When you hear the term ‘inventory’ it may evoke thoughts and images of crowded warehouses or neat supermarket shelves. In its simplest sense, inventory refers to everything a business holds to support production, facilitate operations and, ultimately, generate revenue.
The fundamental understanding of inventory is key to smooth operations and financial stability in any business, whether it’s a bustling e-commerce site or a quaint provincial coffee shop.
Understanding business inventory
Inventory is the lifeblood of a retail or manufacturing company; it consists of items that are ready for sale, or of those that are being used in the creation of products to be sold, or that are required to facilitate the process.
An inventory accounting process is critical to gauging product demand, identifying best-selling items, managing costs, and optimising cash flow.
When you run a retail operation, your inventory includes the products you sell. If you manufacture these products yourself, your inventory includes the raw materials you use to make more products.
The different types of inventory in accounting
There’s no one-size-fits-all approach to Inventory accounting; There’s a need to differentiate between different types of inventory (depending on where they are used in the production process), each with its own characteristics and implications for your financial statements and tax obligations. Common types of inventory in accounting include:
- Raw materials: These are the ingredients or components that will feature in the final product.
- Work in Progress (WIP): This encompasses uncompleted goods in production.
- Finished goods: These are sale-ready products.
- MRO (Maintenance, Repair, and Operations) supplies: These are not inventory, as they’re not for sale. However, these items support the production process and can, at times, be confused as being part of inventory when they’re actually supplies.
Deciphering inventory models
Inventory models are mathematical equations or formulas that enable the inventory control, anticipate demand, manage reorder points, and minimise costs. The two most popular inventory models are the Economic Order Quantity (EOQ) model and the Just-in-Time (JIT) model. They are used in businesses whose inventory consists of finished goods.
Economic Order Quantity (EOQ): This model endeavours to ascertain the optimal order quantity that minimises total inventory costs. These costs include purchase, holding, and shortage. The EOQ model is ideal for organisations with consistent demand and steady production.
Just-in-Time (JIT): The JIT inventory model is designed to order inventory as required for production or sales; it reduces inventory holding costs and waste, and needs accurate forecasting and reliable suppliers to prevent stock outs.
The understanding and application of these models can greatly enhance inventory management, helping increase efficiency and profitability in an organisation.
One way of estimating inventory reorder levels is efficient inventory tracking. This prevents stock outs (which can lead to lost sales and brand reputation damage) and overstocking (which could tie up capital and increase costs for storage). Maintaining the optimal stock will ensure smoother operations, better cash flow management and, ultimately. improved customer satisfaction.
Manual vs. automated inventory tracking
Inventory tracking can be as simple as having product details and quantities on a spreadsheet, or as sophisticated as using an inventory management software.
Manual Tracking: This method involves manually counting your inventory and updating records, usually on a spreadsheet. While this can work for small businesses with limited items, it can be time-consuming and human error-prone, especially as the business and inventory grows.
Automated Tracking: This involves employing inventory management software that automatically updates inventory levels as products are traded. Automated tracking systems can also provide real-time inventory updates, track products across multiple locations, generate sales forecasts, and send reorder alerts when stock levels are low. Whilst an upfront investment is required, the increased efficiency and accuracy can result in potentially huge long-term rewards.
Barcode scanning and RFID systems
Modern inventory tracking has evolved beyond simple spreadsheet updates or automated software entries. Many businesses are now using technologies such as barcode scanning and Radio Frequency Identification (RFID) systems to track their inventory.
- Barcode Scanning: Each product is assigned a unique barcode with item information. The barcode is scanned at the point of sale and the system automatically updates the quantities.
- RFID Systems: Unlike barcodes, which need to be scanned by hand, RFID tags can be automatically detected and tracked by RFID readers. This affords real-time inventory tracking, resulting in a significant reduction in manual labour and mistakes.
Regular inventory audits
Regardless of the tracking method employed, regular inventory audits (where inventory is physically counted) are a crucial part of an effective inventory tracking system, helping to ensure the accuracy of your inventory records and identify any discrepancies through theft, damage, or administrative errors.
Inventory audits can be time-consuming, which is why many organisations choose ‘cycle counting’, which involves the counting of a small subset of inventory on a specific day without interrupting daily operations.
The bottom line on inventory tracking
When done well, inventory tracking can offer a comprehensive overview of a business’s stock levels. By choosing the correct method for your organisation and carrying out regular audits, you can streamline operations, optimise stock levels, creating a foundation for growth and success.
Ultimately, just tracking inventory isn’t the goal; it’s about leveraging information gained from it to make informed decisions in the business.
