Companies track changes or additions to inventory in one of two ways: a periodic inventory method or a perpetual inventory method. You need to decide which method is best and most cost-effective for your business.

For the periodic inventory method, you need to decide how frequently you want to do a physical count of your inventory. Assume that Lisa’s Candle Shop follows a monthly periodic inventory method. Each month she starts calculations using the beginning inventory amount, which is the ending inventory amount for the prior period. (A new business would have a beginning inventory amount of $0 in the first month.) She then adds any purchases made during the month to that number and gets a total of goods that were available for sale. At the end of the month she physically counts what is left in inventory and subtracts that amount. The remaining number is the number of items sold. The calculation looks like this.

If the items sold number does not match the actual number of sales, then you know there is a problem. There could be misplaced items, items that were damaged and discarded, or items that were stolen. Either way, the cost of goods sold is calculated using the items-sold number. Even if the items were lost or stolen, they still impact the cost of goods you sell.

You certainly want to track any differences between the items-sold number and the actual number of sales for several reasons. You need to know what is causing the differences because every item you don’t sell negatively impacts your profit. You may be able to write off losses due to theft or damage, but you need to document those losses.

A perpetual inventory method is calculated based on actual transactions. You must be using a computer to be able to track things this precisely. Many major retailers link their cash register sales to their inventory control system. That’s why you sometimes go to a store and find a cashier can’t even record sales when the system is down. You may even see expensive cash registers sitting in the check-out area while cashiers are writing down every transaction for later input. You also might get quite frustrated when a cashier can’t input an item because he or she can’t locate the proper inventory number on the item you want to buy. Yup, they do call this progress.

Tracking the number of items sold is just one part of the equation. You also have to track the cost of each item. You can track costs in five ways: last in, first out (LIFO); first in, first out (FIFO); average costing; specific identification; and lower of cost or market (LCM ).

Companies that sell big-ticket items, such as cars or computers, often use the specific identification system. Frequently the way the item is built can greatly impact the price charged. For example, a car’s price can vary greatly depending on how many extras you want, such as stereo system, automatic locks and windows, automatic or manual transmission, and so on. Computers are priced by the extras as well. For example, price can vary greatly depending on storage capacity, processing speed, software upgrades, and drives. Each item is assigned an inventory identification number, and when sold, the sale is tracked by that number.

Companies whose inventory can face rapid price changes use the lower of cost or market system. For example, companies dealing in precious metals, commodities, or publicly traded securities commonly use this method.

For the purposes of this book, we will delve into the three most common inventory systems for small businesses: FIFO, LIFO, and average costing. You can choose any of the three. Before getting into the specifics of how these systems work, you first need to understand their impact on your bottom line.

The FIFO system assumes your oldest goods are sold first. This order can be very important if you are selling goods that spoil quickly or become obsolete. If prices go up, the FIFO method gives you a lower cost of goods sold because you are using the costs associated with older, cheaper products. This system makes your bottom line look better, but it also increases your tax bill because you have higher income.

LIFO assumes your newest inventory is sold first. If you are selling items that don’t spoil or become obsolete, this system will work. When prices rise, the higher-priced goods are sold first, leaving lower-priced goods in inventory. This system increases the costs of goods sold and decreases net income, which means a lower tax liability.

Average costing gives you the best picture of inventory cost trends rather than the actual ups and downs of prices. This method can level out the peaks and valleys of your inventory costs through the year. If you are selling a product that has many ups and downs through the year, this system might be your best choice.

Let’s practice using these three methods so you can see the impact of each one. Assume Lisa’s Candle Shop purchased candlesticks three times during the month of February. On February 1, Lisa bought 100 candlesticks for $10, which was the same amount she paid in January. On February 15, Lisa bought 100 candlesticks for $15. Realizing her supplier had dramatically increased the cost of candlesticks, Lisa found a new supplier. On February 26, Lisa bought 100 candlesticks for $12.50.

As this example illustrates, knowing your purchase costs and being able to quickly calculate their impact on your cost of goods sold is important. The accounting process collects critical information, but you must ensure that that information is shared quickly and with the right people in your business in order to be successful.

To practice the inventory-costing methods, let’s calculate the cost of goods sold using each method. First, you need to know what you have on hand. Assume Lisa’s Candle Shop has a beginning inventory of 50 candlesticks at $10 each for a value of $500. As described in the last section, Lisa also made several candlestick purchases in February at different prices.

At the close of business on February 28, Lisa’s employees did a physical count of all inventory to provide information for February’s inventory calculation.

You use these numbers to calculate the cost of goods sold. Your result differs depending on which inventory system you use (LIFO, FIFO, or average costing). The following table shows the results of these calculations using the data from Lisa’s Candle Shop.

Each of these inventory calculations results in a different number. FIFO has the highest value in its ending inventory, and LIFO has the lowest value. In all three cases, we started with the same beginning inventory: 50 units at $10. The differences occurred when we calculated which units were sold.

The average costing system is easiest. To use it, you first need to calculate the average cost of each item:

We know 260 units were sold at an average price of $12.143, which equals $3,157.18. The ending inventory of 90 units is $1,092.87. (We rounded these numbers so we wouldn’t have to track cents.)

So if you were using the average costing system, you would need to adjust the Inventory account on the balance sheet to show the change in the value of the inventory, which you calculate by subtracting the beginning inventory value ($500 in this case) from the ending inventory value ($1,093 in this case). The entry would look something like the following.

Note that the Inventory account is debited to show the increase in the value of ending inventory for February, which becomes the beginning inventory number for March. The amount in the Purchase account is also decreased to reflect the inventory that is still on hand. This adjustment lowers the Cost of Goods Sold account amount on the P&L statement, which now reflects the actual purchase costs for the goods sold that month. Lisa made purchases that totaled $3,750 plus had $500 in beginning inventory. As a result of adjusting for the ending inventory, the Purchase account now has a balance of $3,157 ($3,750 minus $593), which matches the cost of goods calculation. The Inventory account increases from $500 to $1,093 ($500 plus $593), which matches the ending inventory number.

When we calculated FIFO, we assumed that the first items sold were the 150 candlesticks at $10, which included the candlesticks in beginning inventory plus the ones purchased on February 1. Next to be sold were the 100 candlesticks at $15, which were purchased on February 15. Finally, the last 10 sold were bought for $12.50 on February 26. The remaining 90 candlesticks cost $12.50 each, for an ending inventory value of $1,125. The adjusting entry for FIFO would look like the following.

When we calculated LIFO, we assumed the first items sold were the 100 candlesticks at $12.50, next were the 100 candlesticks at $15, and finally the 60 candlesticks at $10. You’re probably thinking, “But we didn’t even have the candlesticks bought for $12.50 until the end of the month!” That’s true, but if you’re using LIFO, you calculate the value using the inventory bought in that period, whether you are physically counting inventory monthly, yearly, or for some other time period that suits your business. The inventory costs are based on the prices you paid for inventory during the period involved. You don’t worry about the exact dates purchased within a given period. In order to match monthly costs with monthly sales, you need to calculate the cost of goods sold and inventory value monthly.

You may remember setting up an overall Inventory account and three subaccounts to track candlesticks, scented candles, and unscented candles separately. In this case, Lisa would need to do a similar calculation for each of the inventory accounts.