Inventory accounting: What it is, why it matters and how it works

Every business that deals with physical goods must have a firm understanding of inventory accounting. Having a good handle on your inventory helps you make smart decisions about what to buy and when to buy it, plus how to price your products. 

QuickBooks' Entrepreneurship in 2025 report found that 47% of business owners are planning to develop new products or services, which means that getting your inventory accounting right is more important than ever. 

In this guide, we'll cover the basics of inventory accounting, explore different types of inventory, and dive into some advanced techniques. By the end, you'll be able to master inventory accounting, whether you're a seasoned business owner or just starting out.

Jump to:

• Why is inventory accounting important? 
• How inventory accounting works
• Key inventory documents
• Types of inventory
• Periodic vs perpetual accounting
• Common inventory valuation methods
• How does inventory impact balance sheets and income statements?
• Benefits of inventory accounting
• Streamline your accounting and save time
• Inventory accounting FAQ

Why is inventory accounting important? 

Inventory accounting provides the foundation for sound financial management, informed decision-making, and operational efficiency. Accurate inventory data empowers you to understand your business’ true costs, optimize inventory stock levels, and improve profitability overall.

Impact on cost of goods sold (COGS):

Accurate inventory accounting is key for calculating the cost of goods sold (COGS)—a figure that represents the direct expenses—materials, labor, and overhead— tied to producing the goods your business sells. 

However, if you don't know what you have in inventory, you can't accurately calculate what it costs you to sell it. Precise inventory tracking directly impacts COGS by capturing all of these expenses. Inaccurate inventory data leads to a cascade of problems:

• Misstated COGS: The foundation of your cost accounting is flawed
• Distorted profitability: Gross profit and net income figures become unreliable
• Impaired decision-making: You're operating with a distorted view of your financial health, making it impossible to make sound business decisions

Avoiding stockouts and overstocking 

Effective inventory accounting helps businesses balance demand and inventory to avoid excess that can lead to losses. Two common inventory challenges:

• Stockouts: Lost sales, unhappy customers, damaged reputation
• Overstocking: Tied-up capital, obsolescence, storage costs

Good inventory accounting—demand forecasting, real-time tracking, and timely replenishment—helps maintain optimal inventory. This minimizes stockout and overstocking risks, improving cash flow, reducing waste, and boosting your customer satisfaction.

How inventory accounting works

Inventory accounting tracks your inventory from purchase to sale, providing a clear picture of its movement and value. This involves recording inventory transactions, calculating the cost of goods sold (COGS), and valuing remaining inventory. It ensures accurate financial reporting and informed decision-making.

The flow of inventory typically follows these stages:

1. Purchase: Inventory is acquired from suppliers
2. Storage: Inventory is stored until needed
3. Production (if applicable): Raw materials are converted into finished goods
4. Sale: Finished goods are sold to customers

Each stage has associated accounting entries that reflect changes in inventory levels and value.

Key inventory documents

Several key documents are used to manage and track your inventory throughout its lifecycle. These documents are essential for maintaining accurate records and supporting the accounting process.

Purchase order

A purchase order (PO) is a document a business sends to a supplier to authorize a purchase. It specifies the:

• Quantity: The number of units you're ordering
• Type: The specific product or item 
• Price: The agreed-upon price per unit

The PO initiates the purchase process and serves as a control mechanism to ensure the supplier only delivers and charges for the authorized purchases. It also provides a clear record of the order for both the buyer and the supplier.

Receiving report 

A receiving report (RR) is a document created when a business receives inventory from a supplier. It verifies the:

• Quantity: The number of units actually received
• Condition: The quality and condition of the received goods

The RR is compared against the PO to ensure that the received goods match the order in terms of quantity, type, and condition. Any discrepancies are noted and addressed. The RR triggers the recording of the inventory purchase in the accounting system.

Sales invoice

A sales invoice is a document businesses issue to customers after making a sale. It provides details of the sale, including:

• Goods sold: The specific products or items purchased by the customer
• Price: The selling price of the goods
• Terms of sale: Payment terms, delivery details, etc.

The sales invoice triggers the reduction of inventory in the accounting system and the recognition of revenue. It serves as a record of the sale for both you and your customer.

Inventory count sheet

An inventory count sheet is a document used to record the physical count of your inventory on hand. Most businesses do this periodically to verify accuracy and identify discrepancies between the recorded and actual inventory levels. 

Inventory count sheets are crucial for inventory valuation and reconciliation. They help businesses maintain accurate inventory records and identify potential issues such as theft, damage, or obsolescence.

