How to Choose The Best Inventory Accounting Method for Your Online Business (2023)

How to Choose The Best Inventory Accounting Method for Your Online Business (1)

One of the most important parts of building a profitable, viable, and scalable online business is ensuring that you always manage inventory effectively. Whether you’re an ecommerce rookie or veteran, inventory management can definitely be challenging –, especially when deciding which inventory accounting method is best for you.

In this article, we’ll look at what inventory accounting methods are and why they’re important.

Finally, we’ll highlight how to make the right choices for your online business when various inventory obstacles enter your path to success.

What Are Inventory Accounting Methods?

As an ecommerce seller, inventory management is the task of tracking all your products while maintaining enough stock to meet demands, but not so much that capital is tied up in slow-moving products.

Your products are considered an asset, and you need a consistent way of measuring its value for many different reasons. Using an inventory accounting method is the perfect way of assign value to your inventory in a dependable fashion. These methods allow you to apply a particular price to each product, which is important information that helps in many different areas of your business.

Why Are Inventory Accounting Methods Important?

Inventory accounting is an essential part of inventory management. It allows you to evaluate the Cost of Goods Sold (COGS) and, subsequently, your overall profitability. To effectively price your products, you must truly understand how much they cost you. There are different methods of tracking the cost, just as there are different types of online businesses. The important thing to remember is that they all can affect your bottom line – so you must choose wisely.

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Common Inventory Accounting Methods

Below, we outline the most familiar methods available to you and why they may or may not be the best option for your business.

First In, First Out (FIFO)

The FIFO method is the most popular inventory method because it’s the one that most closely matches the actual movement of inventory for most businesses. This method assumes that the first products you acquired will be the first that are sold. It’s a theoretically sound method.

Here’s why: In times of increasing prices (which is almost always the case), the earliest units in your inventory were purchased at the lowest prices. But when they are sold, they are sold at today’s market value. Thus, the FIFO method will lower your COGS which, in turn, leads to a higher reportable income and more taxes paid.

How to Choose The Best Inventory Accounting Method for Your Online Business (2)

The FIFO method will provide the healthiest balance sheet. If your business is looking to impress investors or needing to qualify for a loan, the FIFO method is your best bet.

Last In, First Out (LIFO)

The LIFO method assumes that the products you acquired last are sold first. That also means that products that remain in your inventory are the oldest ones. This doesn’t follow the natural flow of inventory for most businesses. It’s also a method that the International Financial Reporting Standards prohibits, making it illegal in many other countries, and closely regulated in the U.S.

LIFO isn’t a good indicator of your ending inventory value because your leftover stock could be very old or even obsolete. That will result in a valuation much lower than today's market prices. The LIFO method will show lower profitability because the COGS is higher, which means lower taxes are paid.

How to Choose The Best Inventory Accounting Method for Your Online Business (3)

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If you’re looking for tax benefits, then LIFO may be the strategy to use. However, because it’s closely regulated, you should consult a tax expert to determine if it’s the right strategy for you.

Weighted Average

The weighted average method falls right in the middle of FIFO and LIFO. It’s not an inventory method that very many companies use. This method averages the cost of any new inventory purchases with the cost of existing inventory to arrive at a weighted average cost, which is then readjusted as more inventory is purchased.

How to Choose The Best Inventory Accounting Method for Your Online Business (4)

If your company sells similarly priced products, then this may be a viable option. For companies that sell products of widely varying prices, final figures will be much less accurate.

Specific Identification

Specific identification is the most accurate inventory accounting method. It tracks the cost of each item in your inventory and the actual price of each item that sold. This method requires a massive amount of information tracking, so it is typically only used for unique, high-cost items, like cars, works of art, jewelry, and other luxury items.

How to Choose The Best Inventory Accounting Method for Your Online Business (5)

If your business specializes in items that are expensive and you don’t have a large product catalog, then the Specific ID method will provide you with very accurate records. However, if that doesn’t describe your business, the Specific ID method will be way too much work. Choose FIFO or LIFO instead.

