Whether your business is driven by product resale or selling components with accompanying services, it’s necessary to account for inventory. Special rules apply to inventory accounting, even for a smaller operation maintaining cash basis books that record expenditures as they are paid.
Inventory is defined as merchandise your business obtains for the purpose of selling to customers. Accounting for expenditures for these items is not considered a business expense until the merchandise is sold. Rather, the cost for resale merchandise is recorded on the company balance sheet as inventory. The business merely exchanges a cash asset for inventory assets.
Inventory appears on the balance sheet at its cost, not its retail value. When inventory is sold, the cost for these items is transferred from the balance sheet to the income statement as “cost of goods sold.”
The cost of inventory includes delivery. So purchasing 1,000 units of item “X” for $3,000 plus $50 in shipping expenses results in a cost of $3.05 per item. When one hundred items are sold, inventory is reduced by $305.00 and cost of goods sold is increased by the same amount.
The circumstances clearly become complex if cost for the same item changes. Acquiring another one hundred units of item “X” for $320 plus $15 for shipping results in $3.35 per unit added to inventory. When two hundred more items are sold, confusion reigns.
The default accounting method for variable inventory unit costs is called FIFO-an acronym for First In, First Out. Accordingly, the cost for the two hundred sold items is $3.05 each. You’re still selling from your original 1,000-item batch. But if you’re selling 1,000 items, the first nine hundred are the remaining units from the original batch and the next one hundred are from the second batch, and have a cost of $3.35 each.
All small businesses should consider an inventory tracking system. The “periodic” system places all inventory purchases in a “cost of goods sold” account, a temporary holding station. At the end of an accounting period – at least annually – a physical inventory count is taken, and the known inventory cost is recorded on the balance sheet. The difference between inventory figures from one period and those of the next offsets the cost of goods sold, so the purchases no longer belong in a temporary holding station. The difficulty in this method is assigning differential costs for units acquired at various prices; however, it’s satisfactory for smaller companies with few types of inventory items and little fluctuation in cost.
By contrast, “perpetual” systems continuously update the costs for all units on hand in the inventory account. Most accounting software will automate these systems, which are superior for tracking inventory in stock, as they constantly update the income statement for true FIFO cost as items are sold.
Learning the data entry steps for these programs is challenging, but for larger organizations with multiple components of inventory, the output is certainly worth the effort.