Best Practices for Managing Inventory

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IMGCAP(1)]Inventory management is the practice of planning, directing and controlling inventory so that it contributes to the business' profitability.

Inventory is an asset on the balance sheet that remains there until goods or merchandise is sold. It should include all of the following—merchandise or stock in trade, raw materials, work in process, finished products, and supplies that physically become a part of the item intended for sale. For tax purposes, an allocation of certain overhead costs normally expensed must be capitalized and individualized as part of inventory.

Second, why is inventory management important? From a financial perspective, it can help a business be more profitable by lowering their cost of goods sold and/or by increasing sales. Inventory is a major factor in calculating taxable income. When an ending inventory overstatement occurs, the cost of goods sold (COGS) is stated too low. This means that net income before taxes is overstated by the amount of the inventory overstatement. From a business perspective, it is about having the right stock at the right time to meet customer demands.

In order to properly manage inventory, there are a number of factors to consider:

• Have a solid inventory control system. Two common systems are the periodic and perpetual systems. A periodic system updates the accounting ledger on a periodic basis —weekly, monthly, quarterly. A perpetual system updates inventory after each purchase, sale and adjustment. The more frequently it is updated, the easier it is for a business to plan.

• Have a proper inventory ordering system. Know what you need, how much you need and when you need it. This is important as it often leads to undesirable consequences such as longer lead times, reduced responsiveness and customer service, lost sales opportunities and increased inventory costs.

• Categorize your inventory. The 80-20 rule often applies to inventory (80 percent of the sales comes from 20 percent of the products) so it is a good idea to categorize and set priorities accordingly. It may be a good idea to make sure you have a larger stock buffer for faster moving items than slower items.

• Demand forecasting. Sales often fluctuate due to seasonality, business trends and the economic outlook. Thus, the ability to forecast can help one better plan inventory needs to maintain appropriate levels.

• Automate and consider an asset-tracking system. This can streamline the inventory management process, simplify documentation, increase accuracy and save time and money. It correlates with having a proper ordering system.

• Take physical inventory counts. This is a method to control inventory and reconcile it to the amounts shown under a periodic or perpetual system on the books. These are normally taken at least once a year, often close to the end of a business’ fiscal year. Larger businesses, those with a large number of items, those who need to verify the accuracy of their inventory more frequently and those who prefer periodic or seasonal inventory counts often do it more frequently.

• Make adjustments as necessary to account for goods that are unsaleable, obsolete, damaged, stolen or where the market value is lower than the cost (if you use the lower of cost or market method). The effect of a write-down is to lower the value of ending inventory. COGS are equal to beginning inventory plus inventory purchases minus ending inventory. Any decrease in ending inventory increases COGS and cuts gross profits. The effect on the income statement is lower taxable income.

The preceding points summarize a number of best practices when it comes to managing inventory. It is one of the more overlooked areas that impact increasing profitability, especially for smaller, less sophisticated businesses.

Jeffrey Arnol, CPA, JD, is managing partner of Kessler Orlean Silver & Company, a CPA firm in Deerfield, Ill.

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