Types of inventory

Inventory can be broken down into four main categories based on its role in the production process: Raw Materials, Work-In-Progress, Finished Goods, and MRO supplies. Understanding these types of inventory is crucial for effective management and accounting, as each type has unique characteristics and requires specific management strategies.

Raw materials

Raw materials are the basic materials used to manufacture finished goods. They are the starting point of the production process and are typically purchased from suppliers. 

Examples of raw materials:

• Manufacturing: Steel, aluminum, plastic, wood, fabric
• Food production: Wheat, sugar, fruits, vegetables, meat
• Technology: Silicon, copper, chemicals
• Pharmaceuticals: Active pharmaceutical ingredients, excipients

Proper storage, handling, and tracking of raw materials help maintain their quality and minimize waste. This involves implementing appropriate inventory control measures and ensuring timely procurement to meet production demands.

Work-in-progress

Work-in-progress (WIP) refers to partially finished goods that are still in the production process. They have undergone some transformation but are not yet complete and ready for sale.

Examples of WIP inventory:

• Partially assembled cars on an assembly line
• Furniture in various stages of construction
• Electronic devices being assembled
• Pharmaceutical products undergoing formulation and testing

Tracking the value and quantity of WIP is essential for accurate cost accounting and production planning. Monitoring WIP levels will ensure that you can identify bottlenecks, optimize production flow, and ensure the timely completion of finished goods.

Finished goods

Finished goods are completed items that are ready to sell to your customers. They have gone through the entire production process and are available for immediate delivery or sale.

Examples of finished goods:

• Cars available at a dealership
• Fully assembled furniture in a store
• Packaged electronic devices ready for shipping
• Bottled and packaged pharmaceutical products

Effective management of finished goods inventory involves balancing supply and demand to meet your customers’ orders while minimizing storage costs and obsolescence risk. This requires accurate demand forecasting, efficient order fulfillment processes, and appropriate storage and handling practices.

Maintenance, repair, and operating supplies

Maintenance, repair, and operating (MRO) supplies are items used in the production process but not directly incorporated into the finished product. They are essential for maintaining and operating your production equipment and facilities.

Examples of MRO supplies:

• Cleaning supplies for a factory
• Lubricants and spare parts for machinery
• Safety equipment for workers
• Office supplies for administrative staff

Although MRO supplies do not directly contribute to the final product, their availability is crucial for ensuring smooth and efficient production operations. Proper management of MRO inventory involves optimizing stock levels to avoid disruptions while minimizing carrying costs. 

Periodic vs perpetual accounting

You can manage inventory accounting through two primary systems: periodic and perpetual. Each system has its own approach to tracking inventory and calculating the cost of goods sold (COGS), with distinct advantages and disadvantages.

Periodic accounting system

In a periodic inventory system, the inventory balance is updated at specific intervals, typically at the end of an accounting period, whether it be monthly, quarterly, or yearly. The cost of goods sold is then calculated using the following formula:

Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold

This system may be suitable for businesses with small inventories and simple operations, where the cost of implementing a perpetual system may outweigh the benefits. As your business grows and your inventory becomes more complex, however, you may find that you’ve outgrown this system.

Perpetual accounting system

A perpetual inventory system relies on technology like barcode scanners and more involved software to track inventory movements. With each purchase and sale recorded in real-time, you can keep tabs on even the most complex array of products. 

Demand for real-time inventory visibility and the accessibility of software and technology have made perpetual inventory systems increasingly popular. 

They particularly benefit businesses with large inventories, high sales volumes, and complex supply chains, as it provides the data needed to optimize inventory levels and make informed business decisions.

Common inventory valuation methods

Inventory valuation involves assigning a monetary value to your company’s stock of goods. It’s an important aspect of inventory accounting because it directly impacts the cost of goods sold (COGS), profitability, and the overall financial health of a business.

Different inventory valuation methods can lead to different financial outcomes, so choosing the right one is crucial for accurate reporting and informed decision-making. The most common ways to value inventory are: FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and WAC (Weighted Average Cost).

LIFO (Last-in, first-out)

LIFO is an inventory valuation method that assumes the last items purchased are the first ones sold. This means you'll use the cost of the most recently acquired inventory to calculate COGS.

Imagine your company purchases 100 units of a product at $10 each, then another 100 units at $12 each. Under LIFO, if you sell 150 units, the COGS would be calculated as:

• 100 units x $12 = $1200
• 50 units x $10 = $500
• Total COGS = $1700

One advantage of LIFO compared to FIFO is that it can result in lower taxable income during periods of inflation, as it assigns higher costs to COGS. This can, however, also lead to an understated inventory value on the balance sheet. 

