Every item you have in stock has a value — and you need to be able to report exactly how much it’s worth. But sometimes goods get damaged and need to be written down or even written off, while others risk becoming obsolete.
Effective inventory accounting tracks how much stock you have and what it’s all worth, which is crucial for understanding and maintaining your organization’s financial health. And with the right methods, you can ensure accurate reporting, reduce costs, and optimize operations.
Keep reading to learn key strategies for improving your inventory accounting, or scroll to the bottom to learn how Fishbowl streamlines inventory accounting for you.
What is inventory accounting?
Inventory accounting is a part of business accounting that specifically tracks the value of a company’s inventory. Inventory levels fluctuate often due to purchases, sales, and other factors like shrinkage, so proper inventory accounting is crucial to keep your financial records accurate and up to date.
When accounting for inventory, you must determine the value of every item used in production. This includes raw materials, work-in-process (WIP) inventory, and finished goods. You must also measure the cost of safety stock, dead stock, and maintenance, repair, and overhaul (MRO) inventory. All these types of inventory count as reportable assets and must be included in the total inventory value.
Inventory accounting formulas explained
Accurate inventory accounting relies on several key formulas. Here’s a breakdown of the most important ones.
Cost of goods sold
Your cost of goods sold (COGS) represents all the direct costs you incur to produce the goods you sell over a given period. For example, a coffee company’s COGS would include the cost of coffee beans, roasting, packaging materials, and wages paid to production employees during the production process. It might also include the cost of developing a special blend or purchasing roasting machinery.
To calculate COGS, use this formula:
COGS = Cost of materials + Cost of direct labor + Other direct costs
You can also calculate COGS this way:
COGS = Beginning inventory + Purchases – Ending inventory
Ending inventory
Ending inventory is the value of unsold stock at the end of a financial period. You can calculate it using this simple formula:
Ending inventory = Beginning inventory + Purchases – COGS
Beginning inventory
Beginning inventory is the value of the stock you have on hand at the start of a financial period. It’s always equivalent to the ending inventory for the prior period. You can find your beginning inventory for the prior period by following this formula:
Beginning inventory = Ending inventory + COGS – Purchases
Days sales in inventory
Days sales in inventory (DSI) represents the average number of days it takes for a company to sell all its inventory. This figure takes into account both finished goods and WIP inventory, since both have financial value. Here’s how to calculate DSI:
DSI = (Average inventory level / COGS) x 365 days
Inventory shrinkage
Inventory shrinkage occurs when you lose valuable stock items. This often happens because of damage, spoilage, accidents, or theft. Shrinkage creates a mismatch between your recorded inventory levels and the actual number of items in stock.
To calculate the value lost to inventory shrinkage, use this formula:
Inventory shrinkage = Value of recorded inventory – Value of actual inventory
This gives you the monetary value of the goods you’ve lost, but you can also find your rate of inventory shrinkage with the following formula:
Inventory shrinkage rate = (Inventory shrinkage / Recorded inventory) x 100
Inventory turnover ratio
The inventory turnover ratio measures how often a company sells and replaces inventory within a given timeframe (usually one year). You can use this value to determine how efficient your inventory management is. If your ratio is too low, you probably carry surplus inventory that’s at risk of becoming dead stock. But if your ratio is too high, you can probably expect to face stockouts.
To find your inventory turnover ratio, use this formula:
Inventory turnover ratio = COGS / Average inventory value
Essential inventory costing methods
There are several ways to value your inventory, and each method can impact your financial reporting differently. Here are three of the most common inventory methods for accounting:
- First In, First Out (FIFO): With FIFO, you assume the first items purchased or produced are the first ones sold. So in your financial records, you assign the cost of the oldest inventory items to those you sell first. As a result, your COGS tends to be lower, which can increase profit margins.
- Last In, First Out (LIFO): LIFO is the opposite of FIFO. You assume the most recent inventory items are sold first, so you assign the cost of your newest inventory to goods sold. LIFO gives you a higher COGS, which is beneficial when inflation is high, or when you want to reduce your taxable income.
