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Bookkeeping

Inventory Accounting: How to Track and Value What You Sell

Inventory accounting records what you hold for sale and moves its cost to cost of goods sold when it sells. Getting it right affects your reported profit, your taxes and your cash. The key choices are how you count stock and how you assign costs.

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Why inventory accounting matters

Inventory is an asset until it is sold. When it sells, its cost becomes an expense. Errors in either step misstate profit.

If you overcount inventory, profit looks higher than it is. If you undercount it, profit looks lower. Inventory also ties up cash, so tracking it helps you decide what to reorder and what to discount. See inventory turnover for a measure of how efficiently you use it.

Periodic vs. perpetual systems

Periodic systems update inventory with a physical count at set times. Perpetual systems update it with each sale and purchase.

Periodic is simple and fits very small operations. Perpetual, usually in software linked to your point of sale, gives real-time counts and catches shrinkage sooner. Even with a perpetual system, do periodic physical counts to check it.

Cost flow methods: FIFO, LIFO and average cost

FIFO assumes the oldest stock sells first, LIFO assumes the newest sells first, and average cost blends all unit costs.

This is an illustrative example. You buy 10 units at $10, then 10 more at $12. You sell 10.

  • FIFO: COGS is 10 x $10 = $100. Remaining inventory is $120.
  • LIFO: COGS is 10 x $12 = $120. Remaining inventory is $100.
  • Average cost: average unit cost is $11, so COGS is $110.

When prices rise, LIFO shows higher cost and lower profit. Tax rules limit which method you may use, so confirm with your accountant.

Calculating cost of goods sold

COGS = beginning inventory + purchases - ending inventory.

Example: beginning inventory $30,000, purchases $80,000, ending inventory $35,000. COGS is $75,000. Include freight-in and other costs to get goods ready for sale, according to your accountant's guidance. See calculating cost of goods sold.

Valuing slow, damaged and obsolete stock

Inventory should be carried at the lower of cost or what you can realistically sell it for. Write down items that will not sell at cost.

Review aging reports each quarter. Items that have sat for a long time, or are damaged or out of style, may be worth less than you paid. Writing them down reduces profit now but gives a truer picture. Consider promotions or bundles to clear them and free up cash.

Common inventory accounting mistakes

Skipping counts, expensing purchases instead of recording them as inventory, ignoring shrinkage and mixing up units of measure are the usual culprits.

  • Not reconciling counts with the books.
  • Recording purchases directly as expenses.
  • Missing theft, damage and waste.
  • Poor receiving records, so you pay for goods you did not get.
  • Inconsistent costing methods from year to year.

Set a count schedule and a rule for who can adjust inventory records.

A quick inventory control routine

A simple weekly and monthly routine keeps counts accurate without much effort.

Weekly, count a small rotating sample of items, usually your highest-value or fastest-moving ones, and fix differences right away. Monthly, compare book inventory with a physical count of key categories and investigate shrinkage. Quarterly, review aging and decide what to discount or write down.

Receive goods against purchase orders, so you pay only for what arrives. Limit who can adjust inventory records. These controls cost little and protect profit, since inventory is often the largest asset a product business holds.

Funding inventory: do the payback math

Buying more stock only makes sense if it sells fast enough to repay the cost of money plus a margin.

See our inventory funding payback math before you borrow. For seasonal or bulk purchases, working capital or a business line of credit can fit. ROI Funder considers 500+ FICO, 6+ months in business and $20,000+ monthly revenue, with a complete file being an application plus 3 months of bank statements.

Frequently asked questions

How often should I count inventory?

At least once a year, and ideally quarterly or monthly for high-value or fast-moving items. Cycle counts spread the work.

Which costing method is best?

FIFO and average cost are widely used and simple. Confirm with your accountant which methods are allowed and best for tax.

Is inventory an expense?

Not when you buy it. It is an asset until sold, then its cost becomes cost of goods sold.

What is shrinkage?

Inventory loss from theft, damage, spoilage or errors. It shows up as a difference between book and physical counts.