Accurate inventory accounting is vitally important to companies in the business of selling products. But its importance should not be overlooked by small service-oriented operations.
An entrepreneur billing for a service may scarcely realize that some element of the work entails items acquired and resold, such as parts and components installed for customers.
Costs are subjected to inventory accounting when they comprise expenditures to purchase or manufacture resale items, as well as outlays that make products ready for sale-as in retailers who purchase items from suppliers to resell later to customers.
Whether the business is a big box store or an individual marketing products on the Internet, the circumstances require the recording of inventory.
As examples, consider the IT consultant who installs devices as part of the service, the home healthcare provider who procures durable medical equipment for patients, or the plumber or master electrician who is expected to have on hand those items that are sold with a service.
Things bought by all of these business people for their future projects are held as inventory. Inventory includes items such as routers and switches stored by the IT consultant; walkers and medical monitoring devices stockpiled by the home healthcare provider; the plumber’s pipes; and the HVAC repairman’s air conditioner parts.
Costs for inventory are not expenses; inventory appears on the business balance sheet in an asset account. As items are taken from inventory for sale to customers, their cost is transferred to the expense category for cost of goods sold.
Hence, accurate inventory accounting ensures correct reporting of profit on the income statement. Incorrect inventory accounting leads you down the primrose path, skewing your perspective on profit and cash flow. This becomes an ongoing problem because ending inventory for the current accounting period automatically becomes beginning inventory of the next period.
Businesses with multiple inventory items and high costs generally rely on computer programs for tracking. The significance of this procedure is that it ensures that sums are not lost in the confusion of constantly changing unit costs due to price inflation.
As a general rule, the oldest items are removed first when sold. The result is inventory valuation using the most recent costs.
That said, many small operations have no reason for fancy approaches to inventory accounting. An inventory with low costs or few items doesn’t require a computerized perpetual system for tracking acquisition costs and reductions upon sale.
Instead, a business should record acquired inventory in an account called “purchases” that is adjusted at the end of an accounting period-monthly or annually.
Under this periodic system, the cost of ending inventory is determined by a physical count or an estimate. When an accountant subtracts ending inventory from annual purchases and adds beginning inventory, the result is costs of goods sold.
A small business owner who marks up inventory items by a certain percentage can estimate the cost of goods sold as a percentage of unit sales. Ending inventory is therefore the beginning inventory plus purchases, minus cost of goods sold.