Your shop wouldn’t be poppin’ dollar signs if it didn’t have inventory. We know this area is a maze for business owners, that’s why we want you to have this inventory accounting guide. It is a showcase of e-commerce inventory best practices and dives into the details of inventory management.
In this article:
- Inventory accounting software we swear by!
- Inventory cost methods: average cost method vs FIFO vs LIFO
- Perpetual vs periodic accounting
- Inventory valuation journal entries
- 5 tips on how to do inventory management
Why Do I Need An Inventory Management System?
Do you feel lost in inventory? Tired of counts being off, confusing COGS, or discrepancies between marketplaces? Any eCommerce venture will benefit from an inventory management system performing these basic functions:
- Track your stock levels
- Relay stock information to your accounting system and your store
- Keep track of your cost of goods sold
- Create purchase orders for fulfillment
Manual tracking with a couple of products is doable. Throw in hundreds of items, multiple sales channels, and suppliers and it is a full-time job. So it is a top priority to minimize errors and free up time to grow your business. How?
First, you need to have an accounting home base. Xero is our recommendation for any company with an inventory under 4000 units. All your transactions from all your sales channels should be reconciled in one accounting system. It will drive your business with clear insights into inventory costs.
Next, get an omni-channel inventory management software. What’s that? It is an inventory system that will track your inventory levels, sales channels, and customer orders. With information flowing seamlessly to all necessary channels, the core purpose of sales is solved.
Top Inventory Systems For eCommerce
Both of these cloud-based inventory programs integrate with Xero. They facilitate collaboration between your accounting, sales, and stock
A DEAR inventory system oversees all the moving parts of your business. With up to the minute reporting on stock levels, you can see how much product you have on hand. You can move inventory to other locations with a click, and track costs to transfer. For sellers with high unit inventories, this is the system to label, SKU, and segment products. DEAR helps dropshippers by simultaneously creating an invoice for the customer and a purchase order for the shipper.
DEAR is host to expanded accounting capabilities. Just starting out, and want to save some money on accounting? It is possible to run with a DEAR system only. However, their reports are only focused on inventory and don’t paint the entire picture of your business.
This inventory system is better for more established e-commerce companies. Not only can it perform most of the functions of DEAR, but they also offer loads of additional features. Our favorites are the real-time reporting capabilities and content management integrations. CIN7 will tap into CRM’s and marketing platforms to track purchasing, sales, and discounts. This gives you an extended view of your omni-channel e-commerce business.
How To Do Inventory Accounting?
Now that you are set up with software it’s time to dig into inventory accounting. This wouldn’t be a proper inventory guide if we didn’t go over Cost of Goods Sold (COGS) and inventory cost methods. To begin, it’s important to understand your inventory account on the balance sheet.
Is Inventory An Asset?
Yes! While on the balance sheet, it is a current asset. The idea here is that you sell your products quickly and earn income. That is why they are considered liquid assets, or current assets because they move out and transform into cash. That means that inventory is counted as your working capital. To place a number on your working capital, inventory valuation is your cost of purchase.
Inventory Valuation And Cost of Goods Sold (COGS)
You made a sale! Now the total valuation of your inventory needs to be updated. When a product is sold, its total cost moves off the balance sheet. That same amount is expensed as COGS moving onto the income statement.
COGS Master Formula
COGS = Beginning Inventory + Purchase – Ending Inventory
This calculation measures the difference between your buy price and sell price. It is important to calculate COGS monthly if you have a high turnover. The balance of your inventory is figured into your monthly close so that at the end of the year you can properly file taxes on leftover inventory, held as assets, as well as total COGS expenses to income.
The fun with COGS doesn’t stop at taxes.
Mastering COGS is unlocking the code to increase profit margins. This metric will inform you of lower-performing products, and your markdown thresholds, better preparing you for competition in the marketplace.
But before we get into e-commerce inventory best practices and growth tips, we have to break down inventory cost methods.