How to Choose the Right Inventory Accounting Method

The examples above are the most common inventory accounting methods. There are other methods out there, but you can likely find one that works great for your business from the list above. Choosing the best inventory valuation method for your company depends on various factors, such as where your business is based, whether costs are increasing or decreasing, and how much your stock fluctuates.

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The most popular inventory accounting method is FIFO because it typically provides the most accurate view of costs and profitability. However, because there isn’t a one-size-fits-all solution, it’s a good idea to talk with your accountant or tax expert to determine what will work best for your business.

Common Inventory Obstacles You May Encounter

It’s inevitable to face challenges when managing inventory. If you aren’t utilizing the best inventory management methods, you’ll experience far more than your fair share. Once you have your accounting method in place, be sure to keep it consistent. That will eliminate many headaches down the road.

Being prepared for inventory challenges and having solutions in mind ahead of time may mean the difference between a lucrative and unprofitable year.

Here are some of the common inventory challenges that ecommerce retailers, like you, may experience and how to deal with them:

Too Much or Not Enough Inventory

When you’re not using the right methods to manage your inventory, you may find yourself in the position of having too many products or, conversely, running out of stock.

While overstocking has little or no impact on your customers and may seem like a good idea, having too much inventory can create problems:

  • It can be costly. You must store your unsold items and that isn’t free. Tying up your capital in unsold inventory isn’t an effective way to grow your business.
  • Products don’t last forever. Even if you don’t sell perishable products, there are ways that overstocking can lead to dead stock. There are seasonal changes, discontinued product lines, shifting trends, upgraded branding, and worn packaging to contend with when you have too much inventory. All of those factors can make products unsaleable.

On the other hand, when you aren’t proactively managing your inventory, you risk running out of products. When you oversell (allow buyers to purchase items that are out of stock), you will face customer service challenges that mar your reputation.

Whether it’s overstocking or overselling, the challenges can be detrimental to your bottom line.

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Solution: The best solution for this type of obstacle is forecasting. Accurately forecasting your product needs is both a science and an art. To start, you need to study your sales across each platform over the last year. Monitor for trends and seasonality. From there, you can determine your typical sales on a 30-, 60-, and 90-day span. Once you’ve calculated these numbers, factor in your supplier’s lead time. Always make forecasting a priority – your sales will always fluctuate but having a base line to start will help you get a hold on your inventory needs.

No Scalability

Another challenge that online businesses may experience is not adjusting as the business grows. Scalability is easily overlooked when your business is new. It’s not difficult to manually track inventory and fulfill orders yourself, even when you are selling across multiple platforms, when you’re seeing a humble amount of sales orders. But, as your business grows, it can become increasingly difficult and time-consuming to continue using those methods.

In fact, when you are relying on manual data entry to manage inventory, you’ll reach a point at which it becomes impossible to handle any more growth without sacrificing accuracy. Inaccuracy, when it comes to inventory, can quickly lead to dissatisfied customers when you’re unable to fulfill orders.

Not being able to see your total inventory across all channels and warehouses is another challenge you will face as you expand to more channels. As the demand for your products increases, managing your stock will become more complex.

Without having a clear picture of what you have available, you’ll have a hard time making the best decisions when forecasting and restocking.

Solution: The best way to plan for scalability is to either hire more resources or incorporate a software solution. There are many inventory solutions out there that can help automate many of the data entry tasks and allow you to focus on the bigger picture.

Final Thoughts

Just about every piece of an ecommerce business is affected by inventory. Without an effective system to manage stock, you’ll see other areas of the business start to struggle.

First, you need to choose the best inventory accounting method for running your online business. Consult your accountant before deciding, because this isn’t something you can change easily mid-way through the year. Once you’ve chosen the best option, you need to start tracking your inventory effectively with human or software resources. These obstacles will be fewer and farther between when you keep your inventory under control, which will ultimately lead to a healthier bottom line.

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FAQs

What is the best accounting method for inventory? ›

First In, First Out (FIFO)

The FIFO method is the most popular inventory method because it's the one that most closely matches the actual movement of inventory for most businesses. This method assumes that the first products you acquired will be the first that are sold.

