Methods of calculating and tracking your inventory
Accounting for a retail business comes with the challenge of calculating and tracking inventory. Here are some methods you can use.
Keeping an accurate record of your money is vital for every business, but some aspects of retail set it apart from other industries when it comes to accounting. Mainly, you have the daunting but necessary task of tracking inventory. Tracking your inventory has to include calculating costs as well as monitoring the number of each item you have in stock. This is an essential piece of accurate accounting.
Calculating the cost of inventory
Keeping track of your revenue and profit means you have to monitor the cost of the goods you sell and the dollar amount of the inventory you have left. There are many different methods for calculating costs. We've explained three costing methods and the retail method below. Be sure to keep track of which method you use, as you'll need to know this when it comes time to file your taxes. Keep in mind that you need to stick with one accounting method for your business from year to year. Any changes in accounting method have to be approved through the IRS, generally by filing a Form 3115. You can learn more about accounting methods and the IRS by reading Publication 538.
Inventory: Costing method
One of the key challenges to retail is tracking inventory, especially if you buy multiple inventory units that do not all cost you the same amount of money. If this is the case, you need to figure out a way to assume the cost of goods sold so that you can compare this to your ending inventory and calculate your profit. To do this, you must make some cost-flow assumptions. Note that this does not track the physical movement of goods sold, but rather assigns cost to the inventory so that you can later determine your profit.
You can do this in various ways. Most industries use one of three costing methods to track their inventory. For each of these costing methods, we will use the following scenario:
Editor's Note: Are you spending too much on credit card processing? If you're looking for information to help you choose the credit card processor that's right for your retail store, use the questionnaire below to have our sister site, BuyerZone, provide you with information from a variety of vendors for free:
Let's say you own a game store. You have a small bucket of dice that you never allow to go empty. You bought 30 dice at 5 cents apiece first, then a second order of 25 dice at 7 cents each, and a last order of 15 dice at 10 cents each. In total, you've purchased 70 dice. Only 20 are left at the time you track your inventory, and you're not sure what cost to assign to the 50 dice that you've sold. To find out, here are some of the different costing methods you can use.
First-in, first-out (FIFO)
If you use the FIFO costing method, you take the cost of the first order you purchased, compare it to the revenue you've had come in, and assign that revenue to the cost of goods sold. For the above example, you assume that you sold the cheaper dice first. Since the 30 dice at 5 cents each were ordered first, you'll match this against your inventory and assume that 30 of the dice you sold cost 5 cents each. You'll then assume that the next 20 you sold were from the second order, meaning that those dice cost you 7 cents each. Following the FIFO method, then, you'll take 30 and multiply it by 0.05, and add that to 20 multiplied by 0.07. The cost of goods sold is $2.90, and the cost of your ending inventory, the inventory you have left, is $1.85 (five dice at 7 cents plus 15 dice at 10 cents). The FIFO method would be best to use in our scenario if customers took dice out of the bottom of your bucket.
Last-in, first-out (LIFO)
Since you're refilling your bucket of dice with your most recent order, it might make sense that you've actually sold more of the dice you last put in than the dice you put in first if your customers are taking dice from the top of the barrel. If this is the case, you can use the LIFO costing method. This method is similar in theory to the FIFO method, but instead of matching the cost of the first order of dice to the number of goods sold, you match the cost of the last order of dice. In this case, 15 of the 50 dice you've sold would have cost 10 cents ($1.50), 25 of the dice cost 7 cents ($1.75), and 10 cost 5 cents ($0.50). When you add these numbers together ($1.50 plus $1.75 plus $0.50), this would make your total cost of goods sold $3.75, and the cost of your ending inventory $1 (20 dice at 5 cents apiece).
It might make more sense that the dice have gotten mixed up in your bucket, and there's a good chance that you've sold a number of dice from all three orders you placed. In this situation, you may want to use the weighted-average costing method by dividing the total cost of the dice by the total number of dice you purchased. In this case, this would end up being $4.75 divided by 70 dice, or approximately 7 cents per di. You know you sold 50 dice, so you match the number of items sold to the average cost of 7 cents, which is a total of $3.50 for the cost of goods sold and $1.40 for ending inventory.
Inventory: Retail method
Depending on what type of inventory you sell, you may be able to use the simpler retail method to calculate the cost of goods sold and the cost of your ending inventory. If you sell products that have a consistent markup, you can divide the purchase and beginning inventory costs by the cost-to-retail percentage, which is done by dividing the cost of the product by the amount you're selling it for. Take this number and subtract the sales total multiplied by the percentage and subtract it from the cost of goods sold to get the ending inventory total.
