A Beginner’s Guide to Inventory Accounting

Inventory accounting is more of an issue for product businesses, such as manufacturers, wholesalers, and retailers. However, if you are in a service business that also has some inventory, it could impact you, too.

Inventory accounting comes into play when you buy, use, and also hold in inventory identical goods at different prices. This leads to the question of how you account for the value of the inventory you have on hand versus the inventory you sold. There are different acceptable methods that you may choose for valuing inventory in these circumstances.

Let’s say you have a service business, such as a house painting business. Chances are, you keep some paint in inventory. Let’s say, to make things simple, that all you use is white paint, you only buy full-gallon cans, and you only use one brand. Sounds simple, but the price of paint may increase during the year. So, at the end of your accounting period, which price do you assign to each can of paint that you used during the period: the new price or the old price?

One way that accountants think about this is to ask the following: Are you assuming that you used the oldest and least expensive cans of paint first (called the First In/First Out, or FIFO, accounting method)? Or are you assuming that you used the most recent and most expensive cans of paint (called the Last In/First Out, or LIFO, accounting method)? Still another way accountants could look at your paint usage is to just use the average cost of your total inventory to assign value to each paint can used (this is the Weighted Average Method). It’s really not that complicated, but it can be a little tedious to keep track of.

Inventory accounting may sound like a huge undertaking, but in reality it is quite straightforward. You start with the inventory you have on hand. No matter when you sell product, the value of your inventory will remain constant based on accepted and rational methods of inventory accounting. Those methods include weighted average, first in/first out, and last in/first out.

If you need a little extra help with understanding these three types of inventory accounting, I will run through it again using new examples.

How Do I Calculate Inventory Value Using the FIFO Method?

First in/first out means exactly what it says. The first widgets you bring into inventory will be the first ones sold as product. First in/first out, or “FIFO,” as it is commonly referred to, is based on the principle that most businesses tend to sell the first goods that come into inventory first.

Suppose you buy five widgets at $10 apiece on January 3 and purchase another five widgets at $20 apiece on January 7. You then sell five widgets on January 30. Using first in/first out, the five widgets you purchased at $10 would be sold first. This would leave you with the five widgets that you purchased at $20, which would leave the value of your inventory at $100.

First In/First Out (FIFO) Inventory Accounting Formula

Five widgets at $10 each = $50
Five widgets at $20 each = $100
Total number of widgets = 10
Sell five widgets using cost of first purchased at = $10
Have five widgets left in inventory using cost of last purchased = $20

How Do I Calculate Inventory Value Using the LIFO Method?

This method, commonly referred to as “LIFO,” is based on the assumption that the most recent units purchased will be the first units sold. The advantage of last in/first out accounting, is that typically the last widgets purchased were purchased at the highest price, and that by considering the highest priced items to be sold first, a business is able to reduce its short-term profit, and hence, its taxes.

Suppose you purchase five widgets at $10 apiece on January 4 and five more widgets at $20 apiece on February 2. You then sell five widgets on February 20. The value of your inventory (using LIFO) would be $50, because the most recent widgets purchased, at a total value of $100 on February 2, were sold. You were left with the five widgets valued at $10 each.

Last In/First Out (LIFO) Inventory Accounting Formula

Five widgets at $10 each = $50
Five widgets at $20 each = $100
Total number of widgets = 10
Sell five widgets using cost of last purchased at = $20
Have five widgets left in inventory using cost of first purchased = $10

How Do I Value Inventory Using the Weighted Average Method?

Weighted average measures the total cost of items in inventory that are available for sale divided by the total number of units that were in inventory at the beginning of the accounting period and that were purchased during the accounting period. Typically, this average is computed at the end of an accounting period.

For example, suppose you purchase five widgets at $10 apiece and five widgets at $20 apiece. A “widget,” in this situation, is an imaginary item that could be just about any product. You sell five units of product. The weighted average method is calculated as follows:

Weighted Average Inventory Accounting Formula

Total Cost of Goods for Sale at Cost / Total Number of Units Available for Sale =Weighted Average Cost per Widget
Five widgets at $10 each = $50
Five widgets at $20 each = $100
Total number of widgets = 10
Weighted Average – $150 / 10 = $15
$15 is the average cost of the 10 widgets