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Running a business

Checking your inventory and inventory management for the new year

You started the year with a sufficient cash balance, and you’ve been profitable each month. But for some reason, the year-end cash balance is lower than where you started. How can that be?

Accounts receivable and inventory can tie up a large amount of cash, and the receivable problem may be easier to fix than your inventory issue.

To reduce your receivable balance and collect cash, you can improve your collections efforts and invoice customers faster. If you have too much cash tied up in inventory, the problem is more complex.

Inventory management is a balancing act for every small business.

Filling orders; using cash

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.

Inventory formula

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.

Manufacturing costs

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.

Meet Julie, an owner who manages inventory

As an example throughout, 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.

Managing 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.

The next step is to consider how to accept payments for purchases.

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Using a POS system

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

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 Sunshine’s bank account.
  • Confirmation: The payment processor confirms the transaction to both the customer and Sunshine electronically, so that both parties have a record of the sale.
  • Product shipment: Once the payment is confirmed, Sunshine Greeting Cards 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. Sunshine 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.

Inventory transactions

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.

Valuation of 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 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.

Physical inventory count

Businesses typically conduct an inventory count at the end of an accounting period, such as a month or year.

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

Talk with everyone on your staff, and document all of your current inventory procedures. Create a FAQ sheet for your staff, so everyone understands how to manage inventory. Move away from manual tools, and embrace technology, including a POS system.

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

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