What Is Inventory? | Understanding This Important Business Term

Unless you own a service-based business, you likely have inventory. Knowing how much inventory you have is crucial for managing accurate small business accounting books, ordering new stock, and making pricing decisions. So, what is inventory?

Inventory meaning

Inventory represents the goods your small business has for sale or in storage. Your small business’s inventory includes raw materials used to create finished products, items in the production process, and finished goods.

Small business inventory is one type of asset. An asset is property that adds value to your business. Record inventory as a current asset on your small business balance sheet. Current assets are assets that can be converted into cash within one year.

When you sell inventory, you record the revenue on your income statement. You must also calculate the cost of goods sold (COGS) and record it on your income statement. COGS refers to how much it costs to produce your goods (e.g., purchasing inventory, turning raw materials into the goods you sell, etc.).

Inventory losses

Inventory can be expensive. Not only do you need to purchase inventory and hope it sells, but you also need to worry about inventory loss.

Inventory loss, called inventory shrinkage, is when the amount of inventory you have decreased due to items getting damaged, expiring, or being stolen.

Let’s say you buy 100 light bulbs, but 30 fall off the shelves and break. You have inventory shrinkage of 30 bulbs. Inventory shrinkage is expensive because you paid for the items but cannot sell them. Try to limit inventory shrinkage to decrease your expenses.

Inventory management for small business

Turning inventory into cash and turning some of the cash back into inventory is basically the life cycle of your business. When it comes down to it, inventory represents the value of your company’s possible revenue.

Because inventory plays such an essential role in your business, you need to know how to manage it. The main purpose of inventory management is to increase earnings at a low cost.

Inventory management for small business involves making wise purchasing decisions, tracking new purchases of raw materials, monitoring inventory throughout the production process, selling off inventory, and limiting shrinkage.

For effective inventory management, you need to have enough inventory on hand, decrease shrinkage, and prevent inventory from sitting around in a back room, warehouse, or storefront.

Use an inventory tracker and record inventory when it comes into your business. When you are cautious about tracking inventory, you know when to order new materials. As a result, you can avoid having insufficient inventory.

To decrease shrinkage, double check your numbers. Delegate inventory management to two or more employees to discourage employee theft. Train employees on how to properly handle inventory to avoid damages. Implement new handling procedures if damage rates are high. And, prevent shoplifting by monitoring suspicious customer behaviors.

If outdated inventory is piling up in your small business, you know you need to get rid of it. To sell off old inventory and make room for new inventory, offer discounts, like a buy one get one free deal.

Inventory management in accounting

You must record inventory in your accounting books. To maintain accurate records of your inventory, you must update your accounting books when you purchase new inventory, lose inventory to shrinkage, and sell finished products.

The IRS sets inventory recordkeeping requirements for most businesses. If you are required to use accrual accounting, you need to regularly value your inventory. Businesses that use the cash-basis accounting method must also account for and value inventory, but the requirements vary.

Under IRS requirements, you must value your inventory at the beginning and the end of the year. You need to use these assessments to determine your cost of goods sold. Record your beginning and ending inventory in your accounting books.

To value your inventory, come up with a consistent system using generally accepted accounting principles (GAAP). For more information on inventory management requirements, consult IRS Publication 334.

To comply with IRS requirements, you must maintain accurate accounting records for business transactions. Why make it complicated? Manage your books with Patriot’s online accounting software. Get your free trial now!

This article has been updated from its original publication date of April 2, 2015.

This is not intended as legal advice; for more information, please click here.