an inventory accounting system.
What is Inventory Accounting?
Assets are anything a business owns which has potential future utility – so they need to be accurately valued by their company if there want accurate valuation reports. Inventory accounting is the body of accounting that deals with valuing and explains changes in inventoried assets. A company’s inventory typically involves goods in three stages of production: raw, unfinished products (or “in-progress”), and finished items ready to be sold. Inventory accounting assigns values to these various aspects according to its industry standards as well as any other necessary criteria.
Methods Of Inventory Accounting
Inventory items, at any of the three production stages, can change in value. Changes in value occur for several reasons including depreciation, deterioration, obsolescence, and so on. An accurate inventory accounting system keeps track of these changes to a company’s assets and adjusts accordingly. Here are the four methods of inventory accounting:
First In First Out (FIFO)
The FIFO inventory method assumes that the oldest goods purchased for resale or use in manufacturing are used before more recent additions. When you take a physical count at month-end, all of your remaining items are counted and valued by applying their most recent cost to each one until they’re gone – unless there’s too many left.
When using the FIFO method, accountants assume that items purchased or manufactured first are used or sold first. This aligns with inventory movement in many companies and makes it a common choice among accountants who want to charge less expensive units for the cost of goods sold so they can create more operating earnings and pay taxes on them too. Companies can use the oldest items first, so they do not have to worry about expiration dates or inventory that does not move.
Last In First Out (LIFO)
The LIFO method of inventory accounting is the exact opposite of FIFO as it assumes that most recently purchased goods are first used or sold. The previous cost for each item must be applied to the amount left in the hand unless there isn’t enough current stock, in which case, one can apply what was just bought and add this total with any leftover from before, resulting in a new valuation.
With LIFO, when prices rise the last units purchased are the first used- this results in higher costs of goods and lower operating earnings. This causes a company to have obsolete inventory which decreases their income tax revenue.
The average cost method assigns value to end inventory based on the average price of the items purchased. For each item, you add up all individual prices and then divide by the total number of purchase prices for a given period to determine the average unit cost per item. By multiplying this figure with the remaining units in stock, one can derive ending inventory values. Companies that opt for the average cost method have just one layer of inventory. They also roll new purchases into old ones to get a “weighted” costing that is readjusted as more stock comes in or goes out.
The direct cost method of inventory assigns a value to an item that is individual to that one item. This method can be applied with items such as art; it’s most often used when highly customized goods are sold and purchased. The direct cost inventory method is a data-intensive system that requires companies to keep track of every individual item to charge the specific costs associated with particular items. This accounting process can be time-consuming, but it works for high-priced goods.
Inventory Accounting – Why Do It?
The main advantage of inventory accounting is to have an accurate representation of the company’s financial health. Inventory accounts can also be used as a tool for determining profit margins on products at certain stages in their production cycles, allowing companies to maximize profits across all parts of their business model.
TThe benefits of using inventory valuation methods are most prominent in products that require exceptional time or expense in secondary stages of production. Items such as pharmaceuticals, machinery, and technology can be three examples among many others where significant overhead is incurred after their initial design. With a few adjustments, companies can adjust the variables at certain stages to keep product value and increase profit margins.
Inventory accounting is important for many reasons, but it’s also a lot of hard work. To get the most out of your inventory management and reduce costs associated with not having enough or too much product in stock, you need an expert team that knows how all this works. If you want help managing your inventory on a day-to-day basis, our experts are ready and waiting to partner with you!