Inventory Accounting: Definition, Methods & Examples

Inventory accounting is valuing and tracking fluctuations in inventory assets. The three primary inventory costing methods are average cost, last-in, first-out (LIFO), and first-in, first-out (FIFO). Businesses using manual bookkeeping systems should use the average cost method. However, businesses with nonperishable products should use LIFO, while FIFO is right for businesses that carry perishable items.

To ensure your inventory valuation is accurate, we recommend you invest in accounting software. QuickBooks allows you to keep track of all inventory products at every stage of the purchasing and sales cycle through the FIFO inventory costing method. On top of inventory accounting, QuickBooks keeps track of all income and expenses for your business. Sign up for a free 30 day trial and check QuickBooks out for yourself.

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What Is Inventory Accounting?

Inventory accounting is a way of tracking of merchandise you’ve purchased and intend to sell to customers. Inventory in your possession is recorded as a current asset at the cost it was purchased for on the balance sheet report. Once it’s sold, you remove the cost from the inventory account and record entries in the cost of goods sold and product sales (revenue) accounts.

How Inventory Accounting Works

There are three key stages to inventory accounting: ordering product from your vendor supplier, receiving the products that were ordered and selling the products to your customers. Placing an order with your vendor supplier does not impact your financial records. However, to keep track of orders, you may create a purchase order form.

The second step, receiving products, involves increasing inventory to record the products purchased and an increase to accounts payable to record the amount owed to the vendor supplier. The last step, selling the product, results in an increase in sales, an increase in the cost of goods sold, and a decrease to the inventory and A/P accounts.

A brief explanation of what takes place in each inventory accounting stage is below:

1. Place an order for the product with the vendor supplier: In this stage, you create a purchase order that includes the supplier’s contact details, such as address, email, and phone number. You also need to include the quantity, cost, and a description of each product you are ordering. At this stage, there is no financial entry to the books.
2. Receive products from the vendor supplier: When the products are delivered, you need to create a receiving document to record the products and the quantity of each product you received. Compare the receiving document to your original purchase order to ensure that all items have been received.
   When you record the receipt of products into your accounting software, the inventory account increases by the quantity you have received. If you paid cash, your bank account decreases. However, if your supplier has extended credit, your accounts payable increases by the total cost of the products received.
3. Sale of products to customers: When you sell products to customers, you need to record several transactions. First, you create an invoice to record the sale to the customer. When you do this, your product sales (revenue) account and accounts receivable balance increases by the total amount of the sale. Next, your inventory account decreases based on the inventory costing method used. Finally, the cost of goods sold account increases based on the inventory costing method used.

Next, we cover the three common inventory costing methods: average cost; last-in, first-out (LIFO); and first-in, first-out (FIFO).

Inventory Accounting Methods & Examples

The three primary inventory costing methods are average cost―also called weighted average―last-in, first-out, and first-in, first-out. New business owners who don’t have accounting software often chose the average cost method because it’s the easiest to calculate. If you sell nonperishable products like clothing or computers, the LIFO method is ideal for you. However, FIFO is ideal for businesses selling perishable items such as milk or medications.

When products are sold, your inventory accounting method is used to calculate the cost of goods sold. It’s also used to value your ending inventory at the end of the fiscal year. This amount shows up on your balance sheet report. We discuss the impact of inventory accounting on financial statements later on in this article.

Average Cost Method

The average cost method, also known as the weighted average method, is an inventory costing method in which the value of each item is based on the average cost of similar products in inventory. It is calculated by dividing the cost of goods in inventory by the total number of products available for sale.

The formula to calculate the average cost inventory costing method is:

Cost of goods in inventory/Total number of products available for sale

Let’s look at an example of how to use the average cost method.

Average Cost Method Example

Let’s say a T-shirt retailer made the following T-shirt purchases:

If the company sold 10 T-shirts on June 1, the weighted average cost is calculated as follows:

Cost of goods in inventory/Total products available for sale = Weighted average cost

$200/100 = $2 (weighted average cost)

The cost of goods sold for the June 1 sale would be calculated as 10 x $2 = $20

LIFO Method

The LIFO inventory method assumes the most recent purchases are sold first and method works best for businesses that sell nonperishable products like office supplies or clothing. It gives you the most accurate inventory valuation and sales profit. With the LIFO method, your cost of goods sold is generally higher, and that results in lower profits and a lower tax bill. Below is an example of how to calculate the cost of inventory under the LIFO method.

LIFO Method Example

Let’s go back to our T-shirt retailer who made the following purchases:

If the company sold 35 T-shirts on May 1, the cost of goods sold under the LIFO method is calculated as:

30 at $2 = $60
5 at $1.50 = $7.50
Cost of goods sold = $67.50

The first 30 T-shirts were valued at the cost of $2 because the last product in (April 30 purchases) is the first one out under the LIFO method. The additional five T-shirts were valued at $1.50, which is the cost of the T-shirts purchased on April 15.

To learn more about how the LIFO inventory method works and the advantages and disadvantages of using it, check out our LIFO inventory costing guide for more details.

FIFO Method

The FIFO method assumes the oldest purchases are the first sold and works best for businesses that sell perishable products like food and medicine. Under the FIFO method, inventory is valued at a higher cost, which results in a stronger balance sheet. It also yields a higher profit resulting in a larger tax liability. This could work in your favor if you are considering potential investors or applying for a loan or line of credit.

FIFO Method Example

For this example, let’s say a grocery store owner made the following purchases for eggs:

If the company sold 36 dozen eggs the week of January 29, the cost of goods sold under the FIFO method is calculated as:

12 dozen at $2 = $24
24 dozen at $3 = $72
Cost of goods sold = $96

The first 12 dozen eggs were valued at the cost of $2 because the first product in (January 1 purchases) is the first one out under the FIFO method. The additional 24 dozen eggs were valued at $3 each, which is the cost of the eggs purchased on January 8.

