All businesses want to run smoothly, have happy customers who return to buy more of their products and, of course, turn a profit on a consistent basis. Having a steady flow of inventory is integral to helping achieve these goals.
To maintain a stock of products and to value a business for financial reporting and taxes, companies must calculate the inventory of the goods they have to sell. The good news is there is a software that businesses can use to help them manage inventory and revenue. Accounting software helps calculate how many products a company has in stock, track orders, balance budgets, maintain the list of goods and determine projected profits.
However, there is no one-size-fits-all approach to calculating product inventory; there are four: first in, first out (FIFO); last in, first out (LIFO); average cost; and specific identification.
Deciding which method to use depends on the type of goods a company sells and the preferences of their management team.
Before digging into the four methods, let's unpack why a business needs to practice proper accounting methods and why accounting software is essential for managing inventory.
The inventory is the list of items to be sold by a business. Maintaining an accurate and complete assessment of products is essential for running a successful business. And, since the value of goods changes depending on manufacturing costs, demand for goods and the market, knowing what you have and how much it's worth is vital to achieving your business goals.
The goods or items sold can be standard or varied depending on the type of business. For example, if a business sells only shirts, they have a standard inventory of goods. If the company sells different types of products (shirts, pants and shoes) with different values, the products are varied.
For some companies, products, such as food, also have a shelf life. These products need to be sold in a particular order to protect them from spoiling. Both standard and varied items have different costs that affect the profit margin of the business.
To choose the proper inventory costing method, managers must know the differences among the four accounting types to better record and analyse the financial transactions of their business.
First in, first out (FIFO)
Most businesses use the “first in, first out” (FIFO) method. Products are assumed to sell in the order they're added to the inventory, meaning the first products in stock are the first to be sold. The FIFO method makes the most sense for businesses such as restaurants, bakeries and butchers because the products have a shelf life.
Last in, first out (LIFO)
Unlike FIFO, “last, in, first out” (LIFO) is used when the last products added to a company's inventory list are the first to be sold, which means the earlier inventory stays in stock. However, fewer businesses use this method. Businesses, such as grocery, drug and convenient stores, with varied products tend to use LIFO because most inventory carried has an expiration date and has seen inflation over time. Newer items would likely be priced higher with older items decreasing in value.
A company that sells clothes may also sell newer seasonal items first. Sales can then come in to move older inventory and to attract customers. It also helps clear stock, so the business does not carry too much old product.
Average cost
Average cost is the other most common accounting method. Manufacturing, pharmaceutical and fuel companies are examples of business types that use a weighted average to track inventory.
By calculating the average cost of products, inventory can be pretty straightforward and simple. Management takes a weighted average value of all products to determine inventory.
Specific identification
If it's possible to know the exact amount of physical goods and how much each item costs at various points in time, then specific identification is the most accurate way to determine the accounting for inventory.
Serial numbers are used to identify each product in the inventory to track, analyse and value the product over time. The specific identification method is often used for large items like furniture or vehicles, because their value changes over time, depending on the manufacture dates, models and other specifications.
The goal of accounting and taking inventory is to ultimately determine the cost of goods sold, which is an inventory of the products a company has sold during a particular period like a month, quarter or year. Management calculates the cost of goods sold through proper accounting during their set time:
Beginning Inventory + Purchases of New Products = Available Products to Sell
Available Products to Sell – Ending Inventory = Cost of Goods Sold
When a business knows their expenses, which includes their inventory, operating costs, material costs and taxes, they can predict the company's revenue from sales of their products. By subtracting the company expenses from profits, they can determine the profit margin of the company as a percentage.
Companies using accounting software like NetSuite and inventory costing methods can better understand the health of their businesses, which, in turn allows them to better execute their business and marketing strategies.