Other than learning how to forecast inventory as a business owner in the retail market, understanding how to accurately account for your assets is vital to your company’s financial success. That’s where inventory accounting methods come into play. Inventory accounting allows you to assign value to all of your assets—from raw materials to in-progress items to saleable goods—so they can be accurately reported in financial records at the end of the year.
Why is inventory accounting important to business success?
Because any increase or decrease in inventory valuation affects your company’s bottom line, incorrect accounting can result in over- or under-estimating the value of your physical inventory and, by extension, your business. To learn more about inventory accounting, take a look below at the most common inventory accounting methods used for businesses.
Methods For Calculating Inventory Value
Determining the accounting method that’s right for you will depend on a number of factors, such as the type of product you sell. For accurate—and in some cases, legally acceptable—inventory reporting, you’ll need to ensure you implement the most appropriate accounting method for your specific business.
There are 4 different valuation methods that businesses primarily use to calculate the value of their inventories.
- First In, First Out (FIFO)
- Last In, First Out (LIFO)
- Weighted average
- Specific identification
First In, First Out (FIFO)
The First In, First Out inventory valuation method follows the movement of inventory in and out of the warehouse under the assumption that the first goods purchased by your business are the first to be sold. This means that when end-of-year accounting or the accounting period is tabulated, it’s the newer, more recently purchased remaining inventory that is in stock to be counted as assets.
In most economic markets, the cost of goods is ever rising. This means that the first goods sold were also purchased at a lower price than newer inventory. When the FIFO method is implemented, the price of this less expensive inventory is used to determine a business’ cost of goods sold, resulting in lower total expenses and a higher net income. Understanding what a warehouse inventory management system is, and knowing the difference between implementing a warehouse inventory management system vs inventory management system will also help you make this valuation method more effective.
The FIFO method of accounting offers several advantages to business owners, including:
- Increased accuracy of inventory cost flow assumption
- Reduced impact of inflation
- Decreased risk of inventory becoming obsolete
Last In, First Out (LIFO)
The Last In First Out or LIFO valuation method assumes that the first goods sold by a business are also the most recently purchased—an assumption that doesn’t reflect the natural flow of inventory in most instances. With this method, the newest, and often most expensive, inventory is tabulated as the cost of goods sold, while the less expensive and oldest inventory is counted as company assets.
Assuming that newer inventory sells first and is reported as the cost of goods sold means that your business will likely report a lower gross profit and therefore pay fewer income taxes. However, implementing the LIFO method can also result in increased inventory layers and inventory obsolescence, as older products remain unsold even as new products are added.
Although this method is banned under International Financial Reporting Standards, it’s allowed by Generally Accepted Accounting Principles—the accounting framework used within the United States.
The weighted average method of inventory accounting groups the cost of new inventory with the cost of merchandise inventory that’s already on the shelf to determine the weighted average unit cost. That average is then used to calculate inventory value, and the cost of goods sold.
This accounting method can be particularly useful when a business’ inventory is intertwined in a way that makes it difficult to determine cost on an individual basis, such as when items are identical. The weighted average cost method also assumes all physical inventory is sold simultaneously.
Unlike the FIFO valuation and LIFO method, which group inventory based on cost and purchase timeline, the specific identification method requires each inventory item to be tracked individually. When an inventory item is sold, its cost is charged to a company’s cost of goods.
Individualizing inventory can have certain benefits, such as:
- Providing a more accurate picture of what inventory is and is not selling
- Simplifying the process of calculating inventory cost
However, because specific identification typically requires a significant amount of data tracking, it isn’t always a practical solution. Retailers that specialize in high-cost items, such as furniture or automobiles, are usually better served by this method than other types of retailers.
Simplify Your Inventory Accounting By Outsourcing To Flowspace
At Flowspace, we understand that your business is your livelihood. You work hard to make sure that each facet of your company operates accurately and efficiently, including your accounting. But understanding and implementing the right inventory accounting method can be complicated, and even the tiniest error can result in major problems for your bottom line.
That’s where we can help. Working with a partner like Flowspace can help you anticipate your inventory needs and costs, and streamline your warehouse operations.
With the Flowspace platform you gain access to:
- Real-time inventory visibility
- eCommerce and retail fulfillment experts
- Industry-leading innovations and solutions
To simplify your inventory accounting, optimize your workflow, and increase your gross profit, switch to Flowspace today.
Allison Champion leads marketing communication at Flowspace, where she works to develop content that addresses the unique challenges facing modern brands in omnichannel ecommerce. She has more than a decade of experience in content development and marketing.