The IRS and GAAP (Generally Accepted Accounting Principles) rules both state that you have the choice to either count your complete inventory on an annual basis once a year or maintain a perpetual (constantly counting) counting system. So, which method of tracking is generally best for a handmade business?
To find out, we'll see how each method works and then go through some pros and cons of each.
Periodic (Annual Physical Count) Systems
This system involves undertaking a complete count of your inventory at least once a year. You can do this via any method you use: some people like using a paper-based system, while others feel more comfortable with a spreadsheet approach. Once you have a complete count of all materials at your end of year, you'll then also need to calculate their average unit cost based on the purchase history. This means also keeping corresponding records of your material expenses - again this can be done either with a paper system, spreadsheet or a basic expense tracking system.
- This method is relatively easy if you have a very small inventory as you only need to set aside an hour or two at the end of the year to do your basic count (but don't forget to also count any materials tied up in your unsold stock!).
- If the purchase prices of your materials haven't varied, or if you haven't restocked very often through the year unit prices can often be fairly simple to calculate by hand.
- As a consequence of this method's simplicity, it is quite appropriate to use simple systems like paper books or spreadsheets to track and count.
- As you are not keeping records of inventory levels during the year, you'll need to constantly be "eye-balling" your stock levels to ensure that you don't run out of materials you need to produce your products. This in reality means several ad-hoc stocktakes through the year rather than the one, so you'll need to factor this time in.
- If you have a large inventory, once a year counts can be very time intensive and prone to error - especially if you are a solo entrepreneur trying to get orders out at the same time.
- If you purchase many lots of the same materials at different prices during the year, calculating your unit price can be time consuming and difficult.
- This system puts all the work at the end of the financial year when your figures are due: this is one of the most stressful times in the year for a small business. For self-employed people, having an unexpected event occur around this time (sickness, large influx of orders) could jeopardise your chances of getting these numbers together in time for the deadline and thus you risk the chance of fines.
- Your COGS (Cost of Goods Sold) final figure will not be known until year end, so you'll need to be ready for an unexpected tax total if your cost of manufacture is less than expected.
- This system doesn't tend to scale well as you grow your business - eventually you'll need to switch to something more robust when your inventory and purchasing activities become too complex to track using spreadsheets and paper.
- It can be difficult to keep your records with enough granularity to satisfy IRS auditing - you'll need to make sure that you "show your working" for any material unit cost calculations you are doing manually and ensure that they are in line with the IRS recommendations (i.e. FIFO, LIFO or Rolling Weighted Average)
Perpetual (Constantly calculating) Systems
Although technically possible to do by hand, this approach almost certainly requires software, as each inventory change triggers a recalculation of unit costs in real time. The most common approach in perpetual systems is to use a rolling average calculation to produce a constant tally of your material unit costs and cost usage in orders.
Popular perpetual Inventory systems include Craftybase, Quickbooks Premier and Unleashed.
- A perpetual system does all the calculations that are required to produce the numbers you need. You'll be responsible for is entering in the data for your expenses and manufactures as they occur and manually checking for accuracy.
- This method also gives you a constant view of your stock levels and most systems also provide the ability to configure low stock alerts to be even more on top of your stock situation.
- Any differences in unit prices are automatically averaged using a rolling average calculation as part of how the system works, so you'll have a really accurate valuation of material stock at all times.
- COGS (Cost of Goods Sold) can be seen throughout the year to enable you to tweak your production costs and identify any issues in your manufacturing process.
- Every little detail is logged and is thus reviewable and (most importantly) auditable: you can show the IRS exactly how you came to the calculations you did on your return.
- No time investment is needed at the end of the year for stocktaking - as everything is logged during the year as they occur (along with some regular small cycle counts to ensure your accuracy) you'll be able to generate the numbers you need for your bookkeeper instantly.
- Due to their complexity, perpetual inventory systems can sometimes be pricey as they are often designed for and promoted to large businesses. Craftybase bookkeeping + inventory software is a bit of an exception - as we are designed specifically for handmade small business, so we have very cost effective prices to match.
- You'll need to get in the habit of logging your inventory, expenses and manufactures when they happen rather than leaving for later in the year to get organised, which can be a bit of an adjustment to make.
- No matter what software you choose, there will be a learning curve involved which will need to be factored in to your workload - you'll most likely need to set aside a couple of dedicated hours to figure out the system and find a workflow that best fits with your business.