It’s no secret that inventory is complicated and dynamic for the inventory entrepreneur. It seems simple - figure out a cool product to sell, find all the bits and pieces needed to create the product, sell it and live happily ever after in the business world. The small business dreamer will start to get bogged down almost immediately when all of the little pieces that turn into that product need to be tracked and have a cost associated with it. Those finished products have to sit and wait somewhere until they get sold, get in the hands of people to try and promote them, and sometimes they get broken, spoiled or stolen (all with costs associated). So many factors need to be considered when accounting for inventory. So where do you start and how should you do it? Let us enlighten you a bit, so you, the aspiring entrepreneur, can get a handle on the accounting side of inventory and cost of goods sold.
Inventory Basics From Asset to Expense
The easiest way to start understanding how inventory applies to your business, accounting wise, is to understand where it is in relation to its production, sale and after it is sold. You’d be surprised to know that many people think inventory is simply an expense, because they are purchasing it for resale. It’s an asset. You are buying/creating an asset, so it should be shown on your balance sheet as such in an inventory asset account. The value of the inventory is in its potential sale. Once it is sold, that is what changes. Now it turns into an expense as it is applied to a cost of goods sold account.
That is a lot of accountant-ey sounding terminology already, we know. As your outsourced accounting firm, we want to not only ensure we are properly accounting for your inventory from raw material to finished goods, but understanding the true data so we can analyze and understand your margins. Assessing these important items means we can accurately address areas to ensure the company is making the most of their products on both the cost and the revenue side. That’s why it is important to account for these items properly.
How to Keep Track of the Data - Simple to Complex
To ensure the best chance at getting to know the true numbers and understanding the ins and outs, is to analyze the supply chain and have a central document that records the process and numbers behind each product - this is where the Inventory Workbook comes in. This displays the variables in one place and is dynamic and interactive, so that you can adjust for any changes in cost, revenue and production process notes on the micro level to see the effects throughout the product life cycle. You can read all about the inner workings of the Inventory Workbook here.
By having all of this data centralized in the Inventory Workbook, it provides you with a foundation from which to decide how complex you want to get when it comes to inventory accounting. It also provides you with an easy way to access all of the complex data and change it as needed. Some may choose to keep it very simple, having one inventory asset account and basic COGS accounts for labor, freight-in, etc., and some may want to get farther into the weeds. We have narrowed it down to a few basic areas that can affect your decision on how intricate your accounting should be.
Complexity Factor 1: How Many Accounts to Have
A good first question to ask yourself in deciding how many accounts to have is, how detailed do you want to be on your balance sheet? Would you like one big inventory account or many accounts? If you are dealing with a ton of variables in getting the raw materials to become the final product, (i.e, a complex supply chain), it may make sense to keep track of all of the tiny factors affecting your margins along the way.
One major benefit is the balance sheet presentation can look really nice drilled way down, but there can be more mistakes with more variables at play. You will need to be more meticulous and exacting to ensure it is not just a pretty report, but an accurate one. The higher the complexity of this reporting, the higher skilled accountant team, is a good general rule.
Complexity Factor 2: Timing of Sales vs Shipping (It Makes a Difference)
Another complexity to address is when to account for a sale of the product. Small deviations in dates could change the balance sheet drastically. Imagine selling a massive amount of inventory at the end of the month - let’s say March 30th - but shipping it out April 3rd. The date you consider this inventory as a “cost of goods sold” could shift your data to not only a new month, but a new quarter. Setting a standard for making these adjustments needs to stay consistent, so that your data is dialed in. The COGS should be inline with the associated revenue from the sale.
Accountfully recognizes the ship date as the date of the sale, for simplicity’s sake. Based on the ship date, you recognize the ship date as the date it turns into revenue. On this same date, is when we apply the cost of those sales. This is where it gets tricky again, and that has to do with how you access your sales data from each sales channel. Merging all of the sales data together and staying inline with the dates can get complicated.
Complexity Factor 3: Sales Channels and Using Their Reports
The amount of sales channels a product is sold through, will up your sales report complexity. If you are basing your sales and COGS reporting on pulling these reports, there are bound to be variables in each one. How do you pull these reports? Are they from your website? Amazon? Are each channel’s dates in line with how you need to apply your sales and costs? How accurate is it?
Let’s also consider drop shipping as an example. Are you sending a PO/order manually, then waiting for an invoice/shipping document with tracking info and dates or something similar? There will certainly be lag time involved between the product selling and receiving this information. This is an example of where (and why) it makes sense to apply the sale to the shipping date versus the sale date. The product is technically sold, so you sent a PO to an alternate warehouse to fulfill, but using the tracking info on the corresponding invoice helps to keep track of the timing in line with applying it to your COGS account(s).
Another item you will need to look at for accuracy is the SKUs. Are they different on Amazon listings than they are on your website? That same wholesaler you drop shipped from may have their own SKU for your products too. You will need to comb through these and make sure nothing is missing.
If you are using co-packer or 3PL reports, the same variables may come into play - their dates associated with the sales and shipping, as well as the SKU number consistency. The more locations and sales channels involved in the product’s storage and sales, brings us to another complexity to consider in accounting - locations and freight cost.
