So the topic of inventory interests you. Great you have came to the right place. Today we will learn about the difference between the two main inventory systems.
The two main types of inventory accounting are:
Periodic Inventory System
Companies physically count the inventory on hand and update it only once a year. Due to this the inventory account will only show how much inventory cost at the end of the prior year. Companies who use the periodic inventory system will not be able to look at the general ledger and see how much inventory is on hand or how much cost of goods sold is.
Perpetual Inventory System
Companies who have a perpetual inventory system will continually update inventory kept on hand as it is bought or sold. They also update it when items are moved to a different location or are discarded. By keeping track of inventory and costs after each transaction made, whether it was a purchase for more inventory or a sale of the inventory to customers, the company will be able to look at the the general ledger to see how much inventory is on hand and how much cost of goods sold is. When customers by inventory items the company needs to make two journal entries to reflect this. The first journal entry will show the actual sale and the second one will be to update the inventory count.
Are you interested in learning about the different categories of inventory? Then you have came to the right place.
Inventory is divided into three different categories:
The first type of inventory are the raw materials. These are the products that have not gone into the production process yet. Raw materials are divided into two different types:
- Direct Materials
These are the materials that are in the final product and can easily be traced such as the fabric used to make a blanket.
- Indirect Materials
These are the materials that are used during the manufacturing process but are not easily traceable. Examples of indirect materials would be lightbulbs, any cleaning supplies, lubricants, and oil.
Work in Progress (WIP)
The second type of inventory is the work in progress inventory. These items are the products that have started to go through production or manufacturing process but have not yet made it all the way to the finished product. Costs that are considered to be work in progress inventory are the raw materials, labor and overhead costs.
The third and last type of inventory is finished goods. These are also referred to as merchandise. These are the goods that have finished the manufacturing process and are then sold to the supplier or customer directly.
Are you starting a business and are unsure of which inventory valuation method to use? Don’t worry, after reading the differences among the four different inventory valuation methods and the purpose for each, the decision will be easy.
1.First In First Out (FIFO)
The first inventory method is the first in first out method, or simply FIFO. In this method the inventory that comes in first is the inventory that goes out first. The current costs are reflected in this method. The most recent costs go to the ending inventory while the oldest costs go to cost of goods sold. This method is ideal for places like grocery stores and restaurants because they have perishable products. Other companies that would use this method are those who carry products that are subject to style changes, discontinuance or rapid technological changes.
2. Last In First Out (LIFO)
The next method is the last in first in out method, or simply LIFO. In this method the cost of goods sold is the price used first when selling products. Companies use this method to reduce profits and taxes. However, this method is not useful for finding the ending value of inventory because the newer products are the ones that sell first so the older ones could potentially become obsolete. LIFO is ideal for companies who accumulate inventory and maintain a base stock like a mining company does.
3. Weighted/Moving Average
The third method often used by companies with homogeneous goods is the weighted or moving average method. In this method you find the total cost of products that are in inventory. You then take this cost and divide it among the amount of products you have in inventory. Finally, you take the resulting amount and use it as the price for you next sale. An example would be a company who sells vehicle covers for boats, cars, and RV’s because they are homogenous goods that are sold at a high volume.
4. Specific Identification
The final inventory valuation method is the specific identification method. Inventory in this method will have serial numbers, stamped receipts or RFID tags for tracking and identification purposes. An example of a company who would use this method would be a car dealership because cars are a high cost product that have a low units sold volume.