Inventory Cost Methods
How you calculate COGS depends on your chosen method. An inventory cost method determines the “Purchase” part of the COGS equation.
COGS = Beginning Inventory + Purchase – Ending Inventory
You choose an inventory accounting method in the first year of business, for your first tax return. You need to commit to a cost method for a couple of reasons.
One, after the first year it cannot be changed at will. You have to get permission to change your inventory cost method from the IRS and any changes need to be submitted using Form 3115.
Second, GAAP and IFRS accounting rules require consistent inventory accounting. If you are a publicly-traded company you will likely be following these rules, meaning you have to follow a specific inventory cost method year-to-year. Some methods are NOT permitted, so you must become familiar with which is suitable.
As if picking a method wasn’t puzzling, we’ll throw all that in for good measure.
Not to worry, this is a breakdown of the three inventory accounting methods. Plus the advantages of each cost method, and for what situations they are most applicable.
3 Inventory Cost Methods
Average Cost (AVCO): Weighted average of all your units
- AVCO = (Total Cost of Inventory Available) / (Total Number of Inventory Available)
First In First Out (FIFO): The assumption that the oldest units have been sold first.
- FIFO = (Cost of Oldest Inventory) x (Number of Units Sold)
Last In First Out (LIFO): Assumes the most recent units are sold first
- LIFO = (Cost of Newest Inventory) x (Number of Units Sold)
Average Cost Method vs FIFO vs LIFO
When discussing inventory cost methods it is important to remember that these calculations are cost flow assumptions. In essence, they are used for accounting purposes only. It does NOT represent how your inventory literally flows in and out of your business.
If you sell charcuterie meats and cheeses—please don’t sell the old items last.
Average Cost Method (AVCO)
We recommend the Average Cost Method (AVCO). It is easy to use for inventories large and small. It is especially useful for smaller companies since they have an intimate knowledge of inventory-related costs. Plus it is less labor-intensive to calculate than FIFO or LIFO, therefore it is often viewed as the least expensive.
The average cost method helps you calculate inventory costs that are always in flux. You don’t want to be stuck with a method when you know pricing may vary. AVCO will find the median and normalize your inventory costs helping you anticipate annual expenses.
First In First Out Cost Method (FIFO)
The First In First Out Method (FIFO) accounts for inflation in the market. A company assumes that the first products in, are sold first. For companies wanting to transparently report rising inflation, this is the best cost method. For Example: fashion retail, beauty products, and perishable goods.
There is no tax advantage to performing this cost method. Tax liability is higher because there is more net income, due to lower COGS expenses. For this reason, FIFO is viewed as the most accurate cost method and is preferred by GAAP and IFRS reporting rules. This inventory cost method requires an experienced accountant and an inventory management system. Note: Investors who like to see a high net income like this method.
Last In First Out (LIFO)
The Last In First Out Method (LIFO) also considers inflation in the market, but in a different way. A company assumes that the last products in, are sold first. Companies that always anticipate rising prices in inventory would use this cost method. For Example: car dealerships, oil, and raw materials.
The LIFO method will be more tax advantageous. The newest inventory would be more expensive and would result in a lower net income, with a high Cost of Goods Sold (COGS). However, for IFRS the LIFO cost method is not permitted. In the U.S. businesses using this have to justify why the newest products are going out the door first. Note: Assets on the balance sheet will always be lower using this cost flow assumption, reducing the value of the company.
Perpetual vs Periodic Accounting
Successful inventory management relies on a counting method: Periodic or Perpetual. After you pick your inventory cost method, you’ll need to pick a counting method. This determines the “Beginning Inventory” and “Ending Inventory” parts of the COGS equation.
COGS = Beginning Inventory + Purchase – Ending Inventory
Periodic Accounting is manually counting everything and reconciling how much you sold in the last year or period.
Perpetual Accounting is a point of sale system that accounts for all products coming or going, and the costs of those products.
Bottom line: for a limited supply of units, use the periodic accounting method. The perpetual is an ideal counting method for large quantities of items.
