Small business inventory accounting is how you record, track, and value the goods you hold for sale. The numbers matter because the value of your inventory feeds directly into your cost of goods sold, your profit, and your balance sheet. When inventory is tracked well, you know what you own, what you have sold, and what your products really cost.
This guide explains what counts as inventory, how to track and value it, and how to calculate cost of goods sold and inventory turnover. It includes worked examples with sample numbers.
What Is Small Business Inventory Accounting?
Small business inventory accounting is the process of tracking the cost of items you buy or make to sell. At the start and end of each tax year, you value your inventory, and those values are used to figure your cost of goods sold. On your financial statements, inventory appears as a current asset, which you can see on your balance sheet.
What Counts as Inventory
According to the IRS, inventory includes:
- Merchandise or stock in trade
- Raw materials
- Work in process
- Finished products
- Supplies that physically become part of the item you intend to sell
Purchased merchandise counts once title has passed to you, even if it is still in transit. Goods you own that are out on consignment also count.
What Does Not Count
The IRS says not to include:
- Goods you have sold, once title has passed to the buyer
- Goods consigned to you by someone else
- Goods ordered for future delivery if you do not yet have title
- Land, buildings, and equipment used in your business
- Accounts receivable and similar assets
- Supplies that do not physically become part of the item you sell
Why Small Business Inventory Accounting Matters
Inventory touches several parts of your business:
- Profit: Ending inventory affects cost of goods sold, so errors in inventory flow straight into your profit. See your profit and loss statement for where cost of goods sold appears.
- Balance sheet accuracy: Inventory is one of your assets, so its value changes your reported financial position.
- Taxes: When producing, buying, or selling merchandise is an income-producing factor, the IRS generally requires you to account for inventory, with some exceptions for small businesses.
- Buying decisions: Knowing what you have on hand helps you avoid ordering too much or too little.
How to Track Inventory: Perpetual vs. Periodic
Perpetual Inventory
A perpetual system updates your inventory records each time you buy, produce, or sell goods. The IRS allows a perpetual or book inventory if it follows sound accounting practices. Inventory accounts are charged with the actual cost of goods purchased or produced and credited with the value of goods used, transferred, or sold.
Periodic Inventory
A periodic system relies on a physical count at the end of a period. You use the count to work out how much inventory you have left and how much you sold.
Count Your Inventory
Whichever system you use, the IRS requires you to take a physical inventory at reasonable intervals. If your records do not match the count, adjust the book amount so it agrees with the actual inventory. Our guide to small business bookkeeping explains how this fits into your regular routine.
How to Value Your Inventory
Start with Cost
For purchased merchandise, cost means the invoice price minus appropriate discounts, plus transportation or other charges you incur to acquire the goods.
Identify the Cost of Each Item
You need a method to match costs to the items in your inventory. The IRS lists these options:
- Specific identification: You match the actual cost to each item. This works when you can identify each item.
- FIFO (first-in, first-out): You assume the items you bought first are the first ones sold.
- LIFO (last-in, first-out): You assume the items you bought last are the first ones sold.
Use FIFO or LIFO if you cannot match specific items to their costs, or if identical goods are mixed together. The IRS notes that the rules for LIFO are very complex, so talk with a tax professional before choosing it.
Lower of Cost or Market
This method compares the market value of each item with its cost and uses the lower of the two. You must value each item separately rather than the whole inventory at once.
Goods You Cannot Sell Normally
Items that are damaged, out of style, or otherwise unsellable at normal prices are valued at their bona fide selling price minus the direct cost of disposing of them.
Stay Consistent
The IRS says your method must conform to generally accepted accounting principles for similar businesses and clearly reflect income. You also need to apply your inventory practices consistently from year to year.
FIFO vs. LIFO Example (Hypothetical)
Suppose a business buys inventory twice, and then sells 12 units. These numbers are hypothetical.
