What is Inventory Accounting?

Inventory accounting is that branch of accounting that helps in determining the specific value of assets at different stages of production and development. 

The firms's inventory commonly includes three levels of production or manufactring through which products or services go through namely; raw goods, in-progress goods, and finished goods after which goods can sold in the market. 

Inventory accounting thereby helps in assigning values to items that go through these processes so that they can record as assets in the balance sheet. 

Advantages of Inventory Accounting 

Following are the advantages of inventory accounting-: 

• The inventory accounting accurately helps in portraying the financial health of the company. 
• It helps businesses to determine where they can increase the profit margin along the product cycle. 
• This method of accounting is generally helpful in those situations where the expenses and time required in manufacturing a product are too much and so by evaluating the product the company can adjust the variable cost accordingly thereby increasing the profit margins and decreasing the expenses 

What Accounting Element is Inventory? 

The inventory is generally classified as a current asset on the balance sheet and there are generally four types of inventories that are recorded under the asset’s column in the balance sheet namely: raw materials, work-in-progress finished, and MRO inventory (maintenance, repairs, and operations). 

What are the Different Kinds of Inventory Methods in Accounting?

There are three different kinds of methods used for inventory valuation. 

• LIFO (Last in First Out) method 
• FIFO (First In First Out) method 
• Weighted Average Cost method 

A. LIFO (Last in First Out)  

In the LIFO accounting method, the items that are produced recently are the goods sold first and are recorded accordingly in the books. Under the LIFO method since the newest products are sold immediately, the lower cost of the old products is considered as inventory. 

The LIFO method of accounting is governed by the Generally Accepted Accounting Principles (GAAP). The LIFO accounting method results in lower net income and is considered tax-advantageous because the cost of goods sold is generally higher. 

Example: Company XYZ has 10 widgets. The first five widgets cost $300 each and arrived two days ago. The last five widgets cost $500 each and arrived one day ago. So, considering the LIFO method of accounting, the last widgets are the first ones to be sold. Seven widgets have been sold, but how much can the accountant document for cost? 

Under the LIFO accounting method, the last inventory will be the first one to be sold, so the widgets that cost $500 will be sold first. The company will therefore sell 5 widgets costing $500 each and the rest 2 widgets will be from the previous lot costing $300 each. 

So, the total cost of goods sold under the LIFO accounting method of inventory valuation will be

($5\times \$500+2\times \$300=\$3,100$).

Advantages and disadvantages of the LIFO accounting method 

Following are the advantages: 

• It is simple and easy to operate. 
• This method appears to be the most suitable when there is a rise in prices. 
• The method is very appropriate for matching cost with revenue. 
• This method is generally helpful for tax purposes. 

 Following are the disadvantages: 

• The LIFO method of inventory valuation involves lots of clerical work. 
• The inventory valuation under LIFO does not reflect the current prices and also since there is considerable variation in the prices, the comparison of the costs of similar jobs is not possible. 

B. First in First Out (FIFO) method

The FIFO method of inventory accounting is based on the perception that the inventories that are produced or purchased first are the first ones to be sold off. Under the FIFO method, the goods purchased earlier are the goods sold first and are therefore removed from the inventory account and the goods that are remaining signify the recently incurred cost. 

The FIFO method matches the older inventory costs against the current earnings which are recorded in the cost of goods sold. The FIFO method results in higher net income because in cases where there is inflation in the market, the older costs which are comparatively lower are assigned to the cost of goods sold. 

Example: A company XYZ purchased 100 items for $10 and 100 more items were purchased next for $15, so under the FIFO method the cost of the first 100 items to be resold at $10 would be $1000. After 100 items of goods are sold, the new cost of the 100 items left would be calculated at $15 each, regardless of any additional inventory purchases made. 

Advantages and disadvantages of the FIFO method 

Following are the advantages: 

• It gives the true and real picture of company finances which makes it possible for the company to plan its future. 

• This method of inventory accounting results in higher profit. 
• This method of accounting is easy to understand and is universally accepted 

Following are the disadvantages: 

• This method of accounting results in higher income tax that a business needs to pay. 
• The FIFO pricing valuation method is easy to understand but at times it may get too cumbersome to operate and extract the cost of goods. 

• The FIFO method is not suitable for times when there is "hyperinflation".  

C. Weighted Average Cost Method  

The Average Cost method also known as the Weighted Average cost method helps in assigning costs to inventory items by dividing the total cost of goods produced or purchased during a particular period by the total number of items produced or purchased in that period. 

The Average Cost method of accounting is mostly used when the inventory items are so intermingled that it becomes very difficult to assign a specific cost to each unit. 

The cost of goods sold is known to be an essential amount for evaluating inventory cost under this method and helps in determining the gross profit margin by deducting the COGS from the sales income. The average cost method uses a simple average of all the similar items in inventory irrespective of the date on which they were purchased.   

Example: A company ABC Ltd. owns a furniture store and purchases 200 chairs @ $10 per unit. The next month they buy another 300 chairs @$20 per unit. Find out the remaining inventory if 100 chairs are sold at the end of the accounting period. 

$\begin{array}{l}Totalnumberofchairs=\left(200+300\right)=500chairs\hfill \\ Totalcostof500chairs=\left(200*\$10+300*\$20\right)=\$8,000\hfill \\ Costofperchair=\$8000/500=\$16/chair\hfill \\ Costofgoodsgold=\$16*100=\$1,600\hfill \\ Remaininginventory=\left(\$8000-\$1,600\right)\hfill \\ =\$6,400\hfill \end{array}$

Is the LIFO or FIFO Method of Inventory Valuation Helpful for Tax Purposes? 

The use of LIFO results in lower taxable income when the price rise, when the price rise because the last inventory purchased is sold first which has a higher value and therefore results in a greater deduction. On the other hand, the FIFO results in higher taxes when the price rise because the first inventory purchase is amongst the goods sold first which will usually have the lower price. 

Context and Applications 

This topic is significant in the professionals, especially for: 

• MBA 
• BBA 
• B. Com 
• B. Com (Hons)