Inventory accounting may sound like a huge undertaking, but in reality, it is quite straightforward and easy to understand. You start with the inventory you have on hand. Your accounting method and the costs of acquiring goods determine the value of that inventory.
Accountants use several accepted inventory valuation methods. These include perpetual average cost, specific identification, weighted average, first in/first out (FIFO), and last in/first out (LIFO).
These methods use cost-flow assumptions to allocate inventory costs between the goods sold and the inventory remaining on hand. They do not necessarily reflect the physical order in which businesses sell products.
Inventory valuation is important because it determines how your business reports inventory as an asset on the balance sheet. It also determines how much your business records as Cost of Goods Sold (COGS) on the income statement. The method you choose can also affect your reported gross profit and taxable income.
Under the perpetual system, the Inventory account constantly (or perpetually) changes. When a retailer purchases merchandise, it debits the costs to its Inventory account. When the retailer sells merchandise, it credits Inventory and debits Cost of Goods Sold for the cost of those goods.
Unlike the periodic method, the perpetual average cost method updates the Inventory account balance whenever inventory quantities increase or decrease.
Under the perpetual system, a business records two sets of entries whenever it sells merchandise:
Under the perpetual system, “average” means the average cost of the items in inventory as of the sale date. The business multiplies this average cost by the number of units sold. It then credits Inventory and debits Cost of Goods Sold for that amount. Because this is a perpetual method, the business uses the current average cost at the time of each sale.
For example, suppose a company purchases 10 identical items for $10 each. Its initial inventory value is $100.
The company then purchases another 10 items for $15 each. Calculate the new average cost as follows:
If the company sells five items, the Cost of Goods Sold is $62.50 (5 × $12.50). The remaining 15 items have an inventory value of $187.50.
Accountants also call this the moving average cost method because the average cost changes as businesses purchase new inventory.
The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Businesses track each individual item, often through its serial number.
With this method, the business records the actual purchase cost of each item. It then assigns that cost to Cost of Goods Sold when it sells the item.
This method is particularly useful for businesses that sell expensive or individually identifiable products. Examples include automobiles, equipment, and other serialized products.
Specific identification provides an accurate way to determine the cost of individual items because it does not rely on an assumed flow of inventory costs. However, businesses must maintain detailed records of each item they purchase and sell.
In addition to perpetual average cost and specific identification, businesses commonly use the weighted average, first in/first out, and last in/first out methods to determine inventory costs.
The weighted average cost method divides the total cost of items available for sale by the total number of units available. Businesses then apply the resulting average cost to both the items they sell and the inventory they retain.
For example, suppose a company purchases five parts at $10 apiece and five identical parts at $20 apiece.
Calculate the weighted average cost as follows:
The average cost of each part is $15.
Unlike the perpetual average cost method, which recalculates the average as businesses purchase inventory, the periodic weighted average method generally calculates the average at the end of an accounting period.
The FIFO method assumes that businesses sell their oldest inventory first. In other words, FIFO assigns the oldest inventory costs to Cost of Goods Sold first. Meanwhile, the most recent purchase costs remain in ending inventory.
For example, suppose a company purchases 10 items for $10 each and later purchases another 10 items for $15 each. If it sells 10 items, FIFO assigns the original $10 purchase cost to those items.
The Cost of Goods Sold is $100, and the remaining inventory has a value of $150.
The LIFO method assumes that businesses sell their newest inventory first. LIFO assigns the most recent inventory costs to Cost of Goods Sold first, leaving older costs in ending inventory.
Using the same example, if the company sells 10 items, LIFO assigns the more recent $15 purchase cost to those items.
The Cost of Goods Sold is $150, and the remaining inventory has a value of $100.
The choice between FIFO and LIFO can affect reported income, particularly when purchase prices change. When prices rise, FIFO generally produces lower Cost of Goods Sold and higher reported income. In contrast, LIFO generally produces higher Cost of Goods Sold and lower reported income.
The IRS explains inventory costing methods and their tax implications in Publication 538.
For businesses that use inventory in customer projects, accurate material costs also play an important role in determining job profitability. Inventory tracking and job costing help connect material costs to the work your business performs.
For additional information about how inventory valuation affects business finances, see Aptora’s guide to retail accounting, inventory, and cost of goods sold. You can also learn about inventory adjustments and how they affect financial statements.
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