Real-time updates for inventory accounting
Discrepancies with actual stock levels
Good for large inventories
Great for automatic fulfillments
Inventory valuation updates after a physical unit count
Costs you time and labor
Less visibility over inventory with delayed results
Great for smaller inventories
Great for a few inventory purchases throughout the year
Note: a physical audit count is always recommended to expense items that are no longer of value (shrinkage, deadstock, theft, damages). It acts as a cross-reference to the data in your system; an added layer of support for accurate accounting.
Perpetual vs Periodic Inventory Examples
Accounting for perpetual vs periodic inventory varies. Your journal entries in your accounting system will affect different accounts depending on the counting method. Here are perpetual vs periodic inventory journal entry examples.
Inventory Journal Entries Perpetual Example
The perpetual method offers a clear picture of COGS. This is because as sales take place your management system can recognize revenue and COGS simultaneously. With this counting method, you are basing numbers on the data in your system. So you are doing accounting directly in the inventory account.
For Example: You purchase 20 watches for your inventory at $100/unit, $2000 total. You sell 5 watches to a customer at $200/unit, earning a total of $1000 in sales.
Under the perpetual method, you would add the Watches to your accounting system by making a $2000 debit in your Inventory Account and a $2000 credit to Accounts Payable (or Cash Account).
Using the same example, to account for the sale you make a journal entry that is a debit in Accounts Receivable for $1000 and a credit to the Sales Account for $1000.
With the perpetual method, an inventory management system is tracking your stock count. So with a sale, you can also recognize the change in inventory and COGS. Therefore, you debit $500 to COGS because that was your cost to purchase the watches and credit the inventory account for $500.
Note: If the customer returned the watches, you would perform a reversal of these entries.
Inventory Journal Entries Periodic Example
For a periodic system, you are only recognizing revenue as sales take place. Under this system, you add inventory costs to a holding account called “Purchases.” Using the same example above we’ll show you how periodic inventory journal entries differ:
For Example: You purchase 20 watches for your inventory at $100/unit. You sell 5 watches to a customer at $200/unit and earn a total of $1000 in sales.
You would add inventory to your accounting system by making a $2000 debit to your Purchases Account and a $2000 credit to Accounts Payable.
At the end of the period, after you perform a count you can enter periodic inventory journal entries.
You can now clear out the Purchases Account and reconcile the Inventory Account. Debit Inventory for $2000 and credit Purchases for $2000. If you had more purchases this would be a different amount.
After your periodic count, you discover you have 15 watches totaling $1500. To find out your COGS of the watches you sold you use the master formula:
COGS = Beginning Inventory + Purchase – Ending Inventory
COGS = 0 + $2000 – $1500
COGS = $500
Now you can recognize COGS as a $500 debit, and credit $500 to Inventory
Inventory Valuation Adjustment
Inventory has value and a business needs to account for it throughout the year. An inventory value adjustment happens when inventory loses value from theft, damage, shrinkage, deadstock, purchase value goes down, etc. You make an accounting adjustment noting the change in your inventory account.
Noting these changes is typically done following a physical inventory audit count. You match actual stock levels with what is in your inventory management system. It is tedious but should be done to have an accurate depiction of income for tax reporting.
Inventory valuation adjustment journal entries utilize an inventory valuation account. This account helps you track any changes due to loss or errors.
For Example: After an inventory count audit, you discover 2 watches went missing from your stock. The watches were purchased for $100/unit.
You would debit the inventory valuation account $200 for the lost watches, and credit the inventory account $200.
How To Do Inventory Management?
There is no doubt about it, mastering inventory will help you scale your business. Now that you understand the key concepts of inventory accounting here are 5 tips on how to do inventory management:
1. Organize Your Inventory Into ABC Classifications
Inventory specialists low stock and overstock conundrums, with ABC analysis. This classifies all products on a low-high value system. The system is based on the Pareto Principle that 20% of your products contribute to 80% of your business value. Thus, you organize products from high value to low value.
