Small businesses use inventory systems to order, track, and account for products sold. Periodic inventory is best for similar merchandise, while perpetual inventory is better for one-off or valuable items. Valuation methods include FIFO, LIFO, and weighted average, with FIFO resulting in higher net income and tax liability.
An inventory system is the internal method a business uses to order, track, and account for the products it sells to consumers. An inventory system for small businesses will mirror the process of a larger business, albeit in a less intensive environment given the difference in size between businesses. Two types of inventory systems are common in the business environment: periodic and perpetual. These are accounting-based systems, although a company will often build its inventory practices around these systems.
Which small business inventory system is best for a particular business often depends on the type of merchandise a business sells. For example, small businesses that sell similar merchandise or large groups of items may benefit most from a periodic inventory system, which is only updated once a month or quarterly. This is advantageous because the small business starts each month with an opening inventory number and updates it at the end of the accounting period. This eliminates the need to spend time counting items that are not easy to separate or involve a time-consuming process that takes away from cash-generating activities.
The perpetual inventory system is much more involved; In this system, a company will update its ledger after each purchase, sale, or adjustment to the inventory account. This small business inventory system works well for businesses with one-off items or extremely valuable inventory products. While more time consuming, it provides small businesses with more accuracy and the ability to accurately order inventory without having too many products on hand.
Inventory valuation is also an important feature of a small business inventory system. The valuation determines the cost on the company’s inventory account and the cost of goods sold for each accounting period. Three methods are most common in business: first in, first out (FIFO); last in, first out (LIFO); and calculating the weighted average cost. FIFO requires a company to sell the oldest products listed first in its ledger inventory account. This will result in the higher cost remaining on the inventory account and the lower cost of goods sold, resulting in a higher net income reported on the income statement. LIFO is the opposite of FIFO; therefore, cost of goods sold is higher and inventory on hand is lower than FIFO. The weighted average method calculates a new cost for each inventory item after purchases and account adjustments.
Selecting the valuation method for a small business inventory system will depend on how the business wants to report net income. The general theory is that FIFO reports a higher net income, resulting in a higher tax liability for small businesses. This can create a difficult cash flow situation if the company needs to pay taxes to the national or local government.
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