Inventory accounting is a term which refers to how you reflect the value of your company’s stock and inventory in your financial ledgers. Several methods are available, and the value of your stock-on-hand can vary at any given point in time depending on which method you choose.
If you are a manufacturer of baked goods, butter prices will vary throughout the year. When the more expensive butter is used to make the cakes, the cost to create the finished cake will increase.
Managing and reflecting these cost fluctuations is what inventory accounting is all about.
When the cake manufacturer is analyzing profits, the Finance Manager has to decide how to interpret the fluctuating cost of the same product when calculating profitability at year end.
Q: Which method is the best for my business?
A: Most businesses use the first in first out method. Any manufacturer of perishable goods should use this method to ensure product moves through the production cycle and out to the customer in the shortest time possible. Ultimately, you should review the benefits of the different methods with your accountant because once you make your choice, it’s very difficult to change over to another method.
Inventory Accounting Methods
There are three different ways to look at the costs over the course of a year and three different ways to compute them. (Your accountant can guide you to the inventory method of accounting that best fits your business).
1. FIFO: First In First Out is a method that assumes you will sell the first product you produced or received (or the earliest raw materials you received to create products) prior to the ones you receive later. If you think about all the industries handling perishables such as the food, chemical, medical and plant industries, they must move their products before they expire or risk throwing them away and losing money. They, and many other industries, will benefit from using the FIFO accounting model.
2. LIFO: The Last In First Out accounting method is the opposite. It offers the opportunity to realize the most profits by reducing taxes paid. This occurs by using the highest item cost when calculating profit to show the lowest amount of net profit. This method may work well for businesses who consistently see increases in their costs throughout the year.
3. Weighted Average: This method takes the average cost throughout the year, adding the costs of all products and/or material and dividing it by the inventory count.
Inventory Costing Method
Not every inventory item will have the same cost; however, some method must be determined to assign cost to each item. Costs will vary by supplier, fluctuate at different times of the year depending on availability, or increase as time goes by. The application of FIFO, LIFO or weighted average will indicate how your business should calculate the item cost and do so consistently throughout the year despite changes in pricing.
Inventory Valuation Method
While most businesses choose the FIFO method, especially where perishable goods are involved, the approach is a decision you should make with your accountant. All calculations used in SOS Inventory will apply your chosen method of accounting. Because SOS can track inventory at all stages from raw materials, work in progress, and finished goods, it is an inventory valuation software tool.
Making the Right Inventory Costing Analysis
Before you start performing inventory costing analysis, keep in mind that the inventory costing you do affects the cost of goods sold (COGS). In turn, your gross profits and taxable income will be affected by your inventory costing. When performed properly, inventory costing will impact the financial statements associated with your business, which may include your balance sheet and income statement.
The costs and expenses that can be inventoried by your business are part of the total product cost. Everything your business does to get items ready for eventual sale will be taken into account as part of your inventory costing analysis. These costs can include everything from labor and raw materials to administrative costs and manufacturing overhead.
Inventoried costs are typically recorded as assets on a balance sheet. However, they will eventually be charged as expenses, which involves them being moved over to the income statement via the cost of goods sold section. The costs that can be inventoried are typically separated into three categories, which include:
- Ordering costs – Figures that accountants allocate to overhead costs since they consist of payroll, supplier pre-qualification, and various benefits
- Holding costs – These expenses involve the costs incurred to store goods that have yet to be sold
- Administrative costs – Expenses that are usually attributed to the accounting department and can include benefits and wages
Administrative costs are regularly partitioned into several departments, which include inventory control, purchasing control, and accounting.
Inventory Accounting Examples:
Imagine the baked goods manufacturer bought 100 lbs. of butter in October, but the following month, he paid more due to demand for the holiday season.
October: 100 lbs. butter – $3/lb. x 100 lbs. = $300
November: 100 lbs. butter – $3.25/lb. x 100 = $325
If the manufacturer sells the cakes made with the butter purchased in October first, the cost of manufacturing those cakes uses the $3/lb. price.
If he made 75 cakes using the 100 lbs. butter, the cost of butter for each cake made in October would be $300/75= $4 of butter for each cake.
If he made the same number of cakes in November, the cost of butter per cake would be $4.33
This example is simply the reverse, but easier to visualize if not a perishable product. If you had 5 chairs purchased for $40 and later paid $45 for 5 more, you would use the higher cost to calculate the cost of goods sold. This assumes you sold the chairs purchased later before those you purchased first.
In this scenario, you simply add up all costs and divide them by the total quantity.
5 chairs at $40 = $200
5 chairs at $45 = $225
Total chairs 10 = $445
Cost per chair = $44.50
No matter the accounting for inventory method your accountant recommends, SOS Inventory can handle them all. You can set up your SOS Inventory account to keep track of all the costs and sales throughout the year to make analyzing data for any period very easy. With a full analysis suite to choose from, you are always a few clicks away from seeing how much inventory you have on hand, what you paid for it and how much profit it generated. Realize the transparency and profitability made possible with a comprehensive inventory accounting system like SOS Inventory.
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