As an ecommerce business, your largest asset is likely your inventory (unless you use a drop-shipping model). Understanding your inventory is key to the success of your business, and it starts with getting the fundamentals right before you worry about accounting systems or valuation methods.
Sound inventory basics ensure your business knows how much stock you have on hand, according to SKU, and more importantly, how much of each SKU you need to have on hand. You can also spot sales trends within your products and assess margins on a SKU basis. Finally, inventory is an item on your balance sheet and needs to be reflected accurately, especially if you ever plan on selling your business.
What counts as inventory (and how it differs for manufacturers)
The products that you have on hand but have yet to sell are your inventory. For most ecommerce businesses, this is merchandise you've purchased from a wholesaler or distributor, and you keep it in stock until someone purchases it on your website. Keep in mind that although you may get inventory reports from your suppliers and list those quantities on your site, this is not part of the inventory you show on your balance sheet. You must actually take ownership of the product before it's considered inventory. For ecommerce companies that use a drop-shipping model, you technically have no inventory, because you never actually take ownership of the product.
If you produce your own goods that you sell online, inventory accounting gets a bit more complicated. As a manufacturer, your inventory moves through phases:
- Raw materials: These are the basic parts or components of your product that have yet to be assembled into a final product. An example would be a swath of leather, which you'll ultimately cut and produce belts out of.
- Works in progress: These are semi-finished products. From the example above, these would be strips of leather that you've cut from a sheet and punched holes in but haven’t yet attached buckles.
- Finished goods: These are products that are ready to sell via your online store. Using the belt example again, these are actual belts ready for a customer to wear.
Do you need inventory software?
Tracking inventory via spreadsheets works fine if you're accounting for inventory periodically. At some point, though, you may want inventory software, and our only warning is to choose carefully. A poor fit can create more headaches than it solves, and integrating inventory software with your accounting software is worth doing only with a consultant or accountant who really knows what they're doing.
We did a video on 5 things to look for when choosing an inventory management software that will be the right fit for your business.
We’ve worked closely with Finale Inventory and Katana. Both are great programs, though you will want to check that they integrate with your sales channels, accounting software, fulfillment services, and 3PL services. See how inventory management software can fuel your business success.
Why a physical inventory audit still matters
The inventory audit involves physically counting the inventory you have on hand. As tedious as it sounds, this is very important for your inventory accounting. We suggest performing an audit at least once a year, but quarterly is best. This ensures your systems and balance sheet accurately reflect your true inventory on hand. Based on the audit, you may need to update your balance sheet accordingly.
You might be amazed at how often you have inventory discrepancies. You can read more about the main causes of inventory discrepancies so that you can make improvements in the future.
Once you have these basics down, two decisions shape how well your books actually reflect your business: how you structure your accounting system, covered in Inventory Accounting Systems and Methods: The 3 Key Decisions for Ecommerce Sellers, and how you value what's on the shelf, covered in FIFO vs. LIFO vs. Average Cost: How Each Inventory Costing Method Changes Your Numbers.
Frequently asked questions
What counts as inventory for my business?
Anything you've taken ownership of and hold for resale. Reports from suppliers about their stock don't count until you actually own the product and drop-shipped goods never count since you never take ownership at all.
What are the three phases of inventory for manufacturers?
Raw materials (unassembled components), works in progress (partially assembled products), and finished goods (ready to sell). Each phase needs to be tracked separately as it moves through production.
Does drop-shipping mean I don't have inventory to account for?
Correct. Since you never take ownership of the product in a drop-shipping model, you technically have no inventory to record on your balance sheet.
Do I need inventory management software?
Not necessarily. Spreadsheets work fine if you're accounting for inventory periodically. If you do move to software, choose carefully based on your specific needs, and get help from a consultant or accountant before integrating it with your accounting system.
How often should I do a physical inventory audit?
At least once a year, though quarterly is better. A physical count is the only way to confirm your books actually reflect what you have on hand, and discrepancies are more common than most business owners expect.
Where do I go next to set up my accounting system and choose a valuation method?
Once your basics are solid, Inventory Accounting Systems and Methods walks through the three key decisions, and FIFO vs. LIFO vs. Average Cost breaks down valuation with a worked example.
Get your inventory fundamentals right
Getting inventory basics right is more than bookkeeping, it directly shapes your margins, your business's valuation, and how well you can actually run your business day to day.
LedgerGurus specializes in ecommerce accounting and inventory, and we can help you build a process that actually holds up, whether you're doing it manually or through software.
