Inventory Accounting for Small Businesses

Valuing, tracking & reconciling stock in practice

Inventory accounting for a small business can seem daunting, but with systematic systems and clear records, it becomes the cornerstone of sound financial management for your company. This guide will cover fundamental need-to-know concepts and everyday practices, as well as useful tips for keeping inventory accurate, knowing how much your goods cost you, then making purchasing decisions with this information.

Know your inventory accounting duties

Inventory is an asset on the balance sheet, and its cost flows through to the income statement where it appears as cost of goods sold (COGS). By accurately accounting for inventory, profit margins can be calculated effectively, taxes will be determined by a true amount and cash flow decisions are based on actual stock. For small businesses, inventory accounting also advises purchasing, pricing and loss-theft prevention strategies.

Choose a costing approach

Decide on a valuation method before you begin tracking individual items. Common approaches include:

FIFO (First-In, First-Out): Sales are made with the assumption that the earliest purchases are sold first. When prices go up, LIFO will often produce lower dated costs than FIFO based on live market values.

Weighted average cost: Adds up all spreads costs and divides by the number of units, which should spread out the cost so that it does not follow price spikes or downturns, because you have a weighted average.

Specific identification: It associates the actual cost to specific items, useful for things that are one of a kind or high value.

Choose the one that best matches how your stock moves and how much detail you want to maintain. Regardless of the method you use, do it consistently and document the policy for future reference and audit purposes.

Perpetual vs periodic inventory systems

There are two main systems for tracking inventory movement:

Perpetual inventory system: Makes accounting records of inventories and COGS immediately after each purchase or sale. This approach has the disadvantage that it is tracking based, at least during part of the flow process, but the advantage that current stock balances are available.

Periodic Inventory System: Records and calculates an inventory-carrying at specific time intervals and, usually, only once a year (physical count). This approach is less time-consuming on a daily basis, but it can create knowledge gaps.

Smaller businesses will implement a periodic system then “graduate” to a perptual sytem as volume increases. Regardless of the system, periodic reconciliations are necessary.

Establish distinct accounts and records

Set up separate ledger accounts for purchases, purchase returns, freight-in, inventory and COGS. Separate track purchase discounts and allowances so that you have clear gross margins. Maintain an organized filing system of Invoices, Packing Slips and Supplier documents to enable accurate costing and for audit purposes.

Record purchases and inventory increases

To the extent you are able, record all of these costs when purchasing stock: purchase price plus shipping, handling and any cost to get goods into a saleable condition, import duties. Apportioning these overheads to stock items provides a more realistic picture of product profit.

Handle returns and allowances promptly

Inventory balances and margins are also influenced by customer returns, supplier allowances, and damaged goods. Actually record your returns, via inventory and sales adjustments rather than ramming it through expense accounts so your gross margin calcs stay in touch.

Conduct physical counts and reconciliation

If you're using a perpetual system, still do periodic, actual physical counts to catch differences between what's on paper and what's physically there (due to theft, damage, miscounts or data entry errors). For a periodic system, conduct counts no less than quarterly; some small businesses would do well to conduct monthly or seasonal counts based on turnover.

If discrepancies between tabulations and records are encountered, determine reasons and prepare adjusting entries. Track losses for shrinkage or obsolescence independently in order to identify the causes of inventory loss, and to make any necessary changes.

Track obsolete and slow-moving stock

You can track turnover rates and aging reports to see which items are moving slowly or are out-of-date. Record or write off inventory that is expected to not sell -- this will prevent you from overestimating inventory values. Adopt a reserves or allowances policy for obsolescence and apply that policy on a consistent basis.

Maintain stock tracking practices

A good stock tracking minimizes counting time and accounting errors. Use logical practical conventions like SKUs, good packaging names, master product descriptions and top stock location. Combine those with regular cycle counts of high-value or high-turn items, and you keep that visibility without doing a full physical inventory each time.

Calculate and report COGS accurately

The calculation for COGS is the starting inventory plus anything purchased during the time period, minus any ending inventory. Apply the selected method to ascertain ending inventory. Correct COGS has implications for gross profit, gross margin percents and price/discounting decisions.

Manage inventory-related metrics

And don’t forget to track some of your key performance indicators to ensure inventory health:

Inventory Turnover: Cost of Goods Sold / Average Inventory. Greater turnover represents quicker flow and that might also mean less holding cost.

Days inventory outstanding: Average days inventory rests before sale. For cash flow, the lower, the better.

Gross margin return on investment (GMROI): Measures profitability relative to inventory investment.

Those metrics can tell you where excess inventory is accumulating, what items aren’t moving quickly enough, and how to shore up purchase timing.

Internal control and separation of duties

Minimize the opportunity for theft and mistakes by having separate duties where possible, with one person making purchases, someone else receiving goods and a third party recording inventory in the books. At the very least, insist upon two signatures for adjustments and keep precise receiving logs (with a specific person authorized to write off).

Make design decisions with seasonality and known demand changes in mind

By forecasting, you can prevent overstocks or stockouts. Base projections on actual sales history with lead time and known promotions. Keep the stock safety level on critical items and update your reorder points as lead times or demand patterns vary.

Tips for efficient inventory accountin

Decentralized item descriptions and SKUs, which were not standardized by corporate headquarters and resulted in redundant records.

Save at all times documentation for your inventory transactions.

Match supplier statements with purchase records on a monthly basis.

Automate regular reconciliations where feasible, even using dumb old spreadsheets.

Conclusion

Inventory accounting for a small business is part good bookkeeping, a smidge of defined policies and operational discipline. Pick a method of valuation that works for your business and keep consistent records there every time all the time, reconcile often, track these important metrics. With these processes in place, inventory ceases to be a black box and starts becoming a tool for better cash flow, pricing and profitability decision-making.