Additionally, LIFO may not accurately reflect the actual flow of goods for many businesses, especially those dealing with perishable goods or those where the oldest items typically sell first. 

FIFO (First-in, first-out)

FIFO is an inventory valuation method that assumes the first items purchased are the first ones sold. This means that you'll use the cost of the oldest inventory to calculate COGS.

To illustrate, let's use the same example as above. Under FIFO, the COGS would be:

• 100 units x $10 = $1000
• 50 units x $12 = $600
• Total COGS = $1600

FIFO often provides a more accurate reflection of the actual flow of goods for many businesses. It also results in a higher inventory value on the balance sheet, which can help with financial reporting. 

However, FIFO can lead to higher taxable income during periods of inflation, which may be a disadvantage for some businesses.

WAC (Weighted average cost)

WAC is an inventory valuation method that calculates the average cost of all inventory items and uses this average to determine COGS.

Here's how it's calculated: Using the same example, the weighted average cost would be:

• (100 units x $10) + (100 units x $12) = $2200
• $2200 / 200 units = $11 per unit
• COGS for 150 units = 150 units x $11 = $1650

WAC is relatively simple to calculate and apply, and it smooths out price fluctuations. However, it may not be as accurate as FIFO or LIFO in reflecting the actual flow of goods for some businesses.

How does inventory impact balance sheets and income statements?

Inventory plays a significant role in your company's financial statements, impacting both the balance sheet and the income statement.

Inventory is always considered a current asset on your balance sheet. The value of inventory reported depends on the chosen valuation method (LIFO, FIFO, or WAC). Accurate inventory valuation is helpful for presenting a true and fair view of a company's assets.

Inventory appears on an income statement through the COGS— a significant expense that directly impacts a company's gross profit and net income. Accurate inventory accounting ensures that COGS is calculated correctly, leading to accurate profit reporting.

Inventory turnover ratio 

The inventory turnover ratio is a key performance indicator (KPI) that measures how efficiently your company is managing its inventory. It indicates how quickly inventory is sold and replenished, and uses the following formula::

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

And here's how to calculate average inventory:

Beginning Inventory + Ending Inventory) / 2

A higher inventory turnover ratio generally indicates better inventory management efficiency. It suggests that your company is selling its inventory quickly and not holding onto excess stock. This can lead to improved cash flow, reduced storage costs, and lower risk of obsolescence.

Impact on profitability 

Effective inventory management and accurate accounting directly impact a company's profitability. Optimizing inventory levels, minimizing holding costs, and ensuring accurate COGS calculations will help your business improve its gross profit and overall financial performance.

Benefits of inventory accounting

Good inventory accounting practices provide numerous benefits that contribute to your business's financial health, operational efficiency, and overall success. Here are some of the key advantages:

1. Accurate financial reporting

Proper inventory accounting ensures that inventory is accurately valued and reported on financial statements. This leads to reliable financial data that can be used for internal decision-making, securing financing, and meeting regulatory requirements. 

2. Better cost control

Inventory accounting helps businesses track and control inventory costs, including purchasing costs, holding costs, and potential losses due to obsolescence or spoilage. This allows businesses to identify areas for cost reduction and improve profitability.

3. Reduced waste

Effective inventory management minimizes waste by optimizing stock levels and reducing the risk of overstocking or obsolescence. This leads to more efficient resource use and lower inventory holding costs. 

4. Increased efficiency

Streamlining inventory tracking and management processes will improve your overall operational efficiency. This can lead to faster order fulfillment, reduced lead times, and improved customer satisfaction. 

5. Enhanced profitability

Ultimately, good inventory accounting practices contribute to increased profitability by optimizing inventory levels, minimizing costs, and improving efficiency. This leads to better financial performance and a stronger competitive position. Effectively managing your inventory will help you gain a significant advantage in the marketplace and achieve sustainable growth.

Streamline your accounting and save time

Implementing robust inventory accounting practices will allow your business to better under its inventory costs, optimize stock levels, and make informed decisions that drive profitability.

Ready to take your inventory management to the next level? QuickBooks Online offers powerful tools to automate inventory tracking, simplify valuation, and generate insightful reports. With QuickBooks Online, you can gain real-time visibility into your inventory, streamline your accounting workflow, and free up valuable time to focus on growing your business.