ABC Classification Rules
A: smallest category with the most important stock items.
B: larger category in terms of volume, product SKUs of mid value.
C: largest category of SKUs that contribute the least to your business’s bottom line
Value is specific to your business. Typically businesses will perform an ABC SKU analysis looking at annual revenue, sales velocity, or annual consumption value. Having a framework for your inventory gives you a way to pinpoint which areas need more attention than others.
2. Do Inventory Forecasting For Each Accounting Period
Did you know—your potential to sell inventory can be measured? Inventory forecasting is the art of determining how much inventory you can sell based on product trends, market demands, promotions, and recurrent fluctuations. Once you understand which products are of high value, you should measure how much you need based on previous sales.
Quantitative forecasting will use historical sales data for stock predictions. The more data you have the more accurate your predictions. Usually, this type of inventory forecast is done 30-90 days out, to prepare for the next fiscal year. However, annual forecasts will keep you on the ball with seasonal sales.
3. Find Your Reorder Point For Stock Replenishment
When inventory levels fall within balanced margins, you have achieved the goldilocks principle. To ensure you aren’t reaching extremes you want to understand cycle stock and safety stock. Historical inventory data can confirm: cycle stock, or your working stock needed to meet regular demands; safety stock, the number of units that should be stored for just in case sales.
Once you know stock figures you should get familiar with procurement lead time. In other words, how long does it take to replenish your inventory? Find that by calculating for your Reorder Point (ROP).
Reorder Point (ROP) = (#Units Cycle Stock x #Days Lead Time) + #Units Safety Stock
Setting auto fulfillment orders to match your ROP will maintain inventory at optimal levels. Since product demand is constantly changing stock quantities should too. Apply maximum control over inventory that is profitable, in high demand, and seasonal by monitoring replenishment.
4. Pay Close Attention To COGS Expenses
What does inventory cost? To tell you the truth, it has many different components, and aggregating all the costs gets complicated. That is why understanding the minutiae of your inventory is so important for accounting income. Your products are a work-in-progress, so anything you do to finalize the product is considered in the cost:
- Shipping + Handling Fees
- Customs Fees
- Direct Labor
- Ordering and Procurement Costs
- Factory Costs: like excess materials in manufacturing
- Storage Costs: warehouse fees, damage, theft, deadstock, obsolescence, etc.
- Admin costs: salary paid to an accountant to perform FIFO cost method calculations.
Some of these costs can be difficult to track and many owners lose sight of how they affect profit. But it is important to attribute these expenses to COGS calculations, to accurately reflect income.
5. Get More Insights With COGS
We perform month-end closings for every client, regardless of industry. It is arguably one of the most important accounting functions because it serves as a milestone of your business performance. For e-commerce gauging income at the monthly close focuses on COGS and inventory valuation. Essentially you are seeing how much is left in stock and the value of what’s left.
Going further with COGS, you can calculate your Inventory Turnover Ratio (ITR). This tells how often your products are sold and replaced in a given period. The higher the ITR number, the faster the turnover. Getting a low number means you are selling less and it could indicate a slow season or a promotion or price change is in the cards.
Pro Tip: your turnover ratio is specific to you, some industries will maintain higher turnover, and others low turnover. Look for consistent numbers month-to-month to find your true center.
Average Inventory (AI) = (Beginning inventory + Ending Inventory)/ Number of months in the period
Inventory Turnover Ratio (ITR) = COGS / Average Inventory
Days Sales of Inventory (DSI) = (Average Inventory / COGS) x 365
In addition to the turnover ratio, you should understand how your Days Sales of Inventory (DSI). It is directly linked to profit for the next period because you can see how long it takes you to sell all your inventory at the going rate.
Inventory Accounting In The Cart
eCommerce is a fun and lucrative way to do business. Good inventory management is what sets your business apart from the competition. If you are automating your inventory management system and feeding your accounting properly, you will have little in the way of understanding your sales. This setup helps you scale by saving you time that can be refocused on your customers.