Complexity Factor 4: Don’t Forget the “Freebies”, Samples and Damaged Goods
A major part of product companies and those who have a lot of raw materials involved in their products are samples, testers, spoilage and breakage. Remember, inventory is an asset and not all of it gets to the point where it is sold. This still needs to be accounted for. Every time you give out a sample, send a tester for a review or to share, and hand things out at a trade show, you are tapping into your inventory for the hope to gain more exposure and promote more sales. Whether you order a certain amount to dedicate to this process, or log them as they go, these should be accounted for as a marketing and advertising expense. These ones happen on purpose, but what about the mishaps? Those need to be accounted for as well. For the food or drink focused inventory, spoilage is a major factor. Sometimes inventory will get damaged in the warehouse, while shipped, or potentially stolen. Especially when items are headed overseas.
Complexity Factor 5: Warehouse Locations and Freight Cost
You will need to know where all of your inventory sits and how much of it is in each location at any given time. Whether you are relying on labor to provide you with this information on a regular basis (there's another cost) or a report to show you (see last complexity factor three), knowing how much inventory is at hand and its location affects things like state sales tax and storage fees. In addition to the locations, is the transit to and from each. Here is where you will dive into freight in and freight out costs. To get more detailed in your full margin analysis, you need to add these into your calculation. Consider all of the costs that are associated with getting your product to the point of it sitting in a warehouse, ready to be sold.
To drill down even further into freight costs, you need to consider a few more things. How did the inventory travel? By air, truck, train, boat? Were there variables in things fuel cost and these transport costs? These costs can be allocated to accounts like COGS - Freight in, COGS - freight out, etc. It is important to know when these items are in transit as well, to better understand these variables when they apply.
These items are all things that should be allocated to the inventory value as landed costs, which encompass all of the costs associated with getting the product to the point it is ready to be sold.
Complexity Factor 6: Prepaid Inventory
What about prepaid inventory? How does that hit your books? This is a payment you have made for an asset that isn't here yet. You will need to account for when you receive it after paying for it. Again, in the Inventory Workbook are all of the arrangements and terms for any of these agreements.
So Why Be So Meticulous, Anyway?
Answering off the cuff, it is a good idea to be meticulous when it comes to inventory accounting because it gives you the real picture of your product’s success - gross profit margin and cost of goods sold. That concept (as we are diving into thoroughly here) also means it requires a high degree of accuracy on the bookkeeping end to avoid inaccuracies. Running an inventory based goods company doesn't have to be an accounting nightmare, there are upsides to diving in deep. With the right team that is knowledgeable at the helm, and with a great foundation to document your supply chain to draw from, it can be quite beneficial.
Remember when we mentioned that inventory is an asset and it should be on your balance sheet? This is a major player in valuing the business for two major things: getting funding and reporting accurate information to investors. When you are aware of the current value of the business and accurately reporting your inventory on the balance sheet, this will help paint the correct value picture. Not only does more finite reporting help to get funding, but also to report to your investment team the true goings-on of the business and its inventory. Any true investor will rely on a professional, accrual based method of accounting, where the inventory will be shown on the balance sheet and the true COGS are accounted for inline with sales. Overstating your margins and inventory will not help when you need a true picture of the business.
How To Ease the Inventory Accounting Burden
Naturally, at this point you are probably overwhelmed by the complexities we have outlined. That’s OK, the good part is a lot of this can be managed and implemented with the right team in place. The more capable an accounting team is when it comes to inventory, the better. Once a business has a handle on how complex they should get when it comes to accounting for their inventory, the process can be pretty smooth.
Accountfully is a leader in the inventory entrepreneur space because we dive into the details and help automate systems for our clients. By diving into each business and understanding all elements of its supply chain; it’s vendors, suppliers, manufacturers, sales channels, etc, we can start with a great roadmap (the Inventory Workbook) that dictates how we need to best proceed. It also gives us a central document from which we can make finite adjustments and better calculate margins.
The goal is to not let the supply chain hold the business back from growth. Without an understanding of the intricacies up front, it is difficult to predict how to fill orders, when to reorder and understand where potential raw material cost savings are. Once a predictable pattern of cost, timing and product revenue is established, more intelligent decisions can be made for business growth. This is why it is best to have a strong team handling the accounting side of your inventory based business. As a timeline is adhered to for making adjustments for sales and when the inventory hits the COGS account, patterns can be established and more items can be automated, making less work in the long run.
Conclusion and Takeaways
In conclusion, it is up to the type of business how detailed you can/want to get when it comes to accounting for inventory. With the right team in place that understands the supply chain inside and out and stays consistent and timely in their reporting, a true margin analysis is a lot simpler, but with the added complexity comes a need for higher accuracy. This is why it matters how strong your accounting team is.
Inventory should be initially shown as an asset, on the balance sheet, because that is what it is. The business’s value is easier to understand and show to current or potential investors. Keeping the COGS reported in the same time frame as the associated sales of the product will also show the true picture of the business. Understanding the factors involved in the product’s life cycle also allows for better understanding of timing and cost involved, so you can better fulfill orders and make decisions to grow the business, by maximizing your margins.
If you are in need of some ideas on how best to account for your inventory based business, feel free to reach out and tell us about your business. Let us wrangle the complexities, so you can focus on growing, not getting lost in the supply chain weeds.