- January purchase: 10 units at $10 each
- February purchase: 10 units at $12 each
- Units sold: 12
FIFO
- Cost of goods sold: (10 × $10) + (2 × $12) = $124
- Ending inventory: 8 units × $12 = $96
LIFO
- Cost of goods sold: (10 × $12) + (2 × $10) = $140
- Ending inventory: 8 units × $10 = $80
Both methods account for the same $220 of goods. However, when prices are rising, LIFO produces a larger cost of goods sold and a lower ending inventory, while FIFO produces the opposite. When prices are falling, the results reverse.
How to Calculate Cost of Goods Sold
A common way to calculate cost of goods sold is:
Cost of goods sold = Beginning inventory + Purchases − Ending inventory
For example, if beginning inventory is $20,000, purchases are $50,000, and ending inventory is $18,000:
$20,000 + $50,000 − $18,000 = $52,000
Inventory Turnover
Inventory turnover shows how quickly your inventory moves through the business. The formula is:
Inventory turnover = Cost of goods sold ÷ Average inventory
Average inventory is estimated by adding beginning and ending inventory and dividing by 2. Using the figures above:
- Average inventory: ($20,000 + $18,000) ÷ 2 = $19,000
- Inventory turnover: $52,000 ÷ $19,000 = about 2.7 times per year
To estimate how many days inventory sits before it sells, divide 365 by the turnover. Here, 365 ÷ 2.7 is roughly 133 days. An acceptable turnover ratio depends on the line of business, so compare your result with your own past results and with similar businesses. The OpenStax Introduction to Business chapter on analyzing financial statements explains this ratio further.
Inventory and Taxes
Under IRS rules, if you must account for inventory, you generally use an accrual method for purchases and sales. However, small business taxpayers, which are businesses under an inflation-adjusted gross receipts limit, can choose not to keep an inventory. They must still use a method of accounting for inventory that clearly reflects income. They can treat inventory as non-incidental materials and supplies, or follow the treatment in their financial statements or books.
If you want to change your method of accounting for inventory, you must file Form 3115. For the full rules, see IRS Publication 538. To learn how accrual and cash methods differ, read our guide to cash vs accrual accounting for small business. This article is general information, not tax advice, so check with a tax professional about your situation.
Best Practices for Small Business Inventory Accounting
- Count regularly. Take a physical inventory at reasonable intervals and adjust your records to match.
- Pick one valuation method and stay consistent. Changing methods can require IRS approval.
- Include acquisition costs. Discounts and transportation charges affect the cost of purchased goods.
- Value unsellable goods separately. Damaged or outdated items should not be carried at full cost.
- Review turnover. A low turnover can signal that goods are sitting too long.
- Track supplier bills. Our guide to accounts payable for small business explains how.
Frequently Asked Questions
What is inventory accounting?
It is the process of recording, tracking, and valuing the goods you hold for sale so you can figure your cost of goods sold and report your assets.
What is the difference between FIFO and LIFO?
FIFO assumes the oldest purchased items are sold first. LIFO assumes the most recently purchased items are sold first. They can give different cost of goods sold and ending inventory figures.
What is the difference between perpetual and periodic inventory?
A perpetual system updates records with every purchase and sale. A periodic system relies on physical counts at the end of a period.
How do you calculate cost of goods sold?
Add purchases to beginning inventory, then subtract ending inventory.
How often should I count inventory?
The IRS says to take a physical inventory at reasonable intervals and adjust your records to match.
Does a service business need inventory accounting?
Generally, inventory accounting applies when producing, buying, or selling merchandise is an income-producing factor in your business.
Conclusion
Small business inventory accounting helps you understand what you own, what you have sold, and what your products cost. By tracking inventory consistently, valuing it with a clear method, and reviewing your cost of goods sold and turnover, you can keep your records accurate and your decisions better informed. Review the IRS rules for your situation and talk with a tax professional before you choose or change a method.