Finance Articles

Inventory Accounting

Inventory Accounting

Inventory accounting is really quite an easy concept and practice though many seem to be quite intimidated by the description of such. The logic of inventory accounting is sound and the standards of accounting practice have nurtured and supported these types of accounting practices for hundreds of years. We will attempt to explain the basic concepts in this article so that it may not be quite as daunting as previously thought.

Basically, when a business starts or the ownership is transferred to another entity, an accounting of the items for sale is taken. Each item is counted and indexed into a document commonly known as the ?inventory.? This index includes all items for sale in one particular location. This way, the management knows exactly how many items are for sale, what each item cost them to buy and how much each item will sell for when it is sold. Records are kept and changed each time the inventory changes (whenever any item is sold). This record is used for many things, including letting the management know how many items remain, how many were sold and for what price they were sold. They can then determine such things as which items are selling best, which items are not selling, how many they need to buy in order to keep up with demand and how many they need to re-order so that the inventory will remain intact. There are actually many things that can be determined and appropriate actions taken from the data just through the accounting practices.

These specific practices are usually based on one of the following methods of accounting: The Weighted Average method, the Last In/First Out method or the First In/First Out method. We will attempt to explain, simply, how each method works.

The Weighted Average method is founded on the following formula: Total cost of items divided by the total number of items for sale. The end result is an average. For example, let us pretend that we have a hardware company and we sell two items, doorknobs and nail guns. We currently have 10 doorknobs that cost $5 each and we have 10 nail guns at $20 a piece. Therefore using a weighted average here is how we determine the approximate worth of our inventory:

10 (doorknobs) X $5 = $50 10 (nail guns) X $20 = $200 ________ Total $250 divided by total number of items (15) = $16.66 which is the Average Cost of each item. This way, we can determine if we need (1) more items, (2) to increase our prices for profit (3) if enough items are selling.

Most businesses use one of the other methods for inventory control.

Last In/First Out (LIFO) With this method the most recently purchased merchandise is placed into the inventory to be sold first. A logical reason may be that the last items purchased were the most expensive items therefore, they should be sold first in order to get a decent return on investment. This is also a way to reduce taxes.

First In/First Out (FIFO) This method is just the opposite of LIFO. The first items to be purchased for resale are the first items expected to be sold and the last items to be purchased are the last items for sale. For instance, if we just received some new types of doorknobs, we will put them on the shelves, in the front row, in order that they will be sold first. The older items, we place further back in the shelf so that they will be seen last and thus sold last.

Those are the three most commonly used inventory methods practiced today. If and when a better method of inventory control is discovered and used, it may become the standard. Until that time, these three methods, tested over time, will continue to dominate the world of business inventory control.

Gary Vaughan invites you to visit his website at http://www.inventory--software-info.com Inventory Management Software

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