What is inventory accounting and why do it?

Small Business Guides

3 min read

Inventory is the biggest cost facing many businesses. But what is it, exactly? We look at the many forms inventory takes and explain what inventory accounting is for.

What is inventory?

Inventory is the items that your business has bought with the intention of reselling to customers. The items may be resold without change, or they could be combined into a new product.

What isn't inventory

Equipment and supplies you’ve bought to run your business, such as work tools, vehicles and stationery, typically aren’t treated as inventory. They’re recorded as expenses or assets.

If you have a drop-shipping business – where you sell goods online but a third-party supplier delivers them to the customer – then you don’t have inventory either. You must own something for it to be inventory.

Types of inventory

Inventory comes in lots of shapes and sizes, depending on the type of business you run. There are three broad categories to keep in mind.

1. Merchandise you’re reselling
This is what most people picture when they think of inventory – items for sale in a shop (and the extra supplies in the stockroom).

2. Products you’re installing
Service providers often keep small inventories of products which they sell along with their labour. A plumber, for example, will sell gaskets and filters as part of a job.

3. Goods you’re making (manufacturing)
Manufacturing inventory is more complex because there are several phases in the manufacturing process. As a result, there are three types of manufacturing inventory.

  • Raw materials inventory:
    This is stock that will be used to make something. It could be ingredients for a cake, or metal used in fabrication.

  • Work in progress inventory:
    These are items that aren’t yet ready for sale but have been moved beyond the raw materials stage.

  • Finished goods inventory:
    Once manufacturing is complete and the items are ready to sell, they’re classified as finished goods.
Inventory accounting - man tips raw materials into a mixer.

Inventory includes raw materials that you use to make products.

What is inventory accounting?

Inventory has a value – even before you do anything with it – and so it’s listed as an asset on your business balance sheet. But it can lose its value fast if it gets old, out of date, damaged, or the market price for that type of product drops. It also costs money to store.

Inventory accounting helps you figure out the value and costs of your inventory. That’s important for things like setting prices, getting insured, budgeting, working out taxes, and selling your business.

Benefits of inventory management

Here’s how inventory accounting and management can help you both save money, and make money:

  • Maximise sales
    Make sure you never run out of a product that people are buying.

  • Lower bills
    Reduce storage costs by ordering fewer of your slow-moving items.

  • Avoid waste
    Keep tabs on write-offs due to damage, product expiry, and theft.

  • Get better deals
    Learn what you should be ordering a lot of, and shop for bulk discounts.

  • Show where the profit is
    Properly tracking inventory costs will tell you the true margin on each product line you sell.

  • Help your marketing
    Identifying seasonal sales trends will help you plan promotions.

Good inventory management will also help your cash flow. Instead of tying up money in slow-moving stock, you can keep it as cash and use it for more productive things like paying down debt or improving the business.

How to do inventory accounting

To understand your inventory, you need to know how much there is, what you’re spending on it, and how much you’re selling it for. Costs include purchase price plus things like transport, storage and losses suffered when things get damaged or go out of date.

You can use rough estimates or get super specific in how you work all this out. It comes down to your inventory accounting methods, and the systems you put in place.

Learn more in our guide choosing an inventory valuation method.