What is inventory accounting?

Inventory accounting is the process of valuing and reporting changes in stock levels. Inventory is considered a current major asset according to most balance sheets. When the company has too much inventory on hand, it’s seen as a liability.

This form of accounting works under the rules of the generally accepted accounting principles (GAAP), which are common accounting guidelines. In the case of inventory, GAAP prevents companies from using their inventory to overstate their company’s value. These rules also dictate how certain inventory can be depreciated over time, ensuring financial accuracy.

Types of inventory management

There are four main types of inventory accounting:

1. Raw materials and components. In accounting, raw materials and components are parts used in the production process to create goods. These are tracked separately because their market value can change, and they can become damaged or obsolete. Examples include lumber, steel and corn.
2. WIP. Work-in-progress (WIP) means partially finished goods. As such, WIP refers to the value of all the parts that go into creating the goods at different stages, including labor and overhead.
3. Finished goods. These are WIPs that are complete and ready for sale.
4. MRO. MRO stands for maintenance, repair and operations or overhaul. These items aren’t directly used in the assembly process but are still a part of maintaining operational standards. Examples of MRO include computers, spare parts and industrial equipment.

In addition to those types of inventory accounting, there are specialty types of inventory management, depending on the industry, including:

• Packing material. Companies that rely on primary, secondary and even tertiary packaging to sell their products need to count packing material as inventory. For example, companies that sell consumables, such as seeds, need to package them and prepare them for storage and transportation.
• Anticipation/Smoothing. This is when companies hold excess inventory in anticipation of higher demand due to a special event or upcoming season.
• Cycled inventory. During regular business times, this is the type of inventory that your business cycles through or turns over and must replenish.
• Transit inventory. This type of inventory consists of items that are shipped by the seller but haven’t yet been delivered to the buyer.
• Decoupled inventory. These are extra raw materials that are set aside. They ensure that if there’s a shortage during any stage of the production process, operations can continue as normal.

Benefits of inventory control

The benefits you’ll get from inventory control depend on the type of inventory management software you’re using. Investing in a good system helps your business bottom line in several ways by:

• Reducing errors. Manual inventory control leaves your records more prone to errors and inaccuracies, such as duplication.
• Lowering inventory cost. Imagine buying a part you thought you needed, only to find that you had plenty, or having items become obsolete or spoiled and needing to spend extra on shipping to keep production going smoothly. Inventory control reduces extra costs by helping you accurately track and forecast stock needs.
• Reducing labor costs. Every time something needs to be searched for or unexpectedly moved, labor costs are involved. Improving inventory efficiency reduces these unintended occurrences.
• Improving customer service. Inventory control policies reduce the times when you aren’t able to service your customers due to faulty stock information. With real-time reporting and optimized workflows, you can reduce the risk of that lost sale negatively affecting future sales from that customer, which can hurt revenues.
• Improving compliance. Inventory systems that seamlessly integrate with your accounting software provide a great audit trail and improve tax compliance. Your accountant will have a clearer picture of how your business is doing and how it can improve going forward.

Best practices

In addition to having a solid inventory control system with comprehensive policies, these recommendations can help you improve your accounting accuracy:

• Use the right measurements. There are times when using the cost of goods sold (COGS) is a valid yardstick. In that case, accountants can understand and adjust their assumptions to generate the most accurate result. However, when it comes to tax compliance, you may need to use ‘last in, first out’ (LIFO) or ‘first in, first out’ (FIFO), in addition to COGS. Some authorities assume how you use your inventory, so relying on one method leaves you open to costly risks.
• Practice re-costing. Even with invoices, working out the landed costs is challenging. With the help of your software, you can more precisely estimate it by doing purchase order re-costing once all invoices are in.
• Continuously track inventory. By continuously tracking inventory with your software, your COGS landed costs and other metrics are regularly updated and more accurate.

Inventory accounting FAQs

What are the types of inventory methods?

The two inventory accounting methods are periodic and perpetual. With the periodic method, stock counts occur at specific times of the year. At those times, you update the general ledger. With the perpetual method, records change when stocks come in. There’s no special equipment required for taking periodic inventory, but for perpetual, businesses rely on either a point-of-sale device or a scanner.

What is ABC analysis?

ABC analysis is a popular method for studying how inventory demand changes over time. ABC denotes three categories:

• ‘A’ inventory denotes the best-selling inventory that takes up about 20% of your stock.
• ‘B’ inventory denotes inventory that’s about 40% of your stock. They sell at the same rate as A stock but cost more to acquire.
• ‘C’ inventory is the remainder of your stock that makes the lowest profits.

What is inventory turnover?

Inventory turnover is the period of time when the company uses its on-hand inventory. For a restaurant, the inventory turnover is much faster than a business that sells vehicle parts. To calculate the inventory turnover, use the following equation:

Inventory turnover = [(Beginning inventory + Ending inventory)/2] + Sales.

This formula is called the average inventory.