Inventory valuation methods
Inventory valuation is critical in inventory accounting. It tells you the monetary value of the products on your shelves or warehouse, shaping your financial statements and influencing your tax liability. The value of inventory directly affects the calculation of the Cost of Goods Sold (COGS) and gross profit, which are important for performance analysis.
The three main methods for inventory valuation are: First-In, First-Out (FIFO); Last-In, First-Out (LIFO); and Weighted Average Cost (WAC). Each one has its pros and cons, and making the choice between them depends on various factors such as the nature of your inventory, your business model, and your regional financial reporting standards.
First-In, First-Out (FIFO)
FIFO is an inventory valuation method that assumes the older goods get sold before the newer ones. It reflects a logical flow of inventory, especially for goods of a perishable nature.
If your business sells fruit, you’d want to sell the oldest goods first. Using the FIFO method, the cost of these older goods is recorded in COGS when a sale happens, leaving the cost of the newer items in ending inventory.
FIFO can increase net income as it assumes that cheaper, older inventory is sold first, leading to a lower COGS, higher profit, and potentially higher taxes, especially during periods of inflation.
Last-In, First-Out (LIFO)
In contrast, the LIFO method assumes the most recently acquired or produced items are sold first, leaving the older stock in inventory. While this might seem counter-intuitive for a physical product flow, it can offer tax advantages during inflation.
Using the fruit example, if you were using LIFO, you would be selling the newest fruit first. The cost of these new goods—likely higher due to inflation—is recorded in COGS, resulting in a higher COGS, lower profit, and consequently, lower taxes.
it’s important to note, however, that LIFO is not an acceptable method of accounting for inventory under some accounting standards, so you must ensure you understand the principles that apply to your situation.
Weighted Average Cost method (WAC)
The WAC method hits a middle ground, calculating a new average cost after each inventory purchase; it divides the total cost of items in inventory by the total number of units available for sale. This average cost gives COGS and ending inventory value.
Imagine your business has goods purchased at different prices. Under the weighted average cost method, you’d calculate the average cost of all items, regardless of when they were purchased. Every time an item is sold, the COGS will be this average cost, and the same average cost is used to value the remaining items.
This method smooths out fluctuations in price, which can be beneficial in industries where inventory items are so intertwined that it is difficult to assign a specific cost to an individual unit.
In industries with high-value inventory, and where identifying individual products is simple (such as jewellery, cars, and houses) the cost of individual items is tracked and used for COGS.
Choosing the right inventory valuation method is a strategic decision, which can greatly impact your business’s reported profit, taxable income, and inventory planning. It’s crucial that you consider your business context and seek advice from an accountant so you can make an informed decision.
An example of inventory tracking in action
Let’s consider an inventory tracking example featuring a fictional bakery.
This bakery offers a range of baked goods. On first opening, the owners used a simple manual tracking system to manage inventory, but as the business grew, they started facing challenges.
Manual tracking became time-consuming and prone to human error, leading to stock outs of popular items, and overstocking of slower-selling products. These inconsistencies started to affect customer satisfaction and profitability.
Seeing the need for better inventory management, the proprietors transitioned from manual tracking to an automated inventory tracking system. Each product in their inventory was assigned a unique barcode that contained information about the product, including type, size, cost, and retail price.
When a purchase occurred, the barcode was scanned at the point of sale, and the system automatically deducted the sold quantity from the inventory records.
The system also sent notifications when stock levels of any product fell below a certain threshold. These notifications gave the owners enough lead time to reorder and replenish stock, preventing stock outs.
The system also gave valuable insights into sales trends, allowing them to discern the bakery’s best-selling products as well as the poor-performing ones. These insights enabled them to optimize their stock levels, reducing the capital tied up in slow-moving inventory, as well as introduce fresh products to replace the poor performers.
Whilst introducing the automated system required an upfront investment, the benefits of accurate, real-time inventory tracking, reduced stock outs and overstocks, and actionable sales insights led to improved customer satisfaction and increased profitability, making the new system a worthwhile investment.
Effective inventory tracking can revolutionise inventory management, highlighting the tangible benefits it can bring to a business, irrespective of its size or industry.
Wrapping up: The power of inventory
Ultimately, inventory—whether it’s raw materials, WIP, or finished goods—has a crucial part to play in business operations. Understanding what it is, recognising the different types of inventory in accounting, and employing effective inventory models can greatly enhance your efficiency and profitability.
Whether you’re an established, seasoned business or a start-up, having an intuitive understanding of inventory can enable streamlining, improving customer satisfaction, effectively giving you a sustainable competitive advantage. The more effectively you manage your inventory, the more effective you’ll be at addressing the challenges you’ll face and exploiting the opportunities that come your way.