By Jeffrey Arnol, CPA, JD
Kessler Orlean Silver & Co. PC, Deerfield IL
Inventory management is the practice of planning, directing and controlling inventory so that it contributes to the business’ profitability.
First, what is inventory? It is an asset on the balance sheet. It 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, supplies that physically become a part of the item intended for sale and, for tax purposes, an allocation of certain costs normally expensed that must be capitalized as part of inventory.
Second, why is inventory management important? Simply, 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 is stated too low, which means that net income before taxes is overstated by the amount of the inventory overstatement. From a business perspective, it’s 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 frequent 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 so it’s 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 better plan inventory and maintain appropriate levels.
- Automate & consider an asset tracking system. These can streamline the inventory management process, simplify documentation, increase accuracy and save time.
- 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’s 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 is equal to beginning inventory plus inventory purchases minus ending inventory, so any decrease in ending inventory increases COGS and cuts gross profits. The effect on the income statement is lower taxable income.
The preceding summarize a number of best practices when it comes to managing inventory, perhaps one of the more overlooked areas, especially for smaller, less sophisticated businesses, when it comes to increasing profitability.
About Jeff Arnol
Jeff is the managing partner of KOS is responsible for the firm’s management and administrative operations as well as it long-term strategy.
With over 30 years in public accounting, Jeff has extensive experience with all significant aspects of federal and state tax matters including tax planning, research, and compliance issues of corporations, partnerships, LLC’s, individuals, estates and trusts. He specializes in income and estate tax planning for closely held businesses, business owners, and high net worth individuals.
In addition, he works with clients in a number of industries including professional service, real estate, not-for-profit, technology and health care. He advises clients on such matters as business valuations, mergers and acquisitions, strategic planning and employee benefit plans.
Jeff is active in CPA Associates International, an association of independent CPA firms with over 160 member firms throughout the world. He is currently the Treasurer and also serves on the Practice Management Committee, the Summary of Operations Task Force and the Leadership Development Program Task Force. He is also a member of the KOS Marketing and Technology Committee.