There are three main types of inventory.
In micro businesses just starting out, they often just record purchases of raw materials, shipping or the actual cost of products as ‘purchases’ and claim the full costs as deductions.
Sam buys $1,000 of merchandise from the supplier. Sam records these in an expense category in their accounting software, showing $1,000 on the Profit and Loss statement. These are claimed in full as tax deductions that year. There is no ‘inventory’ on the Balance Sheet.
So, as you spend money buying things, you record expenses to the Purchases expense category. The full amount of the purchase cost is deducted, at the time the purchase is made.
But you haven’t sold everything you have on hand necessarily.
So… are you claiming a deduction for products that are still sitting in your shed or storage unit? And what about the value of that stock on hand? Is that accounted for anywhere?
This is not a huge issue, but as your business grows we want to make sure financial reports are as accurate and useful as possible. This means we want to properly record inventory. After all, the stock you are carrying (i.e. stock on hand) has a value, right?
Sam may get to the end of the year and still have $400 worth of stock left on hand. So, of the $1,000 purchase of stock, there is $400 left there for them to sell in the next financial year.
In accounting land, ‘inventory’ refers to the value of the stock you have on hand at a particular point in time. It includes the raw materials you have that you can use for manufacturing products. It is different to ‘purchases’, which are the cost of the things you have bought (to later sell).
Some businesses have no stock on hand and make everything ‘made to order’, but most businesses will keep some stock on hand, ready to sell. There are some benefits to this, including taking advantage of discounts and shipping through bulk buying!
Keeping track of your inventory (quantity of each product on hand) will allow you to be responsive to customer demands and manage supply. This way, you will know what your customers want, when you need to get/make more of it, and how many!
To account for this correctly, we need to start doing stock takes to double check exactly which items we have on hand at a moment in time, and of course we need to continue to track the purchases we make. You can do these as often as you like, but we recommend you do them annually at a minimum.
On 30 June, Sam writes a big list of the stock they can see on their shelves and in storage (or have listed on their website). They note the quantity on hand of each product as well as the cost* of each. This could all be noted in a spreadsheet.
Then do some math: Quantity x Cost* = Value
Repeat for every product type.
Then add up the total values.
This is the value of Inventory (closing balance).
Ready to do your stocktake?
Things can get a little trickier when you make the product you sell - like clothes or jewellery. We’ve noted some more info on that below.
*If you are an active client of ours and need a copy of our inventory stock take template please email us: [email protected]
There are a lot of ways to figure out the cost of each product and accountants love to make things overly complicated. I promise there’s a reason for this but when you are running a smaller business it can feel like overkill. So, let’s keep it simple shall we?
3 key ways to measure the cost:
You need to record inventory as the lower of cost, and net realisable value.
Net realisable value is technically the expected selling price minus the cost of completion, disposal, and transportation. To keep it simple, think of it as sale value. What can you sell it for?
So, if a product costs you $30 but its realisable value is $50, then in calculating your inventory balance you use $30 because it’s the lower amount. Whereas if it cost you $30 to buy it, but the product is now obsolete and no one wants it, the market value might be more like $15, so you have to record the inventory value as $15.
Instead of claiming a deduction for purchases you should really be claiming a deduction for the cost of the goods that have been sold within that financial year.
Opening Inventory Balance (which is technically the same as last year’s closing balance)
+ Purchases (made throughout the financial year)
(-) Closing Inventory Balance (which you figured out in the stocktake at 30 June)
= Cost of Goods Sold (this is the amount you actually end up including in the tax return)
This is a simple formula that allows you to figure out how much inventory you had to purchase to earn your revenue.
So, if Sam is just starting out, their formula might look like this -
$0 Opening (because we started with no stock at all)
+ $1,000 Purchases (made between 1 July to 30 June)
(-) $400 Closing Inventory Balance (which was calculated from the stock take on 30 June)
= $600 Cost of Goods Sold
Sam then has $400 Inventory on the Balance Sheet and $600 deduction in the Profit & Loss
Sam then buys $1,500 of product in the new year, and does a second stock take, calculating $300 worth of stock left. At the end of the next year, the formula might look like this…
$400 Opening (which was the closing inventory from last year)
+ $1,500 Purchases
(-) $300 Closing Stock
= $1,600 Cost of Goods Sold
Sam has $300 Inventory on the Balance Sheet, and a $1,600 deduction in the Profit and Loss.
What does this mean for you?
If you are doing your own bookkeeping, here are some tips:
Hot tip: While we love Xero, we don’t love its ‘products and services’ function for tracking your inventory. Check out the Xero app marketplace for a proper Inventory management software add-on that syncs info to Xero, and/or use the Inventory lists and stock management options inside of your sales platform (like Shopify).
Reach out to our team if you ever need a hand with your inventory!