Tying Items to the Chart of Accounts (Part 1)

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So, you have that new inventory client, and you’re excited to see that they get the file setup correctly. But where do you begin?  And what should you consider now to get the information you want about the inventory later?

Clients usually want to start by setting up the items, but you, as their advisor, need to think about which accounts in the Chart of Accounts the items will be ‘pointing’ to. This will help you later with the financial statements, as well as other financial and operational reporting.

Inventory Items

There are three accounts that affect all inventory part and inventory assembly items in QuickBooks: 1) the Inventory Asset account on the Balance Sheet; 2) the Income account; and 3), a Cost-of-Goods-Sold (COGS) account. Having these defined ahead of time makes assigning the appropriate accounts to items easier as you set them up.

Inventory Asset Accounts

Most simple distribution companies will have just one Inventory Asset account on the Balance Sheet. This account holds the value of the items in stock and is reduced as items are sold.  For most distribution-type companies, no other I/A accounts are necessary. However, manufacturers will have several sub-accounts under this category; usually three: 1) Raw Materials; 2) Work-in-Process, and 3) Finished Goods. There may be others for capturing labor and overhead ‘wash’ accounts for rolling up costs into the overall costs of assemblies. 

  1. The ‘Raw Materials’ account will usually include the components that go into the sub-assemblies, or finished goods assemblies that are sold. 
  2. The 'Work-in-Process' (WIP) account temporarily holds those materials in the process of being finished.* 
  3. The 'Finished Goods' account will usually hold the value of items for sale.

Make sure the items have designated the appropriate Inventory Asset account that matches that item’s status in the fulfillment process.

Income Accounts

The Income accounts will depend upon how the client wishes to see his products broken out on the Profit & Loss statement. They might be sub-divided by product line or brands. Other companies may only have one Sales account, and then break the sales out by Class. You need to have this discussion with the client first as it effects which accounts the items will ‘point’ to, as well as for reporting. By having categories of sales, you can run the P&L over a period of time, then view comparison periods, showing the trends of all of those groups of items over time.

Cost-of-Good-Sold Accounts

The Cost-of-Goods-Sold (COGS) accounts setup gets tricky. You could have just one account.  That makes it simple, but doesn’t give much breakout for analysis of where the costs are coming from. Here are just some of the areas to consider as possible COGS line items:

  • Materials – usually items purchased directly for resale or manufacturing
  • Labor – may be for services directly provided by the client or a subcontractor
  • Freight-in – costs incurred for getting usually raw materials or goods for resale to the receiving dock.  If the client is performing ‘landed cost’ on their items, they may be rolling up this cost into the cost of the items, so this account may serve as a ‘wash account. More on this later.
  • Packaging material – many companies carry this as a separate cost.
  • Inventory Adjustment – used in ‘Adjust Quantity/Value On Hand’ transactions as the offset account

Many times, clients go overboard on the Income and COGS accounts, and they want to break out every product group (or even every product) to its own account! Don’t let them do that. It only makes the P&L longer and harder to read, and doesn’t really add any analytical vale.

Service items

The client may want to have items setup for services they purchase (usually called, ‘outsourcing’) or service items they are charging their customers. In either case, you need to make sure the items are ‘pointing’ to the right accounts.

Warning: when you first go to setup a Service-type item, by default, it opens up a ‘one-sided’ item window. The ‘one side’ being the revenue side:

Note: ‘Account’ refers to a revenue (Income) account, not an expense or COGS account. In order to post this Service item to an account associated with a purchase, you must check the box, “This services is used in assemblies or is performed by a subcontractor or partner.”

In this case, the cost will be posted against a COGS account because it is a service supplied by an outside vendor. The Income account may or may not be used, depending upon the item’s use in a sales document. Take note of the fact that when checking the box, the wording went from ‘Account’ (which is confusing) to ‘Income Account.’

What about tracking labor in the assembly builds?  Here, you can setup service-type items to track those costs, and then the costs can be rolled up into the cost of the finished goods.  However, you’ll need to use a clearing, or ‘wash’ account to track the ins and outs that are ‘feeding and bleeding’ the account. As in the case of recording the cost from an outsourced vendor, then transferring that cost through the service item into an assembly. 

For example, say your client sends out the raw materials to be assembled by a contractor who charges $5 per unit. Once the clearing account is setup, you will setup a Service-type item with the Expense account posting to it, and post $5 in the Cost field. When they get the contractor’s bill of $1,000, you or your client will post it to the clearing account. As the client builds their assemblies, $5 will be removed from the clearing account for each service unit used as part of the build.

The ‘preferred’ method of tracking these costs is through a sub-account within the Inventory Asset account group. This allows the debits and credits to be tracked together on the Balance Sheet for easier reconciliation. Sometimes, clients use a COGS account as the wash account.  This is acceptable, but the transactions tend to get convoluted with other costs, so reconciling becomes difficult. When internal payroll is used, we recommend a separate wash account to track the balances rather than cluttering-up the payroll account. I will cover handling labor items in detail within a future article.

Next time we will look at non-inventory parts, other charges and specifics related to mapping of items and cleaning-up previously improperly posted account mappings.

* You can have a light-manufacturing company that doesn’t have a WIP account at all because the time frame is so short. On this point, some of my fellow accountants might disagree, but if our client finishes her product in 1-2 days, why run them through a WIP account at all (except at year-end tax time)?  WIP accounts are primarily for companies where processing takes a lengthy period of time.