Choosing an inventory valuation method for your business

Small Business Guides

5 min read

Inventory accounting can be done a lot of ways. And it doesn’t have to involve painstaking stocktakes. Check out these approaches to one of the most hated jobs in accounting.

Basics of inventory accounting

To correctly account for inventory, you need to know how much stock you have and what it’s worth to your business. Ideally, ‘worth’ will be broken down into:

  • what you paid for it

  • what you’ve spent on it since you bought it, and

  • what you sell it for

Only by knowing all three components can you truly understand how your business spends and makes money.

How to value inventory

The bookends of inventory accounting are your buy price and your sell price. They can both change a lot. If your supplier starts charging more, or you sell a bunch of product on discount, your margin will drop quickly. There are a couple of different ways to link your buy price and sell price.

First in, first out method (FIFO)

Under the first in, first out (FIFO) method, items are assumed to be sold in the order they’re bought. This doesn’t have to happen literally. You can sell them in any order you like. But from an accounting perspective, you imagine that it all happens in sequence.

When a new item comes in, you note what it costs and place it in a queue to be sold. When that sale happens, you record the price. Now you have a buy and sell price for each single item of stock.

Weighted average cost method (AVCO)

Rather than tracking the purchase and sale price for each individual item of inventory, you can use averages. For each product line, work out:

  • average buy price – divide the money you paid over the year by the number of products you got

  • average sell price – divide total revenue for the year by number of sales made

While it’s a simpler method for doing annual accounts, AVCO doesn’t work well when there are big price fluctuations. It can also cause confusion if a manufacturer introduces a new version of a product. You could end up with two inventory items that have the same name but very different prices.

Not all inventory valuation methods are equal. And nor are they always possible. It may depend on the inventory management system you have in place.

A woman at a laptop, managing inventory via perpetual inventory management system.

Software has automated a lot of the manual aspects of inventory accounting and stock-taking.

What is an inventory system?

Inventory management doesn’t have a good reputation with small business owners, and for good reason: It’s the area of accounting that gave us the stocktake, where you laboriously count each item of stock in the shop and storeroom. You can still do it like that but you now have options.

1. Periodic inventory system

Under the traditional periodic inventory system, businesses physically count their stock at the end of an accounting period. The stock count is reconciled against purchase and sales records. If required, adjustments are made to match the two.

2. Perpetual inventory system

Perpetual inventory systems – also known as dynamic inventory systems – are an automated alternative to the manual stocktake.

When you order stock, your software adds the count to your inventory. And when you sell an item, it does the subtraction. This type of software is often sold as an app that can plug into your point of sale (or invoicing) systems and your accounting software. It does all the maths of FIFO accounting in real time, so you’ll see how much money you’re making on each sale.

What is inventory cost?

It’s not always enough to know what you paid for a product, and what you sold it for. Some businesses have to spend a lot on inventory while they have it. These costs typically include things like storage and insurance but there may be others. Dangerous goods, for example, may require you to take expensive health and safety precautions.

Finding the best inventory management system for you

Periodic inventory management may be enough for businesses that only sell a few products. It will show you broadly what inventory costs your business and will allow you to complete annual accounts.

But if your product range or sales volumes grow, periodic inventory management will begin to slow you down. That’s when an automated perpetual inventory management system comes into its own.

It will give you back the time normally spent on stocktakes. Plus it will give you a better view of inventory levels, sales volumes and margin.

Getting the best of periodic and perpetual inventory systems

You can, of course, go for the best of both worlds. Stick with the simplicity of periodic inventory accounting for now, and only upgrade to a perpetual inventory system when your business starts to gather momentum.

A horses-for-courses approach makes sense and is easy to do. Just make sure you set up your other business systems to accommodate a switch at some point in the future. Get a point of sale (or invoicing) system that can integrate with inventory apps. Do the same when you choose accounting software.

It’s not hard to do and you’ll thank yourself when business starts booming.