Inventory Accounting, What Are The 4 Different Methods?

What is inventory accounting, how does it work, and what are the different types commonly used by companies or manufacturers?

To assess the worth of the company’s inventory assets, any business that handles inventory must employ an inventory accounting procedure.

Companies use a variety of inventory accounting procedures to assign value to their goods and maintain acceptable record-keeping.

Inventory valuation is an important corporate procedure that has a direct impact on profits and taxes.

Inventory management system may also make the process easier by assisting with inventory valuation, tracking inventory movement, such as sales orders and customer purchases, and producing financial statements like a balance sheet or profit and loss statement.

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What is Inventory Accounting?

The valuation of inventory products for resale is known as inventory accounting.

Both inventory purchases and inventory turnover should be managed according to GAAP guidelines, which stipulate that all inventory must be correctly accounted for using either the cost method or the market value method.

It’s also worth remembering that inventory is a current asset, which means it’s not depreciable.

Inventory accounting would be straightforward if you just sold one thing, but you’re more likely to have many items in stock and need to account for each of them separately.

Inventory accounting is important for both cost of goods sold and inventory valuation.

Because inventory is an operating expense, materials and product purchases have a direct impact on your income statement, while increased inventory levels have a direct impact on your balance sheet totals.

Inventory accounting is generally used to establish cost of goods sold and inventory valuation at the conclusion of each accounting period.

How Does Inventory Accounting Work?

The sum of your beginning inventory and purchases minus your ending inventory is the primary formula for computing the cost of products sold during a period, which means you must precisely identify the value of your ending inventory using an acceptable inventory accounting system.

For manufacturers, wholesalers, and retailers, inventory accounting is a critical business practice.

Because identical commodities have varying pricing as time passes, many of these product-based organizations confront difficulties attributing value to inventory on hand versus inventory sold.

Businesses, on the other hand, are expected to commit to an inventory cost method in their first year of operation, and while switching methods later on is conceivable, it can be extremely difficult.

As a result, businesses should carefully consider inventory accounting systems to determine which method is best for them, not only now, but in the future as the company (and the amount of inventory controlled) grows.

There is more than one inventory accounting method to use to value inventory.

What are The Types of Inventory Accounting?

Here are some types of inventory accounting method that are generally used:

FIFO Method

When utilizing the FIFO method, accountants believe that the products purchased or made first are consumed or sold first, leaving only the most recent items in stock.

The FIFO approach is popular because it aligns with inventory flow in many businesses.

Prices rise each year, thus accountants can charge the least expensive units to the cost of products sold first, assuming the earliest items are used first.

As a result, the cost of goods is falling, resulting in increased operating earnings and higher taxes to pay.

It also implies that businesses use the oldest things first and don’t have to worry about expiration dates or inventory that doesn’t move.

LIFO Method

Accountants that use the LIFO method believe that products purchased or made last are sold first, hence the oldest items in stock are those that are still in stock.

As a result, this strategy does not match most companies’ normal inventory flow, and therefore is prohibited by the International Financial Reporting Standards.

When prices rise, the most recently purchased units are the first to be used, causing the cost of goods to rise, resulting in reduced operational earnings and lower income taxes to pay.

Companies using the LIFO method also struggle with obsolete inventory.

Weighted Average Method

Businesses that use the weighted average accounting method only have one inventory tier.

They also factor in the cost of new inventory purchases into the cost of current inventory to arrive at a new weighted average cost, which is updated as more inventory is acquired or manufactured.

Specific Identification Method

This method requires businesses to track the cost of each inventory item separately and charge the specific cost of an item to the cost of goods sold when the item is sold.

This inventory accounting approach is best suited to high-cost items because it demands a lot of data tracking.

To maximize income potential while properly managing record-keeping for tax purposes, choose an inventory accounting method that is appropriate for your business needs.

Understanding the 13 Types of Inventory

Inventory management is a critical aspect of running a successful business, irrespective of its size or industry. Properly managing your inventory ensures that you have the right products or materials available when needed while minimizing storage costs and losses due to obsolescence. To effectively manage inventory, it’s essential to understand the various types of inventory that exist within a business. These inventory types can be broadly categorized into four main groups: raw materials, work-in-progress (WIP), merchandise and supplies, and finished goods. However, within these categories, there are several subtypes of inventory, each serving a unique purpose in the supply chain and production process. In this comprehensive guide, we will explore the 13 types of inventory, shedding light on their significance and how they contribute to efficient business operations.