To learn more about how the FIFO inventory method works and the advantages and disadvantages of using it, check out our FIFO inventory costing method guide for more details.

How Inventory Accounting Works in Accounting Software

The best way to do inventory accounting is to use accounting software. Most accounting software programs can track all three stages of the inventory accounting process. You can create purchase orders and send them to vendor suppliers, record the receipt of products when they arrive at the warehouse, and record customer sales. If you have a point of sale (POS) system, most accounting software will integrate with that system.

The benefit of using software for inventory accounting is that most programs keep track of all of the inventory movement and calculations. When you create a purchase order or record receipt of a product, the accounting software automatically updates inventory quantities and costs in real-time using whichever costing method is included in the program. There is no need for you to calculate cost of goods sold manually. If you are a retailer, you may want to check out our article on the best POS systems for small businesses.

How to Track Inventory in QuickBooks Online

You can track inventory easily if you use accounting software like QuickBooks. First, you add your products to QuickBooks, including the product name, product number, cost, sales price, and quantity on hand. Second, create a purchase order and send it to your vendor supplier to place an order. Third, enter the products into QuickBooks once they are received. Fourth, create an invoice or sales receipt to record sales to customers.

QuickBooks records debits and credits behind the scenes for each stage in the process automatically. You can access several reports to see quantity on hand, quantity sold, and total sales. QuickBooks Online uses the FIFO inventory costing method to calculate ending inventory and cost of goods sold. Check out our QuickBooks inventory setup guide for step-by-step instructions.

How Inventory Accounting Affects Financial Statements

Inventory accounting affects both the balance sheet and the profit and loss (income statement). Purchasing inventory causes an account called inventory asset to increase while cash decreases. If your vendor extends credit terms, then accounts payable increases instead of cash. On the flip side, selling inventory makes sales and your cash account go up. If you extend credit to your customer, then accounts receivable increases instead of cash. Cost of goods sold increases and inventory goes down in both scenarios.

Summary of the Impact of Inventory Accounting on Financial Statements

Advantages & Disadvantages of Inventory Accounting

There are advantages and disadvantages of inventory accounting. Inventory accounting gives you useful insight into your inventory’s value, which is one of the largest assets you carry on your books. It also gives you insight into what products you are purchasing and who you are purchasing from most frequently. Complicated calculations and an upfront investment of time and money are just a couple of the disadvantages.

Advantages of Inventory Accounting

A few advantages of inventory accounting are:

• Gives you insight into the value of your inventory: Inventory is one of the largest investments your business makes. Because of the high dollar value, it’s important to have access to what the value of your inventory is so that you can make key business decisions, such as whether you are carrying too much or too little inventory.
• Provides information on product purchases: If you use accounting software, you can run detailed reports to see what products you are spending your money on. These reports also show which vendor suppliers your purchase from frequently vs not at all. This information can help you negotiate better pricing from those vendors you purchase from frequently.
• Provides information on product sales: Again with accounting software, you can run detailed reports to see what products are selling and which are not. You can also run reports by customer to see who is buying what products. This invaluable insight can help you to market products to customers and determine if you need to buy more of certain products.

Disadvantages of Inventory Accounting

Some disadvantages of inventory accounting are:

• Calculations can be complicated: Inventory accounting can be complicated because you have to pick an inventory method and figure out how to calculate it. This is why we recommend you invest in accounting software like QuickBooks. QuickBooks calculates inventory value and the cost of goods sold automatically while also tracking product purchases and sales.
• Accounting software may be required: To ensure that you have accurate inventory costs and quantities on the books, you should invest in accounting software. Many programs record debits and credits behind the scenes automatically as you move from purchasing inventory to receiving it at your warehouse. They can also do all of the calculations for you—no manual calculations required.
• Initial setup takes time: Before you can start tracking your inventory in accounting software, you need to invest the time to set things up. This initial setup requires you to enter information such as product number, name, and description. Plus, you should enter the cost of the product and the sales price.

Accounting software like QuickBooks allows you to import your products from an Excel spreadsheet easily instead of entering each product one by one.

Frequently Asked Questions (FAQs) About Inventory Accounting

We have included the most frequently asked questions about inventory accounting below. If you don’t see your question, head to Fit Small Business forum, and post your question there. One of our industry experts will respond to your question promptly.

What does inventory mean in accounting?

Inventory is merchandise that retailers and wholesalers have purchased to resell to their customers. If you are a manufacturer, you could have up to three types of inventory: raw materials, work in progress, and goods in transit. Inventory is reported on the balance sheet as a current asset.

Is inventory an asset or expense?

Inventory is an asset, not an expense. For accounting purposes, an asset is something that your business owns and has in its possession. It remains an asset until you sell it. An expense is money that you spend to operate your business. For example, utilities, marketing, and payroll are examples of expenses.

What is the best inventory method?

There are three common inventory methods: LIFO, FIFO, and average cost. The best inventory method depends on the type of products you sell. LIFO works best for perishable products, whereas FIFO is best for nonperishable products. The average cost method is ideal if you don’t use accounting software because it is the simplest to use.

Bottom Line

Ensuring that your inventory valuation is accurate is a critical component to having a balance sheet that reflects the right asset value. This also impacts your bottom line profit and, ultimately, your tax liability. Now that you are more familiar with inventory accounting, what it is, and how it works. It’s time to consider investing in accounting software to do the heavy lifting for you.

QuickBooks Online can take the hassle out of doing inventory accounting. It calculates inventory quantities automatically as you make product purchases and sales. It uses the FIFO inventory costing method and does those calculations for you behind the scenes. Take QuickBooks for a free 30-day test drive to see how it works.

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