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Inventory Accounting Explained

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08 min read.

The cost associated with inventory is one of the factors that can significantly impact the levels of profitability of a business. Proper management and accounting of inventory can make a world of difference to the overall business.

Definition of inventory accounting

As per the definition given in Ind AS 2 – Valuation of Inventories, “Inventories are assets that are held for sale in the ordinary course of business.” Inventory accounting refers to the whole process and system of accounting changes in inventoried assets of a business, including its valuation.

The accounting and valuation of inventory have a significant bearing on the financial statements of the business. To ascertain the value and cost of inventory, the business must consistently ensure that inventory accounting is carried out.

Benefits of inventory accounting

Inventory accounting helps enhance the performance levels of the business in the following ways-

  • Healthy and steady cash flows

By properly analysing the inventory needs, cash will not be trapped in unnecessary inventory.

  • Increase in overall sales

Inventory accounting helps in the calculation of the reorder levels. Through this, the business never runs out of stock since orders are placed on time.

  • Reduction in storage costs

The identification of slow-moving goods is key to reducing storage costs.

  • Maximisation of profits

Inventory accounting helps identify areas for cost-cutting and maximising the profit margin.

  • Facilitates better decision making

Inventory accounting aids in the preparation of financial and revenue projections, thus helping the business owner make sound decisions.

Types of inventory accounting

Inventory accounting is mainly focused on analysing the needs and requirements of the business with regard to inventory levels. The business puts this information to use in a way that targets high sales and profitability. The valuation of inventories may be done based on FIFO, LIFO or weighted average methods, as the case may be. The following are some of the best common methods of inventory accounting-

  • Economic order quantity (EOQ)

Inventory has cost components such as ordering cost and carrying cost. Often, without proper planning, these costs tend to escalate. EOQ aims to eliminate wasteful spending when it comes to inventory orders and replenishment. EOQ is the optimum quantity for a particular order to reduce the carrying cost and order cost to an acceptable level.

  • Just in time (JIT)

JIT is an inventory management technique that is focused on cost-cutting and optimal order time. Under JIT, the order is placed with the suppliers so that the inventory arrives only when it is needed. This helps facilitate control over storage costs by placing orders only when the inventory levels are significantly low. JIT aids in better inventory management, reduction of inventory waste and smooth cash flows.

  • ABC analysis

Under the ABC analysis, the products are ranked into A, B, and C groups (A being the highest) based on their importance to the business. Metrics such as demand, cost, and other criteria help arrive at the product’s particular rank. ABC analysis helps improve the inventory turnover rate, thus boosting sales and reducing unnecessary storage costs.

  • Fast, slow and non-moving

This is a method with a focus on the movement of goods. Based on the customers’ demand for the goods, the inventory is divided into fast, slow, and non-moving goods.

The fast-moving goods will be re-ordered frequently, whereas the non-moving goods may not have a repeat order.

Important inventory accounting reports

  • Stock movement analysis

Understanding the movement and flow of the inventories in the business is an important factor that helps in achieving the desired levels of sales and profitability.  This allows the businessman to identify which of the goods are fast-moving and which ones are slow. By better planning the inventory levels, storage costs can be managed effectively as well.

  • Re-order levels

The knowledge of when to order and what to order plays a crucial role in inventory management. Overstocking leads to product decay, additional storage costs, and cash blockage. On the other hand, low stock levels could risk missing out on potential bulk orders. Re-order levels help the business replenish the stock in a timely and effective manner.

  • Ageing analysis

A product being in storage for an extended period is never a good sign. With the help of the stock movement analysis report, the ageing analysis report can also be compiled. This will show the seller the duration of the stock being in storage, which is an essential piece of information, especially for durable goods.

  • Stock summary

The stock summary report gives details regarding the stock-in-hand on a particular date. Details about the stock’s quantity, rate, and closing values are integral in the stock summary report. One of the unique features of this report is that it gives you the information on a real-time basis.

Process of inventory accounting work

Inventory, being a current asset, is an essential component of the working capital of the business.

The inventory of a business is classified into raw materials, work in progress and finished goods. With the help of AS 2 – “Valuation of Inventories” and Ind AS 2 – “Valuation of Inventories”, inventory components shall be valued and classified as assets. The values of the inventory components have to be regularly checked and updated to provide for depreciation, deterioration and obsolescence to arrive at the accurate values.