inventory accounting

If you purchase goods or materials, you need to know about inventory accounting.

Each piece of a manufactured good is an inventory item.  Each product purchased for resale is an inventory item.  You as a small business owner need to track each item, and the cost of each item. 

Let's start with an overview.  A view of the whole process. 

inventory accounting - the inventory process

  1. you purchase materials or products that you will either use to manufacture a good that you sell (manufacturing), or resell the product as is (retail).
  2. you attach a cost to each material/product that you buy, and post this cost to Inventory (an asset account)
  3. you use materials in the manufacturing process or put products out for sale
  4. when you sell a product, you will take the cost of materials used to make that product, or the cost of the product purchased for resale, out of inventory and expense it.

Let's look at these steps in a little more detail.

What is an inventory item?

For manufacturers, you have 3 types of Inventory:

  1. Raw Materials - things like pieces of wood, fabric, steel, liquids, etc.
  2. Work in Process - raw materials in the process of becoming products but not yet completed
  3. Finished Goods - the completed product

For retailers, you just have one category of Inventory.  This would be the products you buy to resell in your shop.

How to cost an inventory item

You buy inventory items in multiples.  I mean, you don't buy one 3 inch piece of steel or a 2x4 wood board in 6 inch lengths.  They come in 6 or 8 foot pieces.  So you have to take the cost of the 'lot' that you buy, and break it down to the smaller pieces that you use to make your product.

There's 3 main methods to use in costing inventory.

  • FIFO - First In, First Out   -  this method assumes you use the items in the order you puchase them.  So the first item you purchased is the first item you use.
  • LIFO - Last In, First Out  -   this method assumes you use the most recent item you purchased.  So the last item you purchased is the first item you use.
  • Average Cost  -  this method gives each item you purchase a cost equal to the average of all inventory items you've purchased.

There's arguments for using all 3 methods, but I'm going to show you the FIFO or First In, First Out method here.  It just makes sense that you're going to use items as you buy them.

So you purchased 10 widgets.  I'm not sure what a widget is, exactly, but it's the accounting industry's blanket name for a material or product.  We could call it a Thingamagig, but Widget is easier to spell.

So, we buy 10 widgets for $106.  That means each widget costs $10.60  ( $106.00 divided by 10 widgets = $10.60 each).  So we would attach a cost of $10.60 to each widget.

Then, let's say we use 6 widgets making products.  We don't want to get too low on widgets, so we buy more.  Let's buy 20 more widgets.  This time we get a price break for buying a larger quantity, so these 20 widgets cost $200, or $10.00 each.

Production keeps using widgets, so now we've used another 8 widgets.  Well, we had 4 widgets left from the 1st purchase, at $10.60 each.  That means we've used 4 widgets from the 2nd purchase of widgets, at $10.00 each.

Cost of used inventory

4 Widgets @ $10.60 each = $ 42.40

4 Widgets @ $10.00 each = $ 40.00

Total Widgets Cost           = $ 82.40

That's a simple example of costing your inventory using the First In First Out method.

At the end of each month, or more often if you have a lot of production, you need to make an accounting journal entry in your General Journal to correct your inventory accounting.  You will take the value of your inventory used out of the asset Inventory account and put it into your Cost of Goods Sold account, usually called Materials or Purchases.

Inventory accounting journal entry

Here's the journal entry you would make:

Debit: Materials......................$ 82.40

Credit: Inventory.....................................$ 82.40

-This entry is to record the usage of 8 widgets (4 @ $10.60 plus 4 @ $10.00) in production.

For a more detailed discussion of how to keep track of inventory costs, check out my ebook on Inventory Accounting.

Inventory Accounting

For you QuickBooks users, I also have an ebook for you, entitled QuickBooks Inventory Manual.

Quickbooks Inventory Manual


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