How does a company choose which inventory method is the best for their business? ›

Most companies choose which inventory method to use based on whether there is a significant overall rise in the costs of goods and services — also known as inflation. The LIFO method generally shows lower profits and inventory values, while the FIFO method typically shows higher profits and inventory values.

How do you choose inventory costing method? ›

If your inventory costs are stable and steady or on the rise, then LIFO is the better choice. Companies with larger inventories and increasing costs appreciate the way LIFO results in lower profits and taxes and higher cash flow. If your inventory costs are falling, then FIFO is the better choice.

What are the methods of accounting for inventory? ›

The four main ways to account for inventory are the specific identification, first in first out, last in first out, and weighted average methods. As background, inventory includes the raw materials, work-in-process, and finished goods that a company has on hand for its own production processes or for sale to customers.

Which inventory method is the most commonly used? ›

First-In, First-Out (FIFO)

The FIFO valuation method is the most commonly used inventory valuation method as most of the companies sell their products in the same order in which they purchase it.

Which inventory system is the best? ›

The Best Inventory Management Software for 2022
  • Best Overall: Cin7 Orderhive.
  • Best for B2B Companies: inFlow.
  • Best for Retail Stores: Lightspeed Retail.
  • Best for Restaurants: Upserve.
  • Best for Manufacturing: Megaventory.
  • Best Free Option: Zoho Inventory.

Which method is important in inventory management? ›

Demand planning is an important part of successful inventory management. It is the process of determining how much of each item you anticipate selling, and when. Once demand is determined, inventory management follows the flow of goods from the supplier through production and ultimately fulfilling customer orders.

What are the 3 main methods of taking inventory? ›

There are three methods for inventory valuation: FIFO (First In, First Out), LIFO (Last In, First Out), and WAC (Weighted Average Cost).

What are the 4 inventory methods? ›

The four main inventory valuation methods are FIFO or First-In, First-Out; LIFO or Last-In, First-Out; Specific Identification; and Weighted Average Cost. We'll dive deeper into these – but first, let's go over some basics.

What are the 3 main inventory costing methods? ›

The three inventory costing methods include the first in-first out (FIFO), last in-first out (LIFO), and weighted average cost (WAC) methods.

What are the 2 most common methods of inventory valuation? ›

The most widely used methods for valuation are FIFO (first-in, first-out), LIFO (last-in, first-out) and WAC (weighted average cost).

What are the 2 methods used to determine inventory quantity? ›

Examples of Inventory Methods

The following are only a few of the many cost flow assumptions used for valuing inventory: First-in, first-out (FIFO) Last-in, first-out (LIFO)

Which inventory method provides the highest profit and why? ›

Under FIFO, you assign inventory costs in purchase date sequence. Because FIFO has you subtract the cost of your oldest -- and therefore least expensive -- inventory from sales, your gross income is higher.

Which inventory system should you use and why? ›

The perpetual system is generally more effective than the periodic inventory system. That's because the computer software companies use makes it a hands-off process that requires little to no effort. Products are barcoded and point-of-sale technology tracks these products from shelf to sale.

What is the best inventory system for small business? ›

NerdWallet's Best Inventory Management Software of December 2022
  • Cin7 Orderhive: Best for E-commerce businesses.
  • Brightpearl: Best for Comprehensive software suite.
  • Square for Retail: Best for Basic inventory needs.
  • Lightspeed Retail: Best for More complex inventory needs.
  • inFlow Inventory: Best for B2B companies.
25 Oct 2022

What are the 5 steps to effective inventory systems your answer? ›

5 Steps to Successful Inventory Management
  • Create a System to Get Accurate and Accessible Information on Your Inventory. ...
  • Create a Unique Process Customized for Your Business Type. ...
  • Keep an eye on Contemporary trends in the industry. ...
  • Be prepared for fluctuations in supply and demand.
29 Sept 2021

How do you calculate inventory for a small business? ›

Inventory is measured in two values: the cost of goods in stock and their predicted value at sale.
  1. Add up the purchase price or manufacturing cost of the goods you have in inventory. ...
  2. Calculate the price of the goods in your inventory if they were all to sell at their current pricing.

