Inventory or stock management is a crucial area that can significantly impact your business’s profitability.
It pays to stay on top of your inventory costing for many reasons. You need to know precise stock levels and understand the shelf life and rotation. How much stock you have directly affects your profit or loss at the end of the financial year. You need to know what you hold and its value to make informed business decisions. And unfortunately, stock is an easy target for theft or fraud if you’re not managing it properly.
Correcting your inventory costing means you’ll always have accurate financial reports showing the cost of sales (COS), the value of the stock you are holding ready for sale, and the value of the inventory account once the stock is sold.
There are two ways of recording inventory value – perpetual or periodic. In this article, we’re looking at the perpetual system. Check our previous blog if you’d like to know more about periodic inventory management.
Perpetual Inventory Method
A perpetual system is updated in your financial accounts every time you purchase, sell or adjust stock. This system relies on every stock transaction being recorded accurately within your accounting software (and point of sale system if you use one).
The perpetual method is more advanced than the periodic method, but when done correctly, it gives you an accurate real-time value of the stock on hand and the cost of goods sold in financial reports.
Every time you purchase stock, the value of your inventory asset account on hand increases. When you sell the stock, the value of inventory on hand (the same asset account) reduces. At the same time, when you sell stock, the value of the cost of sales expense account increases. The value also changes if you need to make an adjustment for damaged or obsolete stock.
Using the perpetual method means that income from stock sales and related cost of sales expenses match in a given accounting period. You can see sales and cost of sales on your profit and loss report and the value of inventory on hand on your balance sheet.
Although the perpetual system is generally more accurate than the periodic system, a physical stocktake should be performed occasionally to assess whether the software used to track purchases and sales is accurate. Errors or theft can occur, and occasional physical comparisons of stock on hand to software count are worthwhile.
How to Value the Stock
There are different accounting methods for stock; some are more appropriate for different types of businesses.
You’ll need advice on the best system for your business and industry. For example, you can use the first-in-first-out method, an average cost per item, specific pricing per item, or a last-in-first-out method.
Whichever valuation method is chosen, stick to it! The method chosen affects the inventory value, so it’s essential to be consistent for the accuracy of your reports.
Whatever valuation method you use, the perpetual inventory equation looks like this:
Ending inventory value = beginning value + purchases – sales +/- stock adjustments
Ending inventory value refers to the financial value of the stock on hand at any given point in time.
Maintaining the System
We’ve often seen businesses with a completely unrealistic stock value listed in their accounts. This could be because a system was started but not maintained, the software was not set up correctly, or poor bookkeeping resulted in an incorrect value of the stock on hand and, therefore, incorrect profit (or loss).
There are sophisticated add-on solutions that integrate with Xero, making stock management more efficient and allowing you to include associated costs for each item, such as freight, storage, or sales commissions. These systems can also track batch numbers, expiry dates, delivery information and customised information such as serial numbers or barcodes.
Good stock management directly impacts the financial performance of your business. Talk to us if you’re considering introducing stock into your business or upgrading your management systems with a Xero add-on. On The Money Melbourne Bookkeepers are all Xero Certified Advisors who know the software in detail, and we can help assess what kinds of systems and accounting are best for you. If you’re already using Xero, check out their range of inventory add-on solutions.
If you’re not yet ready for an inventory add-on but are planning for the future, be sure to choose an app that integrates with Xero for effective and efficient inventory management and reporting.
Benefits of a Perpetual Inventory System
- More accurate and efficient management, tracking, ordering and selling.
- Instant view of purchase price and margins.
- Easier to track across multiple locations.
- Real-time view of stock available for sale.
- Better for more complex inventory systems or large numbers of items.
- Depending on the software, you can see items ordered and delivered.
- More accurate forecasting of demand.
Stocktakes should still be done at least annually to verify the physical stock on hand and its value in the financial accounts.
Setting up a perpetual inventory system takes time initially, as much detail is required. However, once set up correctly, the maintenance of the system should be straightforward with regular attention.
Xero can track up to 4,000 inventory items in the perpetual system. Xero can track items purchased and sold against cost of goods sold, income and stock on hand general ledger accounts.
If you have a large and complex inventory, you record the sale of goods before they are purchased (i.e. you allow a ‘negative’ inventory value), you assemble goods from components, or you require purchase orders and delivery note receipts, then you’ll need an add-on solution. Xero alone will not perform these inventory management tasks.
You’ll also need a more sophisticated app to track overseas purchases when landed costs and freight are paid for separately.
Check out the Xero Guide to Inventory for more information.
Get Your Stock management Sorted with On The Money Xero Certified Advisors
If you’d like an appraisal or upgrade of your current stock management system, talk to us at On The Money Melbourne Bookkeepers, as we can assess what kinds of systems and accounting are best for you. We can also review the relevant accounts in your financial statements to determine the COS percentages, other inventory-related expenses and margins.
Let us assist in organising your stock management systems, and we’ll also help you understand how accurate inventory costing directly impacts your profitability.