Inventory accounting is one of the key or primary areas in the world of accounting with a focus on the asset side of the books. As the name suggests, the inventory account deals with values and accounts that are associated with assets kept in inventory. In a manufacturing business, for example, inventory accounting accounts for raw goods, in-progress goods, and goods that are finished. Values are assigned to such assets to record and process them for the purpose of showing investors, managers, and board members where their current inventory levels are at. For the team running the company, this allows them to keep tabs on what is needed to keep producing their goods without delay. It also allows for a complete valuation of company worth as inventory has value, even if it is in the form of raw material.
How Does Inventory Accounting Work in the World of Business?
Inventory accounting works in a sense to compare profits with an understanding inventory values. This shows a company’s correct worth when investors consider company valuation. It also allows for correct forecasting internally for the cost of goods compared to profits drawn from sales. Some companies may be tempted to show larger profits compared to current inventory levels to overstate their value resulting in a higher valuation when it comes to an EPS breakdown, but GAAP has regulations in place to disallow companies from doing this. Inventory account provides for an accurate allowance of current inventory levels to develop plans to either up production of a good or decrease production to match that of current demands resulting in higher profits and discounts on accounts payable.
What Are the Advantages of Inventory Accounting?
As mentioned above, the key advantage to having an inventory account is to show the correct financial health analysis of a company. This is the main benefit for investors and growth in funding. However, internally the biggest advantage would be understanding current levels of inventory when it comes to forecasting for long-term growth. This opens a realm of viewing current profit margins based on the cost of goods to profits from sold goods and unearth areas of opportunities to cut costs for profit boosts.
This approach is something that is mostly seen in the manufacturing world, but even smaller, non-public, companies utilize inventory accounting. Again, the main advantage of inventory accounting is to understand potential profit growth. It also accounts for correct levels of stock when it comes to buying products for resale; something even small businesses engage in.
Four Steps to Inventory Accounting
Now that we have a better understanding of inventory accounting and why it is important for both publicly traded companies and small businesses, let’s discuss the method of setting up inventory accounts for a small business.
- Determine Unit Counts After Production – This is the step that requires knowledge of production or customer buying needs. When accounting for inventory, one needs to understand what materials are needed to either build a product or sell a product (shows at the finish line is inventory and the quantity needed is the amount requested from the buyers). The easiest way on the manufacturing end is to see how many units are needed at the end of production and then find how many raw materials are needed to make that select amount of product.
- Physical Counts – This is one of the most crucial aspects of inventory accounting and usually is the most tedious. There will need to be an individual that keeps count, either physically or systematically, of inventory levels to report back to the correct accounts to show what is currently in stock versus what is needed to produce the goods needed.
- Estimate Ending Inventories – This is where having current inventory levels accurate can allow for future forecasting of finished products. If the math is correct when it comes to inventory levels, then one will be able to forecast future sales based on what they currently have in stock. This rule goes hand in hand with Rule 1.
- Assigning Costs to Material in Inventory – Once the quantities are accounted for then there needs to be a monetary amount associated with each product in inventory to correctly forecast the cost of goods versus future profits from finished products.
In conclusion, there are a lot of reasons to implement inventory accounting regardless of business size or personal needs. It allows for an accurate representation of current inventory levels compared to finished goods, but it also tracks estimated profits before the sales are made, resulting in incorrect forecasting for inventory needed for business growth.
