Small business owners often found themselves in the swamp of inventory accounting. In simple terms, it refers to a method to track purchased merchandise that you wish to sell to consumers. And in accounting terms, you’ll see your inventory as a current asset on the balance sheet.
Once you manage to sell it, you can exclude the cost from your inventory. After that, you need to record new entries in your cost of goods sold (COGS) to showcase the sale of the products in the revenue account.
Sounds straightforward, right? Well, it is – but there’s more to inventory accounting than just technicality. Remember, you have to report your inventory on your annual tax return. So, let’s dive into some of the foundational information you need to know about inventory accounting:
What Purpose Inventory Accounting Serves?
Primarily, inventory accounting informs you about your remaining stock, its cost structure, and its value to your company. In fact, inventory accounting can help your business perform better.
Calculation: How Does It Work?
First, the purchase of an inventory item is an asset and as well as a cost. It’s an asset because you have the freedom to sell it. Second, once you manage to sell a particular item, you’ll record it as income. Simultaneously, you’ll be able to eliminate that item from your assets’ list.
Now, don’t make the mistake of generalizing inventory accounting. In fact, there are a couple of ways to manage your inventory. Choose the method that is compatible with your business needs. Alternatively, you can, for instance, record your inventory in the form of an asset after purchase. It means you’ll only record the cost after you sell it.
That said, things get quite tricky when you handle a large quantity of inventory. Your payments and price fluctuations can, in fact, overlap. And that’s why accountants use two ways to manage and record inventory:
Average Cost Method – (AVCO)
There’s a good chance you may have heard of the AVCO as the weighted average cost method. It’s an inventory method where you use the base average of cost for all your products in the inventory. Essentially, you divide the COGS in your inventory by the entire sale amount of available products.
COGS / Amount of Products Sold
First-In-First-Out Method – (FIFO)
If you think your business would function better by taking care of old purchases that sell out first, then this is the method for you. The FIFO inventory method is ultimately all about recording the items at a higher cost. The idea is to strengthen your balance sheet.
As a result, you get higher profit margins from extensive tax liability. FIFO inventory method can be a savior for your business if you intend to apply for a loan or attract new investors.
How COGS Come Into Picture?
As much as the stock inventory you are holding matters, the amount of inventory you’ve sold matters even more. After all, this is how you’ll learn to get a clear picture of your business’s entire earnings. And the cost of goods sold helps you paint that picture.
Cost of Goods Sold (COGS) = initial inventory + total purchases – remaining inventory
From small or giant businesses, the cost of goods formula (COGS) will always be at the centre of your inventory accounting. And why wouldn’t it be? You can find more details through COGS and systematically analyze more factors, such as handling cost or storage options for more profitability.
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Disclaimer: We don’t take any responsibility for actions taken based on above information. Please speak to our financial advisor if you need more information. This guide was written specifically for Smart Accounting clients. Some of the information contained in this guide might not be applicable if you do not have a business managed by Smart Accounting. By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details are correct at time of writing.