How, when and why to track your inventory.
There a few key underlying mechanics when thinking about inventory. First of all, when you purchase goods that you are going to resell, they go into inventory, and then when you sell them, they become cost of goods sold. Let’s think about an electronics store, when you purchase TVs that you are going to sell. Let’s say that you buy 12 TVs: they go into inventory. Then when you sell the TVs, they are no longer inventory, they become cost of goods sold.
The second factor when you are calculating inventory is to recognize that prices don’t stay the same. So for example, you may purchase televisions for your electronics store today at $100 each, and then when you go to replenish your inventory, they could be $120 each. At the end of the month when you are trying to figure what your inventory balance is, and what your cost of goods are, you need to be able to understand how to value your inventory, what price you allocate to each television that you sold or didn’t sell. There are several ways that you can do that.
First of all we need to decide if we are going to do a perpetual inventory or a periodic inventory. A perpetual inventory just means that you constantly have a tally of what you have in inventory versus what goods have been sold – what’s been purchased, what’s been sold constantly being tracked. Really the best way to do that is with a POS system: a “point of sales” system, so that every time something is sold you know exactly what is sold.
More realistically, you will be doing a periodic inventory system, meaning at the end of the month, or maybe at the end of every week, you are taking a physical count of what you have in the storeroom. There are four ways to then calculate the value of your inventory. As I mentioned earlier, the prices have very likely changed, if you have bought several times throughout the course of a month, so you need to decide how you are going to allocate the value of your inventory to what you have. The four methods are FIFO, which is “first in first out”, LIFO (“last in first out”), weighted average, and specific cost.