- Weighted Average Cost (WAC): With WAC, you calculate the average cost of all inventory items in stock, regardless of when they were purchased or produced. In a periodic inventory system, WAC smooths out price fluctuations to provide a consistent cost per unit. This simplifies financial reports, which is helpful when inventory costs vary frequently.
Periodic vs. perpetual inventory systems
There are two main systems to track merchandise inventory: periodic and perpetual.
Periodic inventory accounting is the simpler of the two, which conducts inventory counts at scheduled intervals, like each month or each quarter. A company’s COGS is updated with the new data acquired during the manual count. You’d calculate your WAC at the end of each period.
For a perpetual inventory system, the inventory balance updates constantly. Strong inventory management systems make it easier to record inventory and purchases in real time, making COGS, stock levels, and merchandise inventory accurate throughout accounting periods. For perpetual systems, you would have a moving average cost, recalculated each time you purchase new goods.
6 strategies for effective inventory accounting
It’s crucial that your inventory accounting is accurate and efficient. Here are six key strategies to improve your inventory accounting processes.
1. Set reorder points
A reorder point is the inventory level at which you should replenish stock. Setting reorder points ensures you maintain optimal stock levels by identifying when you’ll run out of critical products. This strategy helps you avoid stockouts, which can disrupt operations, and overstocks, which increase carrying costs.
From an inventory accounting perspective, reorder points make it easier to maintain precise records. When you consistently reorder at the right time, you minimize discrepancies between your actual stock and recorded inventory levels. This helps you track costs more accurately and keep your financial reports up to date.
2. Monitor inventory turnover ratios
If inventory is moving too slowly or often becomes obsolete, it can distort your financial reports. Your COGS might be inflated because outdated or excess stock is included in your inventory costs, even if it hasn’t contributed to sales.
Monitoring inventory turnover ratios gives you better insight into your flow of goods. This is important to keep track of because you should treat damaged, obsolete, and expired stock differently than stock that’s in good quality. For example, you can write off or write down inventory that’s lost value over time for more accurate financial records.
3. Conduct regular stocktakes and inventory audits
When you conduct a stocktake, you physically count all your inventory and compare this count to the recorded figures in your system. This process helps you catch discrepancies caused by shrinkage, miscounts, or system errors.
An inventory audit is similar to a stocktake, but you don’t just count stock. You also examine your inventory’s quality. As you compare your physical inventory levels to your records, you make adjustments as needed to account for any damaged, spoiled, or obsolete stock.
Both of these processes ensure that inventory records are accurate and up to date. They let you identify and correct errors while preventing any financial losses that would result from inaccurate reporting. As a result, you have a clearer picture of your inventory’s true value.
4. Adopt the right valuation method
Each inventory costing method impacts your COGS and overall inventory value differently, so adopting the method that best suits your company’s circumstances is crucial. Consult with an accountant about which valuation method is right for you, based on your industry and organization.
Regardless of which method you choose, Fishbowl can help you implement it effectively. Our software supports several methods, including the three most common — FIFO, LIFO, WAC — and additional methods like standard costing or actual costing.
5. Use inventory management software
With inventory management software like Fishbowl, it’s easy to track and manage your inventory. Our solutions automate inventory updates and provide real-time data on stock quantities. You can also generate accurate reports, track inventory turnover, and manage reorder points efficiently. This leads to better overall inventory control and enhanced inventory accounting.
6. Integrate with accounting software
Inventory management software works best when it integrates with accounting software to sync data across platforms. This improves data accuracy and gives you instant visibility into your costs. That’s why Fishbowl seamlessly integration with QuickBooks makes it the best in the business — you can streamline financial reports with ease and precision.
Streamline your inventory accounting with Fishbowl
Say goodbye to accounting headaches and say hello to Fishbowl.
Fishbowl’s inventory management solutions reduce errors to ensure accurate inventory tracking. Even better, our software integrates with QuickBooks to simplify your financial reports like never before.
Experience the power of Fishbowl today. Book a demo to learn more.