Small business inventory management for the New Year

Inventory management is a balancing act for every small business. Knowing how much stock you have, and where it’s located, is essential for keeping everything running smoothly. You also need to make sure there’s enough stock to satisfy demand – without overstocking.

In this guide, we’ll discuss inventory systems for small business owners, and provide tips for improving operational efficiency. We’ll also cover the following topics:

• What is small business inventory?
• Types of small business inventory
• Case study: How Julie manages small business inventory
• How to manage small business inventory
• Calculating your small business inventory needs
• Understanding manufacturing inventory costs in inventory management
• Best practices for managing small business inventory purchases
• Tracking inventory transactions for small businesses
• How to value your small business inventory

What is small business inventory?

In business, ‘inventory’ refers to the goods held for sale or production – including raw materials and finished products. Businesses must keep accurate inventory records to track stock levels, identify trends, and plan for fluctuations in demand.

More detailed information can be found in our guide: What is inventory?

Types of small business inventory

Let’s take a look at the main types of inventory that small businesses manage. These include:

• Finished goods: Products that are completed and ready for sale to customers.
• Raw materials:  Basic materials that are used in the production of goods but have not yet been processed.
• Work-in-progress: Items that are in the manufacturing process but are not yet finished products.
• Maintenance, repair, and operating supplies (MRO): Items necessary for daily operations, such as tools, cleaning supplies, and office materials.

Case study: How Julie manages small business inventory

As an example, meet Julie. She owns Sunshine Greeting Cards, a business that sells greeting cards, candles, and other gifts. The company sells items through its website, and in three retail store locations.

Julie has operated Sunshine profitably for six years, and grew the business from one to three stores. Company growth has led to some problems with inventory:

• Purchases: Sunshine has made some inventory purchases that weren’t needed.
• Stockouts: A stockout occurs when Sunshine runs out of a particular inventory item, and can’t fill a customer’s order. Stockouts frustrate customers, and Sunshine runs the risk that buyers may not return.
• Inventory costs: Sunshine needs a better system for tracking the cost of each inventory item. If Julie can’t nail down the cost of a particular item, she can’t price the product to generate a reasonable level of profit.

To resolve these problems, Julie performs a review of her entire process starting with inventory purchases. Guidance on how to do this can be found in the sections below.

How to manage small business inventory

Good inventory management is essential for balancing cash flow and ensuring your business can meet customer demand without overspending on stock. Keep reading to find out how to implement an effective inventory management system for a small business.

Manage inventory and cash flow

Your decisions about inventory have a huge impact on your ability to increase revenue and profits.

Filling customer orders is a high priority, and your firm needs inventory on hand to fill orders quickly and reliably. If you can meet customer expectations, you can generate repeat business, which helps you increase revenue without spending marketing dollars to find new clients.

But, maintaining a sufficient inventory balance requires a cash investment. If you invest cash for inventory, you’ll have less cash to spend on payroll, marketing, and other costs. Before you can dive into fixing your inventory process, you need to know the basics.

Use a POS system for inventory management

Implementing a Point of Sale (POS) system can significantly streamline your inventory management. POS systems allow you to track sales in real-time, update inventory levels automatically, and generate reports that provide insights into your sales trends.

The most important function of a POS system is to process customer payments, and complete sales.

Here are the steps required to complete an online sale using the services of a payment processor:

• Customer selects item: The customer selects an item for purchase by clicking on the item and moving to the checkout screen.
• Entering card data, purchase: At the checkout screen, the customer enters their credit card or debit card information, confirms the dollar amount of the purchase, and clicks a purchase now button.
• Processing payment: The payment processor charges the customer and sends the sales price amount, less the processor’s fee, to the business's bank account.
• Confirmation: The payment processor confirms the transaction to both the customer and the business electronically, so that both parties have a record of the sale.
• Product shipment: Once the payment is confirmed, the business sends the items purchased to the customer.

In addition, the payment processor must be able to handle refunds, sales price corrections, and other changes to a customer’s order. The business must also be able to use the same technology at the POS terminals in each store location.

Your POS system can be your most effective tool for managing the movement of inventory items.

For most retailers, inventory is the biggest asset balance listed on the balance sheet, and also the largest use of cash. It’s important to find a POS system that provides inventory management capability because a lot is riding on your ability to monitor inventory levels.

