Inventory Cost Accounting for Dummies
Accounting is typically not an entrepreneur’s favorite part about running the business. For that reason, the entrepreneur may take shortcuts or missteps that can cost them big down the road. Accurate accounting for your startup involves more than just balancing your checkbook. You must account for your business assets, including your inventory. At first, you might not think that your inventory accounting method matters, but it can directly affect your profit and loss statements and your tax liability. Often, the type of business you operate will help determine which inventory accounting method you should use. Learn about the following four basic ways to account for your inventory and choose the one that best fits your company.
The United States is one of very few countries that implements a cost accounting method. Whereas the US GAAP system requires businesses to report the historical cost of assets acquired, most countries prefer to report the fair market value of their assets, so that accounting statements will closely imitate potential liquidation value. The major disadvantage of the international system is that it calls for educated guesswork, which can be inaccurate and incentivize many different forms of fraud. From this perspective, the United States system is greatly superior.
An unintended consequence, however, is that you may employ different methods for evaluating the cost of your inventory which need not necessarily relate directly to the way the goods are physically moved. A Dayton Flatbed Trucking Company states that, “A business may employ a first-in, first-out method to account for their inventory to gain a tax advantage, even if the carrier is pulling the most recent pallets out of the warehouse, or vice versa. There is no legal or ethical requirement to match the evaluation method to the shipment policies” (Dayton Expedited Flatbed).
Let’s look at the IRS’s different evaluation methods and their potential impact on profits.
You can choose an accounting method called specific identification to track the cost of every item that is in your inventory. Using this tactic will allow you to assign a specific amount of cost of goods sold to every one of your sales. Businesses that sell high-value items such as jewelry or vehicles often use specific identification. If you have a large inventory or inventories with items that are not easily distinguishable, specific identification can become inconvenient and time-consuming. If an economy of scale is one of your strategic business goals, implementing and maintaining a specific identification system will probably be too expensive to scale.
As you purchase quantities of the same good over time, your cost for that item can vary. The weighted average method attempts to account for price fluctuations by calculating the average cost of the items that you have in stock. Suppose you buy 10 bricks at $1 each and then buy 5 bricks at $1.50, your average cost would be $1.17 each, which your system would use for the cost of goods sold for each brick (click here for more examples that may make the math easier). This method works well when you are warehousing commodities such as grain and potatoes, where sales and shipments aren’t measured in discrete units.
Another way to account for cost variations in your inventory assumes that the first unit of an item that you sell is the first one that you received. This way, regardless of whether an item sold just came off the truck or has been sitting on the shelf for a month, your system would assign it the cost of the oldest unit in your inventory. For items whose price tends to increase with the passing of time (which is most of them), the first-in-first-out (FIFO) system helps the cost of goods assigned to a sale keep pace, since the lower-priced items are sold first.
When your inventory accounting system uses the last-in-first-out (LIFO) method, it assumes that you sell the newest units in your inventory first. Such a method can reduce your gross margin per sale for goods that become more expensive over time. LIFO accounting works well if you hold large quantities of goods in your inventory that have either stable or increasing prices. In such a setting, you have a chance to reduce your profits and taxes while increasing your cash flow.
Large, publicly-traded corporations may choose a method that maximizes reportable profits, even if that decision costs them more in profits. This is because most executive compensation packages are tied to stock price, which is influenced by reported profits. For most businesses, however, it is most advantageous to minimize the tax impact by reporting costs as high as legally permissible. If you’re unsure about which method to use, talk to an accountant for advice.