Accounting for inventory is not the most exciting part of inventory but nevertheless, it is a part of inventory management that often is misunderstood. So, I am going to spend a little bit of time explaining the inventory accounting terms commonly thrown around and used. Followed by an example so that it cements the concept home. My aim is to make it simple and straightforward and I hope it will make sense to both the untrained as well as those that are advanced users in inventory accounting.
FIFO – First In, First out method
As the name suggests, this method of inventory valuation works on the premise that you sell the items you first purchase. A lot of businesses tend to operate under this method and way of thinking. As such, this is one of the most commonly used methods to calculate the cost of goods sold.
- Simple to understand and operate.
- It is a logical method because it takes into consideration the normal procedure of selling first those materials which are received first.
- Under FIFO, materials are costed at the purchase price, so the cost of jobs or work orders is correct so far as the costs of materials are concerned.
- Closing stock is valued at market price, as the closing stock under this method would have the most recent purchase price.
- If costs are increasing, the items acquired first are cheaper. This decreases the cost of goods sold (COGS) and increases profit. Stock on hand is also higher, but so is your income tax.
- Helps minimise obsolete stock i.e. stock with ‘use by’ dates
- Prior to Inventory software, it was quite cumbersome to keep records if your business had high inventory movement. But with the use of software, this is quite simple.
- If costs go up or down drastically over time, costings could be significantly misleading. This would also make it hard to monitor trends and analyse periods, as you won’t be comparing apples with apples, so to speak.
- As mentioned above there are adverse effects of a higher profit, as in income tax. This tends to happen more in a period of inflation i.e. when prices are going up.
FIFO doesn’t work for all industries, but generally speaking, it is well used across most industries.
Deegan defines it as such: “An average cost is determined for inventory based on beginning inventory and items purchased during the period. The costs of the individual units are weighted by the number of units acquired or manufactured at a particular price. The units in ending inventory and units sold are costed at this average cost”.
In layman’s terms that looks like this:
Items acquired or made for a period divided by the total cost of acquiring or making it. Which gives you an average cost per item. This average cost is then used to calculate the cost of goods sold and value your stock on hand.
Finally, there is the Last-in, first out cost flow method, and I won’t go into too much detail as most countries don’t really support this costing method.
Basically, LIFO means the last item put in stock, is the first item sold.
It does have quite a few limitations, most obviously that when you sell your oldest item, it could really skew your figures. But alternatively, it does have much better period matching, as pricing is relatively current, and this would be reflected on better stock on hand (SOH) valuations.
Two other terms are also parlayed around in inventory accounting, and that is periodic or perpetual inventory systems.
Firstly, it is worth noting, if you have an inventory management system you are more than likely using a perpetual system. You can, of course, use your current system by pulling the information via reports to create the journals for a periodic system.
The periodic system tends to be for businesses that don’t analyse their information constantly, or for those that tend to stick to what their accountant told them about 20+ years ago.
Since this series of articles really is about insights into modern cloud-based inventory systems, the main system we will be discussing is the perpetual system.
A perpetual system really should be called a real-time system, because that’s really what it does. It records all stock related movements constantly. The opposite is true for periodic inventory systems, as the cost of goods sold and inventory are only recorded at a set period, usually once a year.
To be honest, I have only ever worked with perpetual systems, and I can’t imagine how difficult it would be for an organisation to run weekly reports analysing stock related KPI’s under a periodic system.
In the following article, I will create an example to illustrate the key areas of this post.
 Deeghan, 2012, Australian Financial Accounting, Mcgraw Hill Australia Pty Ltd