Utilise inventory management software

Inventory programs for small businesses can automate and streamline tasks to save time and ensure accuracy. Here are some of the main functions that inventory management software performs:

• Track inventory levels: By providing real-time updates, business owners can access up-to-date information about stock levels whenever they need it. This automation is typically enabled through technologies like barcodes, RFID tags, or scanners that record product movements during sales, returns, or transfers.
• Product ordering: Inventory management software can also automate the reordering process by using predefined settings and rules, such as reorder points and economic order quantities. In more advanced systems, the software can generate and send purchase orders to suppliers without manual input.
• Report generation: Detailed reports help business owners make data-driven decisions. This function of inventory management software makes it easy to track costs associated with inventory, and create turnover reports. By analysing historical data and current trends, this software can forecast future demand – helping you to adjust your stock levels to meet anticipated needs.

Calculating your small business inventory needs

Accurate inventory calculations help track product availability, reduce costs associated with excess inventory or stockouts, and improve cash flow. Additionally, inventory data is important for making informed decisions about purchasing, pricing, and sales strategies.

Inventory calculation formula

You should plan for an ending balance in inventory at month end, in order to fill customer orders in the first few days of the next month.

The formula for ending inventory is:

(Beginning inventory + purchases – sales = ending inventory)

The desired ending inventory balance is often based on a percentage of monthly sales.

Here’s an example:

A hardware store’s beginning inventory balance of lawn mowers is 50 units, and the company forecasts 300 mower sales for the month. If the business wants 30 mowers (10% of the expected sales) in ending inventory, the number of mowers purchased should be:

(300 projected sales + 30 ending inventory – 50 beginning inventory = 280 purchased)

Use the ending inventory formula to maintain a sufficient amount of inventory items and plan for purchases.

The hardware store is a retailer that purchases inventory. The inventory system for a manufacturer is different.

Understanding manufacturing inventory costs in inventory management

Manufacturing inventory costs include not just the purchase price of goods but also expenses related to storage, handling, and transportation, as well as costs associated with holding excess inventory. An accurate inventory tracking system for a small business can help you track and understand these costs, for efficient business operations.

A manufacturer separates the inventory balance into three categories:

• Raw materials: Items purchased for production
• Work-in-progress (WIP): Partially completed goods
• Finished goods: Goods that are ready for sale

If you own a towel manufacturer, the cotton you purchase to make towels is a raw material. Towels that are partially completed, but missing labels, are assigned to WIP. Finally, towels that are packaged and ready to be shipped to customers are finished goods.

The costs incurred for all three categories make up the total inventory balance.

Best practices for managing small business inventory purchases

Every business should maintain a written procedures manual for routine tasks, and the manual should include specific procedures for purchasing and managing inventory.

A procedures manual ensures that routine tasks are completed in the same manner each time, and the manual allows your staff to train new workers effectively. Here are some key steps to control inventory:

• Purchase orders: Each inventory purchase should be requested using a written purchase order, and a manager must approve each purchase. This control prevents a company from ordering more inventory than is needed.
• Recording the purchase: The Accounting Department should match the purchase order with the shipping documents that verify receipt of the inventory order. A company should record the cost and a full description of each inventory item, so that the accounting records can be used to perform a year-end physical inventory count.
• Processing a sale: When a sale is recorded, inventory is reduced and the cost of goods sold (COGS) is increased. Your accounting software should be able to post a sale and a corresponding reduction in inventory automatically.

Because a company may process dozens or even hundreds of sales each month, it’s critically important to make accurate and timely updates to the accounting records.

Accounting software allows a business to use a perpetual inventory system. Perpetual means that the inventory, sales, and cost of goods sold accounts are updated automatically with each transaction.

Tracking inventory transactions for small businesses

Accurately tracking inventory transactions helps businesses maintain stock levels, manage cash flow, and reduce unnecessary costs. To show how inventory transactions can be tracked, let’s return to our case study of Julie and her business Sunshine Greeting Cards.

One of Sunshine’s best-selling products is a Seaside Candle, which sells consistently each month. When the candles are purchased and received at the company’s warehouse, the candles are assigned SKU number SEACAN12.

SKU numbers are alphanumeric codes used by companies to track units of inventory, and Julie tracks the number of items in inventory by the SKU number.

Here’s where a good POS system can help.

When an item is sold, the POS system reduces the inventory level for that particular SKU number automatically. If Sunshine sells 20 Seaside Candles on Tuesday the 12th, for example, Julie can pull a report from the POS system and immediately know her new inventory levels.

The POS system allows Julie to closely monitor inventory levels, so that she can carefully plan her inventory purchases and conserve cash. If the business consistently sells 300 candles a month, Julie can use that information to make purchases, and avoid buying too much inventory.

It’s also important to track the cost of each inventory item, which brings us to inventory valuation.

How to value your small business inventory

If an inventory item is worth less than what you paid for it, you must adjust the cost down to the current market value.

