The inventory of a business is an asset, and accounting for it properly is crucial to producing accurate financial statements.
If you own a small home technology business, it may be possible to count inventory by hand on a regular basis to keep track of it. In fact, if you order supplies based on projects, there may be little continuously in stock.
However, if you run a larger business, you may need to keep more products and supplies on hand, and you will have to implement another strategy to handle this responsibility. When companies reach this size, it is important to consider not only the physical process of measuring inventory, but also the accounting process for tracking these crucial business assets.
Additionally, you run the possibility of having the same products and supplies in your inventory that cost different amounts of money. As these items move out of the inventory, you have to decide when to change the price of the product or adjust the cost of your services to account for the difference. How you want to handle this issue will help you decide whether to use the first-in-first-out method, the last-in-first-out method, or the average method.
Using this method, you would assume the item bought first is also the item used or sold first. Thus, the items still in stock are the newest items, and those moving out of inventory are the older products or supplies.
Counting in this way requires layers of inventory because each product or supply must have its own calculations, but it often matches the actual use of many businesses. The older supplies are typically used first, especially for those that could go bad or those whose usefulness decreases with age.
Also, because prices mainly rise, the products and supplies used first are those that are cheaper, which means the cost of goods sold remains lower for the businesses. This leads to higher earnings on the financial statements.
This method assumes the products and services purchased most recently are the first to be sold and those remaining in the business's inventory are the older items.
Using this method also requires layers of inventory, but it doesn't often reflect how a business functions in a practical, everyday setting.
Under this method, you would average the cost of products and supplies as new and higher-priced items are added. This means that for each new purchase of products and supplies you make, you recalculate the average price of the items. This can be a more simple method because it only requires one inventory layer.
How to Decide
Any of these methods can result in an accurate balance sheet. However, the variations in figures can create different financial and tax consequences.
The FIFO method will result in an inventory with a higher value than the LIFO method, which means you'll be able to keep a strong balance sheet. This could be good if you need to qualify for loans. LIFO results in a lower value of inventory, but because the cost of goods sold is higher, the revenue is lower and therefore so are the income taxes paid by the business.
If you don't maintain a large inventory and only review it periodically, you may prefer the less complex average method to account for changes in price of products and supplies you commonly use.
For more on inventory tracking, check out these CEDIA resources (free to members):