Handling Inventory for Your Ecommerce Business

Inventory. This is one of the two top issues for online retailers (the second being sales tax). 

No doubt that inventory is the lifeblood of your ecommerce business. Without inventory, you've got no sales.

Inventory Cycle

Before we go any further, let's talk about the inventory cycle and how all of this is supposed to work. I feel like this topic can seem overly complicated, but it doesn't need to be. Here's how it works both operationally and for accounting purposes.

Inventory Cycle

#1 - Order Product

You need something to sell. So you search around and find a good supplier. Chances are high that your supplier doesn't have exactly what you want on hand; perhaps it needs to be customized or built from scratch. In any case, they're probably going to want some kind of a down payment when you place your order.

You will place your order using what's called a "Purchase Order." This is the document that itemizes the terms of the arrangement, including exactly what you're buying, how much you're paying, and what the terms of delivery are. If you are working with an overseas supplier (and even if you're not), you will likely need to provide some form of a downpayment for them to begin working on fulfillment of your order. The product that you're buying does NOT yet belong to you because they haven't delivered on their part of the arrangement, so the monies you've paid is NOT considered inventory. It's considered "prepaid inventory" (or "vendor deposit" or simply just "deposit").

This becomes a current asset on your balance sheet (again, called "prepaid inventory"), and it stays there until your supplier fulfills your order.

#2 - Order Ships

Domestic delivery may be as quick as overnight or may be on a slow boat from China. 

At this stage, you need a clear understanding of when title passes from the supplier to you. Not only do you need to know who legally owns the property for liability concerns (i.e., who is responsible if the cargo gets harmed during transit), but you also need to know for properly recording the transaction in your books.

FOB Shipping Point (Freight on Board Shipping Point or FOB Origin) means that once the inventory is in transit, the title of the inventory is yours - whether you've actually received it or not.

So if your inventory has been shipped to you from San Francisco, you're in Delaware, and the product is in the middle of Montana, you own it. And this is called "Inventory in Transit."

If you provided a deposit on the product, you should apply it according to the terms of the agreement. For example, if you made a 20% downpayment on $100,000 of product, you'll move the "Prepaid Inventory" over to "Inventory in Transit," and you'll owe them another $80,000 on the total $100,000 now showing as Inventory in Transit on your balance sheet.

FOB Destination means that the supplier holds onto title for the product throughout its transit to you. The title doesn't pass to you until you actually receive the product into your own warehouse in Delaware. It doesn't matter to you when the order ships as it has no impact on your accounting file at this stage.

Please check out my YouTube video for more information and about how to easily record your inventory activities in Xero.

#3 - Order Received

When you receive your order, the shipping method no longer matters. It's yours, all yours, and you need to include it as "Inventory" on your books. 

The supplier will generally provide you with an invoice at this stage of the game (it's a sales invoice for them but it's a purchases invoice (a bill) for you). Many people use the date of the invoice to show the date that they include the product as part of their inventory, but again, you should follow the dates that determine when legal title was transferred.

FOB Shipping Point - your inventory is sitting in Inventory in Transit. It's no longer in transit, so move it all to Inventory. Done.

FOB Destination - unlike FOB Shipping Point, the transfer of title just now happened, so it's now time to record that action in your books. Don't forget to apply any deposits you made when you placed the order. Again, check out the video above if you have any questions about how to do this. (Note: although the video talks about Xero, the theory is exactly the same for QuickBooks Online. They just don't have the cool Prepayments feature that Xero does.) 

#4 - Product Stored

There is nothing particularly special about storing your inventory from an accounting perspective, BUT if you're an Amazon seller, you want to keep an eye out for long-term storage fees. If you keep your product there too long, Amazon's fees may skyrocket. Keep an eye out to save yourself some serious bank.

#5 - Product Sold

Selling your product is the final stage of the inventory cycle, and this stage is critical to your accounting. This is the point when the product you purchased moves from your balance sheet (an asset you own) to an expense, "Cost of Goods Sold."
Unfortunately, this is the most complex part of the process. You'll need to keep track of all your related costs so that when you make a sale (or a hundred or thousand sales), you'll know how to make your costs line up with those sales to arrive at an accurate cost of goods sold number. 

What About Other Costs?

You may be wondering what to do with other costs that are associated with the product... shipping, duty fees, labor (if you're actually manufacturing the product yourself), etc. GAAP (Generally Accepted Accounting Principles) dictate that these costs should be included both in the calculation of your inventory and in the ultimate expensing as cost of goods sold.
I realize that this blog post may make the process seem fairly simple, but believe me, it causes many sellers to pull their hair out. The greatest challenge is when you're working with thousands of different SKUs with tons of different costs. If you want any hope at being able to get accurate cost of goods sold numbers, and if you want to scale your business for growth, you're going to need to use a cloud inventory system. Check out this video about why you should be looking into using one of these.
If you have more questions and/or you feel like you're too small to warrant a cloud inventory system, you may want to check out one of our courses, Accounting for Amazon or Accounting for Shopify, which includes details about how to accurately track your inventory costs manually.
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