For example, if you buy collectors' sets of chess for $75 and sell them for $100, the cost-to-retail percentage is 75. If your beginning inventory cost a total of $1,000, and your subsequent chess set purchases cost $2,000 (for a total of $3,000), the relative retail prices would be approximately $1,333 and $2,666, for a total of $3,999 at retail price. Multiply this number by 75 percent and subtract it from the total cost of goods sold (before multiplying it by the cost-to-retail ratio), which is $3,000, and you have your ending inventory cost at $999.
Tracking inventory amounts
Now that you've calculated how much you're spending and making on your inventory, you need to figure out how to keep track of the amount of inventory you have in stock. This helps you make sure that you have enough products in stock to meet customer demand, and helps you keep accurate records that will be important for accounting purposes, including taxes.
Regardless of the system you choose for determining the cost of goods sold and for counting inventory, it's important to keep accurate records and to stay on top of evaluating your inventory and calculating costs. This can save time at the end of the year when you're preparing tax statements, and it helps you keep track of your revenue and profits.
The easiest way to track your inventory is via the perpetual method, which keeps track of the items you sell and the ins and outs of your inventory as changes occur. This is done automatically with a fully integrated point-of-sale (POS) system. As you receive inventory, you enter it into the POS system and the item is assigned a barcode. When the item is sold, the POS system scans the barcode, and at the end of the transaction, the numbers in your inventory – as well as the costs associated with it – update automatically. This can save a lot of time and effort for you and your team.
Even though the POS system will update your inventory numbers automatically, it's important that you still do manual counts of your products, as the POS system won't update your numbers for depleted inventory not related to sales. If, for example, a game store employee accidentally broke a collectors' figurine or items are stolen, the POS system can't account for the loss. You should do a manual counting inventory at least every year to keep your records in order, though it may be wise to count monthly and adjust your records accordingly.
The periodic method of tracking your inventory can be less convenient and more labor-intensive, though it might be preferable if your company can't afford a fully capable POS system. This inventory-tracking method requires you to manually count and track inventory periodically, whether that be weekly, monthly or within another period of time. A major drawback to this method is that, since you don't have a POS system tracking sales, you don't have a way to determine what items were sold, stolen or broken.
If you have an ecommerce store as well as a brick-and-mortar shop, be sure you track inventory across both mediums. When searching for a POS system to use, look for one that can track your inventory on various online stores like Amazon.
One of the most important parts of successful accounting is keeping accurate records. There are three main financial statements that you or your accountant need to keep up to date: an income statement, a balance sheet and a cash flow statement. These financial statements are vital for every business, not just retail stores. You can find sample templates of these forms, as well as many other accounting forms, on AccountingCoach.com.
On the income statement, you track revenue, or all of the money your business is earning. For retail, this is mostly going to come from customers buying your goods. From the revenue, you subtract the cost of goods sold that you've calculated using one of the methods detailed above. The resulting number is the amount you have left to pay your overhead costs. You can track your expenses – like rent or employee salaries – on your income statement as well.
Balance sheets are an important resource for keeping track of assets, liability and equity. On one side of the balance sheet, you list your assets, such as equipment. Then, on the other side of the sheet, you list your liabilities (e.g., business credit cards). Your assets minus your liabilities equals your equity, which is the value of your business outside of what you owe. These three things – assets, liability and equity – should always balance each other, hence the name of this document.
Balance sheets are different from income statements. Where income statements cover a period of time like a week, month or year, balance sheets are for an exact date and time.
The cash flow statement is similar to your income statement in that you're tracking the money that comes in and out of your business. However, the cash flow statement is more specific about when these transactions occur. For example, in your income statement, you might have listed an invoice in your sales, but your client might have 30 days to pay the invoice. The cash flow statement records the actual date the cash is received. Keeping accurate track of your cash flow with this financial statement is vital to keeping your company afloat.
Accounting can be a long and arduous process, especially if you don't have experience. You can outsource accounting, hire an in-house accountant or try to do the accounting yourself. If you want to do the accounting yourself, it may be worth looking into accounting software.
Accounting software keeps track of all of your finances, including purchase and sales orders, invoices, accounts receivable, and accounts payable. The best accounting software helps you fill out important financial documents like income statements, balance sheets and cash flow statements. Accounting software often helps with accuracy and can be a good way to organize your information. Popular accounting software includes QuickBooks and Xero.
Hitting the books and keeping track of your accounts has to be one of the first priorities of your retail business. Because of your inventory, this can be more complicated, but selecting an appropriate method to determine the cost of goods sold and keeping track of your inventory either periodically or perpetually will help. Be sure to keep accurate track of your finances through important financial documents like income statements, balance sheets and cash flow statements. Accounting software may be able to track your finances and make the accounting process more manageable.