Accountants refer to this rule as the lower of cost or market, and the policy is consistent with the principle of conservatism. If the dollar value of inventory has declined in value, the amount must be adjusted in the financial statements.

If you apply the lower cost or market policy, the financial statements will be more accurate.

Sunshine sells every inventory item within six months, and Julie does not purchase items that decline in value over that period of time. The bigger issue for Sunshine is determining which specific items were sold, and the original cost.

First in, first out method

The first in, first out (FIFO) method assumes that the oldest items in inventory are sold first.

The current inventory of Seaside Candles includes these purchases:

• 50 candles purchased on 1 Dec for $10 each
• 25 candles purchased on 15 Dec for $12 each
• 75 candles purchased on 20 Dec for $13.50 each

If Sunshine sells a total of 40 candles on 25 December, the FIFO method values the candles sold at $10 each.

Most companies use the FIFO method to value items sold out of inventory. Some firms, however, use the last in, first out (LIFO) method.

Last in, first out method

To understand the LIFO method, think about buying milk at the grocery store.

The oldest litres of milk are pushed to the front of the refrigerator, so that you’re more likely to buy the older product before it expires. To get to the newer milk, you have to reach behind the old stuff.

Getting to the newer milk is the LIFO method.

LIFO assumes that the newest units are sold first. If Sunshine uses the LIFO method, the 40 candles sold on 25 December are valued at $13.50 each.

Accounting principles require that you consistently use the same method, so that your financial results are consistent from year to year. Fortunately, accounting software can track the costs and post the correct amounts automatically.

The best way to confirm that the accounting records are correct is to perform a physical count of year-end inventory.

Conducting a physical inventory count for accuracy

Conducting a physical inventory count is essential for ensuring that the records in your accounting system match the actual stock on hand. It helps identify discrepancies caused by theft, loss, damage, or clerical errors that may have occurred during the year.

Businesses typically conduct an inventory count at the end of an accounting period, such as a month or year. This process is critical for maintaining accurate accounting, avoiding mistakes, and ensuring proper tax reporting.

Timing of the count

A year-end inventory count, however, confirms that the accounting records match the physical inventory items on hand at the end of the year, when you generate the annual financial statements.

If a CPA firm is conducting an audit of the 31 December financial statements, the accountants will count the physical inventory on the last day of the calendar year. If the auditor cannot access inventory on 31 December, the firm will count inventory as close to the end of the year as possible.

The purpose of the physical count is to agree the detailed inventory listing from the accounting system to the physical inventory units on hand.

Performing the count

Sunshine follows these procedures to ensure that the 31 December inventory count is accurate:

• Accounting listing: Julie’s accountant prints a detailed listing of the firm’s inventory on 31 December, and distributes the listing to each person who is counting inventory.
• Inventory access: Company management notifies the warehouse staff that no inventory should be received after 5pm on 30 December. Access to the warehouse is restricted on the 31st, so that no inventory is moved in or out of the facility on the day of the count.
• Numbered Tags: Each inventory item is tagged, and the tag lists the cost, description, and the number of inventory items (if applicable). The tags are numbered and listed on a separate report that is also provided to each person who is counting inventory. Larger items are given a single tag, while smaller items (a box of greeting cards) have a tag attached to the box of items.
• Matching: Julie and her staff match each item on the detailed inventory listing to a tagged item. Each counter writes the tag number next to the item on the inventory listing. If the information from the tag differs from the inventory listing (cost, number of items in a box, etc.), that information is also noted on the listing.
• Exceptions: Julie and her staff investigate any differences, so that the inventory record can be corrected. If, for example, the physical count reveals a box of 50 greeting cards rather than 100 cards, the inventory records are adjusted. The sum of all the adjustments will ensure that the inventory listing matches the physical inventory on hand.

After the count is completed and the accounting records are adjusted, Julie’s inventory balance will be corrected and stated in the balance sheet.

Accounting for inventory impacts your cash balance, the amount of profit you generate, and the business tax return. It’s time-consuming, but business owners will see a benefit from managing inventory more accurately.

Julie’s changes have fixed the inventory problems, but what can she do to keep things on track next year?

What to do next

By implementing the steps outlined in this article, you can help your business stay on top of its inventory management. It’s also important to talk with everyone in your team about the importance of keeping accurate records, and to document all of your current inventory procedures.

It might help to create a FAQ sheet for your staff, so everyone understands how to manage inventory. We also recommend moving away from manual tools and embracing technology – such as a state-of-the-art POS system.

Most importantly, perform inventory counts on a quarterly basis. The actual count for year-end inventory should take place as close to 31 December as possible.