A Guide to Inventory Accounting Methods

If you keep inventory in stock, you need to ensure that it’s accounted for properly. Here’s a quick guide to inventory accounting methods and how they work.

Inventory movement affects your company in multiple ways -- impacting cash flow, cost of goods sold, and even profit -- which is why accounting for it properly is so important.

Accounting for inventory can be a complicated task, so accounting novices may want to consult with an experienced accountant or CPA for guidance.

Overview: What is inventory accounting?

Inventory accounting is the valuation of inventory products for resale.

The management of both inventory purchases and inventory turnover should follow Generally Accepted Accounting Principles (GAAP) rules, which require that all inventory be properly accounted for using either the cost method or market value method.

It’s also important to remember that inventory is considered a current asset, so it is not depreciable.

If you only sold a single item, inventory accounting would be simple, but it’s likely that you have multiple items in inventory and need to account for each of those items separately. While this is not difficult, you can quickly run into complications when inventory costs vary.

Both cost of goods sold and inventory valuation depend on accounting for inventory properly. And because inventory is considered an operating expense, materials and product purchases directly impact your income statement, while an increase in inventory levels will directly affect your balance sheet totals as well.

Inventory accounting is used primarily to determine cost of goods sold, and to value inventory at the end of each accounting period. When determining your cost of goods sold for a specific accounting period, the formula is:

Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold

For instance, your beginning inventory for the month of March is valued at $5,250. You purchase additional inventory in the amount of $4,100 and end the period with an inventory value of $3,100. Here’s how you would calculate your cost of goods sold for the month of March:

$5,250 + $4,100 – $3,100 = $6,250

Inventory valuation is determined by attaching a specific value to the products that remain in inventory at the end of the accounting period.

We’ll show you how to do that using the three most frequently used inventory accounting methods: first in/first out (FIFO), last in/first out (LIFO), and weighted average, with each method having advantages and disadvantages.

How to do inventory accounting with the FIFO method

First in/first out, or FIFO, is the most common type of inventory valuation method used. It's fairly self-explanatory: First in/first out simply means that the inventory items that were purchased first, or the oldest, are the first to be sold.

For example, on January 2, 2020, you purchase 100 crystals from your regular supplier at a cost of $4 each. On January 15, you need to purchase an additional 100 crystals, but your regular supplier raised the price to $6 each.

When your supply begins to run low in late January, you turn to another supplier, who offers you a price of $5 per crystal, so on January 30, you purchase an additional 100 crystals at the new cost.

In order to properly track your inventory costs and the value of your remaining inventory at month's end, you will need to track pricing and sales for all three pricing levels since how you account for your inventory pricing will directly affect your cost of goods sold, and your inventory valuation.

Let’s break this down further:

• 1-02-2020: 100 crystals @ $4 each = $400
• 1-15-2020: 100 crystals @ $6 each = $600
• 1-30-2020: 100 crystals @ $5 each = $500

In addition to purchasing the crystals in January, you also had two large customer orders; one on January 20 for 125 crystals and one on January 31 for 140 crystals. Here is how you would value the inventory that was purchased on 1-20-2020 using the FIFO method:

• 100 crystals @ $4 each = $400
• 25 crystals @ $6 each = $150
• Total cost of inventory = $550

Because we’re using the FIFO method, our order includes the first crystals that were placed in stock, which were $4 each. The remaining crystals in the order were taken from the second group of crystals purchased, which were $6 each.

The next purchase, completed on 1-31-2020 would be:

• 75 crystals @ $6 each = $450
• 65 crystals @ $5 each = $325
• Total cost of inventory = $775

With this order, the oldest crystals in stock, which were $6 each, were sold first, along with 65 crystals from the most recent purchase. After both of these purchases were completed, you were left with 35 crystals in stock, all valued at $5 each for a total value of $175.

Here is a chart that breaks down the inventory activity using the FIFO valuation method:

Table that breaks down the inventory activity using the FIFO valuation method

The cost of goods sold for the month of January using the FIFO accounting method is:

$0 + $1,500 - $175 = $1,325

How to do inventory accounting with the LIFO method

Last in/first out, or LIFO, calculates inventory value based on the premise that the last inventory items purchased are the first ones sold. Using the same transactions as above, here is how your inventory totals would differ using LIFO:

The first customer purchase, made on January 20 would be:

• 100 crystals @ $6 each = $600
• 25 crystals @ $4 each = $100
• Total cost of inventory = $700

Using LIFO, because the $6 crystals were the last inventory items added before the customer’s purchase on January 20, they are the first ones sold.

The next purchase, completed on January 31, would be:

• 100 crystals @ $5 each = $500
• 40 crystals @ $4 each = $160
• Total cost of inventory = $660

After these purchases, you were left with 35 crystals in stock, all valued at $4 each for a total value of $140, since using the LIFO method, both the $5 crystals and the $6 crystals were sold first, leaving only the $4 crystals in stock.

Table that breaks down the inventory activity using the LIFO valuation method

The cost of goods sold using the LIFO method for the month of January is $1,360. The calculation is:

$0 + $1,500 - $140 = $1,360

LIFO is often used for tax purposes, based on the assumption that the most recent inventory is the most expensive. Using LIFO can reduce taxable income levels, resulting in a smaller tax bill.

How to value inventory using the weighted average method

The weighted average method averages the total cost of your inventory. In this case, you would add the cost of all three of your inventory purchases for the month:

• 100 crystals @ $4 each = $400
• 100 crystals @ $6 each = $600
• 100 crystals @ $5 each = $500

Next you would add your total inventory count for the month, which would be 300. To find the weighted average for your inventory, you would use the following formula:

$1,500 ÷ 300 = $5

Table that breaks down the inventory activity using the weighted average valuation method

Using the weighted average, the ending inventory valuation would be $175, while the cost of goods sold for the month would be:

$0 + $1,500 - $ $175 = $1,325

Weighted average is best used in a manufacturing environment where inventory is frequently intermingled, and difficult to track separately.

Inventory accounting doesn’t have to be difficult

Whether you’re manufacturing items or purchasing products from a supplier for resale, it’s essential that inventory be accounted for properly. Finding the method that best suits your business can go a long way toward making the process easier.

Using good accounting software can also simplify inventory management by assisting with the inventory valuation process; tracking inventory movement, including sales orders and customer purchases; and producing financial statements such as a balance sheet or profit and loss statement.

If you’re looking for accounting software that can track inventory for your business, be sure to check out The Ascent’s accounting software reviews.