Posted on Nov 07, 2017
The task of controlling, supervising and overseeing the ordering, storage and use of involved components that an organization or company makes use of in the production of the items or components markets and sells to customers is known as Inventory Management. Since it's crucial to the overall business performance, hence the accounting involved in it also needs to be of standardized methods which must be followed by accountants of the company. This post will brief you about the basics of the accounting methods used by the majority of the accountants.
Inventory is a pivotal part of any manufacturing centric business. Inventory includes the raw materials, work-in-process, and finished goods that organization has on hand for its own production processes or for sale to customers. Thus it becomes very important for accountants to use a valid method for assigning costs to inventory in order to record it as an asset
The valuation of inventory is a complex task, considering the fact that the accounting method used to create a valuation has a direct bearing on the amount of expense charged to the cost of goods sold in an accounting period, and therefore on the amount of income earned. The basic formula for determining the cost of goods sold in an accounting period is:
Beginning inventory + Purchases - Ending inventory = Cost of goods sold
Thus, the cost of goods sold is largely based on the cost assigned to ending inventory, which brings us back to the accounting method used to do so. There are several possible inventories costing methods, which are as following:
Specific identification method : Under this approach, one has to separately track the cost of each individual item in inventory, and charge the specific cost of an item to the cost of goods sold when you sell the specific item to which that cost has been assigned. Since a lot of data-tracking is involved in this method, it is only usable for very high-cost, unique items, such as automobiles or art related equipment and not that viable method in other scenarios.
First in, first out method (FIFO) : Under the FIFO method, is based on the assumption that items bought first are also used or sold first, which also means that the items still in stock are the newest ones. This method closely matches the actual movement of inventory in most companies, and so is preferable simpler from a theoretical perspective. In price surge situations, assuming that the earliest units bought are the first ones used also means that the least expensive units are charged to the cost of goods sold first. This indicated that the cost of goods sold tends to be lower, which therefore leads to a higher amount of operating earnings, leading to more payment of tax.
Last in, first out method (LIFO) : Under the LIFO method, is applicable when one predicts that items bought last are sold first, which also means that the items still in stock are the oldest ones. This approach inhibits the natural flow of inventory in most companies, that's the very reason this particular method is banned under International Financial Reporting Standards. During price hike situation, assuming that the last units bought are the first ones used also means that the cost of goods sold tends to be higher, which therefore leads to a lower amount of operating earnings, and fewer income taxes paid. There tend to be more inventory layers than under the FIFO method, since the oldest layers may not be flushed out for years.
Weighted average method : It comprises of only one inventory layer since the cost of any new inventory purchases are rolled into the cost of any existing inventory to derive a new weighted average cost, which in turn is adjusted again as more inventory is purchased.
Inventory layers are required in both the FIFO and LIFO methods, under which you have a separate cost for each cluster of inventory items that were purchased at a specific price. Since both are data dependent, hence it's always advised to use Inventory Management Softwares to implement it as it's more reliable and efficient.