What are the 4 basic reasons for keeping an inventory? ›

The reasons for holding inventories can vary from case to case basis.
  • Meet variation in Production Demand. ...
  • Cater to Cyclical and Seasonal Demand. ...
  • Economies of Scale in Procurement. ...
  • Take advantage of Price Increase and Quantity Discounts. ...
  • Reduce Transit Cost and Transit Times.

What is the most accurate inventory valuation method? ›

The FIFO method (First In First Out)

FIFO is the opposite of LIFO by assuming that your oldest inventory is sold first. It's generally the most straightforward inventory valuation method for retailers to use, since it most closely matches the actual cost of inventory and inventory movement.

Which inventory method gives the highest net income? ›

FIFO. Under the FIFO method, the goods purchased recently are sold later. As a result, the cost of goods sold is at its lowest because of which the net income will be the highest.

Which is the best form of inventory control for inventory? ›

5 most effective methods of inventory management
  • 1) ABC analysis. ABC analysis stands for Always Better Control Analysis. ...
  • 2) Economic order quantity (EOQ) ...
  • 3) FIFO and LIFO. ...
  • 4) Fast, slow and non-moving (FSN) analysis. ...
  • 5) Just in time (JIT) method. ...
  • Conclusion.
15 Jun 2020

Which inventory costing method provides the most current? ›

LIFO gives the most realistic net income value because it matches the most current costs to the most current revenues.

Why is LIFO The most popular inventory method? ›

“By using more recent inventory in valuation, your cost basis is higher on current income statements,” Melwani said. “This reduces gross profit and, ultimately, net income. This is the implication of LIFO, and many companies prefer LIFO because lower profit reporting means a reduced tax burden.”

Which method is better FIFO or LIFO? ›

FIFO is more likely to give accurate results. This is because calculating profit from stock is more straightforward, meaning your financial statements are easy to update, as well as saving both time and money. It also means that old stock does not get re-counted or left for so long it becomes unusable.

Which inventory method is better periodic or perpetual? ›

The perpetual system is generally more effective than the periodic inventory system. That's because the computer software companies use makes it a hands-off process that requires little to no effort. Products are barcoded and point-of-sale technology tracks these products from shelf to sale.

What are the 3 most commonly used methods for valuation of inventory? ›

What are the different inventory valuation methods? There are three methods for inventory valuation: FIFO (First In, First Out), LIFO (Last In, First Out), and WAC (Weighted Average Cost).

What are the four methods for valuing inventory which is most commonly used? ›

Below, we break down the four most common methods, and the pros and cons of each.
  • WAC (weighted average cost) The WAC method of inventory valuation uses a weighted average to determine the amount that goes into COGS and inventory. ...
  • Specific identification method. ...
  • FIFO (first-in, first-out) ...
  • LIFO (last-in, first-out)
17 Jul 2020

Why is FIFO the best? ›

FIFO is most successful in industries where a product's price remains steady and the company sells its oldest products first. That's because FIFO is based on the cost of the first goods purchased, ignoring any increases or reductions in price for newer units.

When FIFO method is most suitable? ›

When Is First In, First Out (FIFO) Used? The FIFO method is used for cost flow assumption purposes. In manufacturing, as items progress to later development stages and as finished inventory items are sold, the associated costs with that product must be recognized as an expense.

Which inventory method is best for rising prices? ›

Last-in, first-out, or LIFO, uses the most recent costs first. When prices are rising, you prefer LIFO because it gives you the highest cost of goods sold and the lowest taxable income. First-in, first-out, or FIFO, applies the earliest costs first.

What are the 2 methods of inventory control? ›

There are two key types of inventory control systems.
  • Perpetual inventory system. A perpetual inventory control system tracks inventory in real-time. ...
  • Periodic inventory system. A periodic inventory system is kept up to date by a physical count of goods on hand at specific intervals.

Which among the two inventory system is easier to use? ›

Easy to implement: Periodic inventory is an easy-to-use system since it involves simple calculations and only a few records, including the amount of inventory available and sold.

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