Inventory Accounting 101: Determining Your Inventory Value
Even if you rely on online accounting programs, it is important to understand the basics of inventory accounting. After all, inventory may be your largest asset to report. Inventory includes all items in your possession that are about to be sold, or assets that will be used in the creation of your salable goods. Proper calculation of inventory is considered to be a requirement with Generally Accepted Accounting Principles (GAAP), so sticking to the books will yield an accurate balance sheet.
The Simple Formula
To break down inventory accounting into simpler terms, determining the value of your goods on hand at the end of an accounting period is accomplished by using an easy formula:
Beginning Inventory + Purchases - Cost of Goods Sold = Ending Inventory
The beginning inventory (BI) includes the materials for sale at the beginning of an accounting period. Purchases are also self-explanatory; they include the items purchased during the accounting period at cost. However, the cost of goods sold (COGS) can be more difficult to calculate.
The COGS represents the deductible in your formula. COGS can be anything that went into the production of your product, such as parts, labor, and even operational costs like electricity. Other costs, like transportation and advertising, are not factors in COGS.
3 Methods for Valuing Inventory
The value of your inventory can be determined by different methods, depending on how stock is tracked at your company over time. Like all materials, the price or worth of a single item is generally expected to change over time due to inflation, depreciation, or even obsolescence. The easiest, most common methods to use when calculating the value of your inventory include the following:
- First-In, First-Out (FIFO): This inventory accounting method works just like you would think; the oldest stock is the first to be sold,leaving the newest stock for the end balance.
- Last-In, First-Out (LIFO): This method is the opposite of FIFO. Instead, LIFO sells the newest stock first, leaving the older, perhaps depreciated goods, for the end balance.
- Average Cost: This approach finds the average value of each item in stock to determine its cost when it leaves inventory.
As a small-business owner, you will have better insight into which inventory accounting method would work for you and your company. Like larger corporations that are required to use a single inventory valuing method, small businesses should also consider retaining one method as a best practice.
These days, you don't have to be an accountant to keep track of your inventory value. Tracking stock, managing your materials, and performing simple mathematical equations grants you deeper insight into your company's purchase decisions. It also gives you a better understanding of when to cut retail costs. With basic inventory knowledge under your belt, you can help your business succeed by keeping stock flowing smoothly and eliminating any cash flow issues.