An inventory system is the internal method a company uses to order, control, and account for the products it sells to consumers. A small business inventory system will mirror a larger company’s process, albeit in a less-intense environment, given the difference in size between the companies. 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 company will often depend on the type of merchandise a company sells. For example, small businesses that sell similar goods or large groups of items may benefit more from a periodic inventory system, which only updates once a month or on a quarterly basis. This is advantageous because the small business will start each month with an opening inventory figure and update it at the end of the accounting period. This eliminates the need for time spent counting items that are not easy to separate or involve a time-consuming process that takes away from money-generating activities.
The perpetual inventory system is much more involved; under this system, a company will update its accounting ledger after every purchase, sale, or adjustment to the inventory account. This small business inventory system works well for companies with singular items or inventory products that are extremely valuable. While more time consuming, it provides more accuracy for the small business 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. Valuation determines the cost in the company’s inventory account and cost of goods sold account for each accounting period. Three methods are most common in business: first in, first out (FIFO); last in, first out (LIFO); and the weighted average cost calculation. FIFO requires the company to sell the oldest goods that are listed first in its accounting ledger inventory account. This will result in the highest cost remaining in the inventory account and lowest cost of goods sold, resulting in 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 adjustments are made to the account.
Selecting the valuation method for a small business inventory system will depend on how the company wants to report net income. The general theory is that FIFO reports higher net income, resulting in a higher tax liability for the small business. This can create a difficult cash flow situation if the company must pay taxes to the national or local government.