Raw Materials

Raw materials are the foundational elements used by a company to create and manufacture its products. These materials are typically transformed during the production process and become unrecognizable in their original form in the final product. For instance, the oil used in the production of shampoo is considered a raw material. It undergoes various processes and chemical changes before it becomes an integral part of the finished shampoo product.

Raw materials are a fundamental component of inventory for manufacturing companies. Without an adequate supply of raw materials, production would come to a halt, resulting in delays and potentially lost revenue. Managing raw material inventory effectively involves forecasting demand, ensuring a stable supply chain, and optimizing the procurement process to maintain a seamless production flow.

Components

Components, much like raw materials, are materials used in the manufacturing process. However, what distinguishes them is that they remain recognizable in their original form even after they are incorporated into the finished product. A classic example of components is screws used in assembling various products. While they are used in the manufacturing process, they retain their screw-like appearance in the final product.

Managing component inventory is crucial for businesses that rely on intricate assembly processes. Ensuring a consistent supply of components is essential to prevent production delays and maintain product quality. Just-in-time (JIT) inventory systems are often employed to optimize component inventory levels and reduce carrying costs.

Work In Progress (WIP)

Work-in-progress (WIP) inventory encompasses all items that are in the process of being transformed from raw materials and components into finished goods. This type of inventory includes not only the materials themselves but also the labor, overhead costs, and even packaging materials associated with the production process.

WIP inventory represents the transitional phase in manufacturing. It reflects the value added to raw materials and components as they move through various stages of production. Managing WIP inventory effectively involves monitoring production efficiency, minimizing bottlenecks, and ensuring that resources are allocated efficiently to prevent overproduction.

Finished Goods

Finished goods are the end products of the manufacturing process that are ready to be sold to customers. These items have completed all production stages and are packaged and labeled for sale. Whether it’s a smartphone, a packaged food item, or an automobile, finished goods are what consumers ultimately purchase.

Efficient management of finished goods inventory is vital for meeting customer demand, preventing stockouts, and avoiding overstock situations that can lead to obsolescence. Businesses must strike a balance between producing enough to satisfy market demand and avoiding excess inventory costs.

Maintenance, Repair, and Operations (MRO) Goods

Maintenance, Repair, and Operations (MRO) goods refer to inventory items that support the production process or the ongoing maintenance of a business. MRO inventory includes a wide range of items, from tools and safety equipment to cleaning supplies and spare parts. While MRO items may not directly go into the production of finished goods, they play a crucial role in keeping operations running smoothly.

Managing MRO inventory involves ensuring that essential supplies are readily available to maintain equipment, minimize downtime, and ensure workplace safety. Proper inventory control of MRO items is essential to prevent unexpected disruptions in production or maintenance activities.

Packing and Packaging Materials

Effective packaging is essential for protecting products during transit and enhancing their marketability. Packing and packaging materials encompass a range of items used in packaging products for distribution. There are three primary types of packing materials:

1. Primary Packing: This is the initial layer of packaging that directly envelops the product. Its primary function is to protect the product and make it usable for the end consumer. For example, a plastic wrap around a food item serves as primary packing.
2. Secondary Packing: Secondary packing involves the packaging of the finished product, which can include labels, branding materials, or SKU (Stock Keeping Unit) information. It is the packaging that consumers typically see on store shelves.
3. Tertiary Packing: Tertiary packing is designed for bulk transportation. It involves packaging multiple units of the product for efficient transport, often on pallets or in containers.

Proper management of packing and packaging materials is crucial to ensure that products reach customers in optimal condition while minimizing packaging waste.

Safety Stock and Anticipation Stock

Safety stock is a buffer of extra inventory that a company maintains to cover unexpected events or fluctuations in demand. While safety stock comes with carrying costs, it serves as a safeguard against stockouts, ensuring that customers receive their orders even during unforeseen spikes in demand or supply chain disruptions.

