The value of your company’s inventory on hand can be calculated a few different ways: LIFO, FIFO or Average Cost, to name a few.
“LIFO” is the acronym for “Last-in-first-out” which means that the latest cost for an item is what is used when calculating the cost of a sale (Cost of Goods Sold). So if you bought an item a number of times over a period of months and the last price you paid for it was $5.50, then that is the cost used when figuring out your profit margin on the sale of the item. If you sold the item for $10.75 then your profit would be $5.25. You may have items on the shelf that were purchased for $5.10, but that doesn’t matter in the LIFO valuation method. When you run a current Inventory Quantity on Hand report and see the total valuation of all you have in stock, the amount equals the quantities multiplied by their last purchase cost.
“FIFO” is the acronym for “First-in-first-out” which means that if you bought an item in April for $4.00, in May for $3.80, and in June for $4.05, the system would assume that you are selling the oldest item on the shelf first and that the cost would be $4.00. Ideally, when using this method, you would be pulling from the oldest lot to sell first before selling the ones you bought more recently.
The Average Cost valuation method is what QuickBooks uses to compute the value of your inventory (unless you choose FIFO in QuickBooks Online or in the Advanced Inventory add-on to Enterprise Solutions). Simply put, average cost is just that – an average of all the prices you paid for an item over time. So if you bought an item for $3.00 in March, $3.25 in April, and $3.50 in May, the average cost would be $3.25. QuickBooks would take the number of items you have on hand for this particular SKU and multiply it by the average cost ($3.25) to get the value of inventory on hand.
When you set up Inventory Items in QuickBooks, you must specify an Inventory Asset account and a Cost of Goods Sold Account. When you buy inventory the cost is posted to the Inventory Asset account. When the item is sold, in the background, QuickBooks pulls the cost of the product out of the Inventory Asset account and posts that amount to the Cost of Goods Sold account. In other words, the cost of inventory items is not reported on your Profit & Loss Statement until you sell them.
QuickBooks does not handle negative quantities on hand very well for the following reason: if the average cost is the total paid for the items (say $1000) divided by the quantity on hand (say 500) then calculating the average cost for a quantity on hand of say ( –) 50 is a problem because any value ($) divided by a negative number gives QuickBooks an average cost of a negative number. Many times we sell items we don’t have in stock because we have not put in the bill or packing slip before a customer wants to buy the item. When this happens, QuickBooks tries to go back in time when you put in the bill to rectify the cost posted to your Profit & Loss at the sale, but may have difficulty doing so.
The result can be that the Inventory Valuation Report has a total inventory cost value that does not match the Balance Sheet Inventory Asset account. Here’s the best solution:
1) Do a physical inventory (cycle counts through the year are a great way to stay on top of this).
2) Fix the quantities on hand FIRST with Quantity Adjustments (Items/Activities/Adjust Quantity on Hand).
3) Then check your Inventory Valuation Report for any item that has a total cost value that seems incorrect. In other words, you have 50 items on hand for a SKU and the report says the total value of these items is $4,000 when it should be $350.
4) Fix the values of your items in Items/Activities/Adjust Quantity on Hand – switch the top option from “Quantity” to “Value”. The value you enter is the sum of the quantity x average cost. You must enter the full sum and let QuickBooks divide it by the quantity on hand to get the average cost you see on your Item list detail.
5) Once your Inventory Valuation Report reflects the correct quantity and value, then use that figure as the correct value for your Inventory Asset account on your Balance Sheet. You may post an adjusting journal entry to increase (debit) or decrease (credit) your Inventory Asset account. The offset account would be either Cost of Goods Sold or it could be an Inventory Adjustment Account that you create as a COGS or Expense account on your Profit & Loss so you can easily find your inventory adjustment entries in future.
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