Inventory Accounting Defined – The Importance of Inventory Accounting
April 17, 2019
The flow of inventory is the lifeblood of ecommerce businesses. You need to know which SKUs you have on hand, how to budget for and predict demand, and how much your inventory is worth. Yet the value of your inventory can change over time, which makes keeping track of inventory value a significant challenge. There are a number of inventory accounting methods to deal with changing inventory value.
Here’s a roadmap for ecommerce businesses that explains why inventory accounting is important as well as what the key challenges are and how to solve them.
What is inventory accounting?
Inventory accounting is the process of tracking and accounting for changes in the value of inventory over time as it relates to manufacturing and costs of goods sold.
Why is accounting for inventory necessary?
Inventory is reported as a current asset on your balance sheet. Simply put, if you don’t have an accurate method for keeping track of the value of your inventory, you can’t properly value your assets or goods sold and budget for the raw materials you need to buy for your business. Here are some of the benefits of accounting for inventory in each accounting period.
Calculate accurate profit
The accuracy of your financial statements is directly dependent on the accuracy of your inventory accounting. Think of it this way: If it costs you $10 to create a product and you sell it for $15, then you can record a $5 profit. But if you think you only spent $9 to manufacture the product, you will record $1 more in profit for that sale than you actually earned. These miscalculations can add up quickly and have devastating consequences for ecommerce businesses.
Audit suppliers’ charges
Suppliers frequently overcharge, and it’s difficult to catch it if you aren’t accounting for inventory. Detailed inventory accounting will reveal discrepancies in your books and help you resolve them, and may even help you cut production costs.
Inventory is often the most valuable asset for ecommerce businesses, and is a central component of your budget. This makes inventory accounting critical to properly gauging the overall financial health of your business and can even be the catalyst to looking into inventory financing.
What causes changes in inventory value?
Generally, the value of your inventory is what it cost you to purchase the inventory. This value can change when you purchase new products at a different cost than previously and when products are sold. Inventory value will vary based on how much product you have on hand, how much you are selling, and any changes in supplier pricing when you order each additional batch of inventory.
Inventory value will also change when products are damaged, become expired, or are out-of-date. It’s important to look at the total inventory carrying cost for a more accurate measure.
How to calculate inventory value
The most accurate way to calculate inventory value is to count each unit you have on hand and then add up the inventory costs of each product. Of course, this can be highly impractical, if not impossible for many ecommerce businesses. Fortunately, there are a number of much more efficient methods of calculating inventory value.
Top 4 methods for calculating inventory value
There are four widely accepted inventory accounting methods that can accurately track changes in inventory value while letting you avoid having to hit the shelves and count items one-by-one. Here’s how they work.
1. FIFO (first in, first out)
FIFO, the most commonly used inventory accounting method, assumes that the first products you received from your manufacturer will be the first ones sold and shipped out to customers. This allows you to calculate the value of inventory on hand despite changes in supplier pricing.
For example, let’s say you bought 5 of one SKU at $10 each and then another 5 of the same SKU at $15 each a few months later. If these 10 same products are in your available inventory and you sell 5 of them, using FIFO you would sell the first ones you bought at $10 each and record $50 as the cost of goods sold.
2. LIFO (last in, first out)
In the LIFO method, the most recently purchased inventory items are the ones that are sold and shipped out first.
Let’s use the same example as above of purchasing 5 of one SKU at $10 each and then another 5 of the same SKU at $15 each. If you sell 5 units using the LIFO technique, you would sell the 5 items you purchased most recently at $15 each and record $75 as the cost of goods sold.
3. Specific identification method
Specific identification requires tracking each individual item in inventory from purchase to sale. When an item is sold using specific identification, the cost is matched to the initial buying price. This is the most accurate method, but also requires extremely detailed accounting.
4. Weighted average
The weighted average method, as the name suggests, averages out the cost of purchased goods in your available inventory. To calculate inventory value with the weighted average cost method, you just divide the total amount you spent on the inventory you have on hand by the total number of items on hand.
Let ShipBob take care of inventory tracking and management
Inventory accounting is just one part of of inventory management. ShipBob offers a complete ecommerce fulfillment solution with built-in inventory tracking and management software that gives end-to-end oversight and control of inventory. ShipBob helps ecommerce businesses with high inventory turnover scale and get orders shipped out quickly.
“I felt like I couldn’t grow until I moved to ShipBob. Our old 3PL was slowing us down. Now I am encouraged to sell more with them. My CPA even said to me, ‘thank god you switched to ShipBob. ShipBob provides me clarity and insight to help me make business decisions when I need it, along with responsive customer support.”
Courtney Lee, founder of Prymal
Most ecommerce businesses aren’t equipped to track their inventory in great detail. With ShipBob, you can view and track your inventory levels at each fulfillment center in real-time right from the dashboard.
“We utilize ShipBob’s Inventory API, which allows us to programmatically retrieve real-time data on how many units of each product are currently stored at ShipBob’s warehouses. We currently use this API to generate custom reports to tie this inventory data into our accounting platforms.”
World-class management software
ShipBob’s software syncs up with your ecommerce store to put all the most important information in one place. ShipBob’s software helps you answer important questions about demand forecasting so you have enough inventory in advance and don’t run out.
“One of the greatest features of ShipBob’s software is the inventory management functionality, which lets us track inventory change and velocity over time. Being able to monitor which styles are selling quickly helps us always keep our best sellers in stock. We’ve been able to get through our heaviest seasons while staying ahead of production using ShipBob’s inventory forecasting tools — even as our order volume more than quadrupled in less than a year.”
Ryan Casas, COO of iloveplum
Inventory management is related to every part of your business, and inventory accounting is critical to keeping up with your financial wellbeing.
“I used to have to pull inventory numbers from three places everyday and move all the disparate data into a spreadsheet. ShipBob has an analytics tab in their dashboard with all of this information, which is great for end-of-month reconciliations.”
Wes Brown, Head of Operations at Black Claw LLC
If you’re looking for a third-party logistics (3PL) provider that helps with inventory solutions, warehousing, and ecommerce fulfillment, download the e-guide, “How to Choose a 3PL for Your E-Commerce Business,” and learn important tips and considerations.