On the other hand, anticipation stock comprises raw materials or finished goods that a business procures based on sales and production trends. When a business anticipates a potential increase in demand, such as during a peak sales season or in response to rising raw material prices, it may choose to purchase anticipation stock in advance. This proactive approach helps the company meet customer demand without delay and potentially benefit from cost savings when prices are lower.

The effective management of safety and anticipation stock involves accurate demand forecasting and supply chain planning to strike the right balance between inventory carrying costs and service levels.

Decoupling Inventory

Decoupling inventory is a specialized type of inventory that serves a unique purpose in certain manufacturing environments. It refers to extra items or WIP that are strategically placed at each production line station to prevent work stoppages. While all companies may have safety stock to some extent, decoupling inventory is particularly useful for businesses with production lines where different stages work at varying speeds.

In essence, decoupling inventory acts as a buffer, ensuring that if one stage of production experiences a delay or slowdown, other stages can continue working without interruption. This type of inventory is crucial for maintaining production efficiency and preventing costly downtime.

Cycle Inventory

Cycle inventory is inventory that companies order in specific quantities or “lots” to strike a balance between having enough stock to meet demand and minimizing storage costs. Unlike safety stock, which is held as a buffer against unexpected events, cycle inventory is ordered based on predetermined reorder points and order quantities.

The primary goal of cycle inventory management is to optimize the trade-off between inventory holding costs and stockout costs. Companies must carefully analyze their historical demand patterns and lead times to determine the appropriate order quantities and reorder points for cycle inventory items.

Service Inventory

Service inventory is a concept used in management accounting that measures how much service a business can provide within a given period. This concept is especially relevant in service-oriented industries, such as hotels, restaurants, and healthcare facilities. Service inventory is not limited to tangible goods but also includes the capacity to deliver services.

For example, consider a hotel with ten rooms. In a one-week period, this hotel has a service inventory of 70 one-night stays (assuming all rooms are available for booking). Managing service inventory effectively involves optimizing resource allocation to meet customer demand, especially during peak periods.

Transit Inventory

Transit inventory, also known as pipeline inventory, refers to inventory that is in transit between various points in the supply chain. This includes inventory that is on the move between manufacturers, warehouses, distribution centers, and retail locations. Transit inventory may take weeks to traverse the entire supply chain network.

The management of transit inventory is critical for supply chain efficiency. Delays or disruptions in transit can lead to stockouts or excess inventory at various points in the supply chain. Effective supply chain coordination and logistics planning are essential to minimize transit inventory-related challenges.

Theoretical Inventory

Theoretical inventory, often referred to as book inventory, represents the minimum amount of stock a company needs to complete a specific process without waiting for replenishments. This concept is frequently applied in production environments, especially in industries like food processing and manufacturing.

Theoretical inventory is calculated using a formula that compares actual inventory levels to what is theoretically required to sustain operations without interruptions. By maintaining inventory at or above the theoretical level, companies can ensure continuous production and prevent delays due to stockouts.

Excess Inventory

Lastly, excess inventory, also known as obsolete inventory, refers to items or raw materials that a company no longer expects to use or sell but must still bear the cost of storing. Excess inventory can accumulate for various reasons, including changes in product design, shifting customer preferences, or the discontinuation of certain product lines.

Effective management of excess inventory is essential to avoid incurring unnecessary storage costs and potential losses due to obsolescence. Companies often employ strategies such as discounting, liquidation, or recycling to reduce excess inventory levels and recoup some value from these assets.

Conclusion

Inventory management is a multifaceted discipline that requires a deep understanding of the various types of inventory that exist within a business. Each type of inventory serves a specific purpose in the supply chain and production process, and effective management of these inventories is crucial for maintaining operational efficiency, meeting customer demand, and optimizing costs.

By categorizing inventory into 13 distinct types, businesses can tailor their inventory management strategies to the unique requirements of each inventory category. This approach helps strike a balance between ensuring product availability and minimizing carrying costs, ultimately contributing to the overall success and profitability of the business. Whether you’re a manufacturer, retailer, or service provider, mastering the intricacies of inventory management is a key component of sustainable business operations.