Inventory in Accounting: Definitions, Examples, and Challenges

Michael Pignatelli
Mar 10, 2023

If you have a business selling goods, then you have an inventory. Inventory plays an essential role in ensuring that your business operations are running smoothly and that you meet the demands of your customers.

Inventory is more than stock of your items. Understanding how inventory works will help business owners effectively manage their inventory and overcome potential challenges. Let's discuss this facet further to help business owners understand it better.

What Is Inventory in Accounting?

In accounting, inventory are items in different production stages and are current assets for your business. Businesses can efficiently create, market, and ship their items thanks to inventory. Additionally, it shields companies from the possibility of product shortages and transportation delays. Inventory is considered a major asset for businesses and should not be taken for granted.

When a product is sold from the inventory, its cost is reflected in the cost of goods sold (CoGS) in the income statement. There are three ways to value an inventory:

  • FIFO Accounting Method: Also known as the first in, first out method. This method states that the cost of goods is based on the cost of the earliest purchased material. Additionally, the carrying cost of the remaining inventory will depend on the price of the latest purchased item.
  • LIFO Method: Also known as the last in, first out method. The cost of goods sold is based on the price of the latest purchased product, while the carrying cost of the remaining inventory is based on the earliest material.
  • Weighted Average Method: This method values both the inventory and cost of goods based on the average amount of materials the company purchases during a period.

Different Types of Inventory in Accounting

Generally, inventory is the stock of goods, but understanding its different types will help you make sound financial and business decisions. Here are the three main types of inventory.

Raw Materials

Raw materials is the first step in manufacturing your products. In simpler terms, these stock items are yet to be used for manufacturing. Raw materials are categorized into two: recognizable in their original form and unrecognizable.

For example, flour. If you sell cakes and pastries, the flour is unrecognizable in the final product. Another example is if you sell clothing, its raw material of fabric is recognizable in the clothing you sell.

Work in Progress

Work in progress, or WIP, is referred to as an inventory of partially finished goods that are still in line for completion. This refers to raw materials, overhead costs, and labour of products in the different stages of production.

For example, consider a mountain bike. The different parts, such as the body, seat, tires, handles, and chains, are already in your inventory waiting for assembly.

Finished Goods

From the name itself, you can tell that finished goods are products that have completed the manufacturing process. Finished goods can also be stock bought by the company in its final form, which is not yet sold to customers.

Once a finished good is sold, it is no longer considered inventory. It is considered merchandise. In accounting, the cost of sales of finished goods is categorized under the short-term assets section of the balance sheet.

inventory management software

6 Challenges in Inventory Management

Understanding the basics of inventory is simple, but managing it is another thing. Managing involves coordinating the supply chains and overseeing product purchases. Furthermore, you should also be aware of inventory levels, maintain them, and control sales so you can always meet the demand of your customers.

Managing inventory, even for small businesses, can be challenging. Here are some challenges you can face with inventory management.

Inconsistent Inventory Tracking

There are two ways you can replenish your inventory. One is from completing your manufacturing process, and the other is from purchasing inventory from other businesses. Tracking inventory items is crucial in your day-to-day business operations. A business should have enough stocks to continue selling inventory and generating sales.

One of the most common problems of inventory management is inconsistent tracking. All your items should be properly accounted for so you know which items you need to order or manufacture consistently and which ones you need to slow down on.

Developing and investing in the modernization of your warehouse and process will help track inventory better. Inventory management software options can also automate the process and tracking, so you know what happens in real-time.

Underperforming Vendors

At first glance, this should be an easy decision for business owners, but it's still a common problem for ecommerce businesses. Success in inventory management partly depends on your merchants, so make sure to choose well.

Make surveys and merchant audits before you sign contracts. Ensure that they can meet your requirements, such as shipping schedules, modes of delivery, packaging, and others. If you have a specialty product, make sure your vendors get the quality requirements down.

Some merchants let you try their services for a discounted price. You can capitalize on that to see if the merchant suits your business.

Poor Inventory Process

Inventory processes include picking up or receiving the goods, transportation, packing, and sending them to the buyer. The best option to assess and improve your inventory process is through experimentation. For example, regarding picking and receiving your goods, follow a certain schedule to prevent delays and keep your inventory count consistent.

For packing, you can try different methods until you find the most efficient, and the same goes for shipping. If you're selling from an online platform, you can maximize their fulfillment programs so you can guarantee quality and on-time shipping of your products.

No Contingency Plans

There are always unforeseen incidents that could mess up your inventory management. Even if you don't experience frequent problems, never assume you won't run into one. Always have a contingency plan if things go wrong.

For example, what will be the best solution when you experience delays in your inventory? You can order in advance, so when delays happen, they do not entirely stop your operations. If you have too much inventory on hold (making your sales stagnant), plan to put them up for sale at a discounted price or include them in some of your product bundles.

Poor Labour Collaboration

Cooperation among employees is a common problem of the inventory management team. Proper communication and collaboration are critical to a successful and efficient inventory process. It will be harder for a business to see problems if the teams involved in inventory are not exchanging vital information.

If there is no exchange of information, employees will not know their tasks, how to progress, and the status of their work resulting in disrupted workflow in the inventory warehouse. You can address the communication problem by placing a system that connects all of your teams for easier exchange of information.

Lack of Production Planning

Planning your production process is a must if you are producing your goods. It will help businesses prevent delays and minimize production costs. Every month, businesses should have a report on their product results to plan for their targets in the next month, spot potential problems, and brainstorm for solutions.

Product planning can affect your sales estimates and your production timing. So it's crucial that you get this right.

inventory list tracking

Get Inventory Accounting Help With Unloop

Inventory valuation is essential for businesses to put a price on their items and get an overview of their company's financial health. Managing inventory also involves accounting. Fortunately for business owners, Unloop can help you with the accounting part of your inventory management.

We offer different services, like accounting, accounts payable, forecasting, bookkeeping, payroll, and taxes. Let us handle your finances so you can focus on managing your inventory.

Talk to an expert and book a call with us today!

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228 Park Ave S #82849
New York, NY 10003
United States
7676 Woodbine Ave #2
Markham, ON L3R 2N2
About unloop

Unloop is the first and only accounting firm exclusively servicing ecommerce and inventory businesses in the US and Canada. With the power of people and technology, our team dives deep into COGS and inventory accounting.. You are paired with a dedicated bookkeeping team that prepares accurate financial statements, financial forecasts, and can also pay bills or run payroll for you. Come tax time, everything is organized and ready to go, so you don't need to worry. Book a call with an ecommerce accountant today to learn more.