Filling orders, stocking shelves and creating accurate projections are just a small slice of inventory management. When you couple those tasks with tracking and managing rising costs, raw material and labor shortages and shipping disruptions, you can begin to recognize the complexities that inventory can bring.

Today’s supply chain crisis highlights the critical position that business owners are put in, as well as the need to carefully examine inventory management practices. These insights are meant to demonstrate the major impact inventory management practices have on your financial statements and operations—and how to improve your processes to positively affect both.

What is effective inventory management?

Inventory is the collection of goods and materials that are used to create products that will be sold or are ready to sell. There are two main goals for inventory management:

  1. Have products available in the right type, quantity and location as they are purchased.
  2. Value inventory appropriately within your financial statements.

When products aren’t available, revenue opportunities diminish both for immediate sales and for future sales as customers purchase those goods elsewhere. If excess stock exists, perishable goods may spoil before they can be sold. In addition, carry costs (expenses for the storage and maintenance of inventory) increase, and capital is tied up in the unneeded stock.

For product-based businesses, inventory is usually the largest current asset on your balance sheet. The bottom line on the income statement, your profit, includes your cost of goods sold (COGS) as an offset to the revenue from product sales. As inventory practices become more accurate and efficient, financial statements will reflect those achievements.

Lessons for healthier inventory practices

Whether you’re looking to improve your general inventory practices or you are tackling a bigger issue, like supply chain disruption, the following insights can set your business up for a more profitable future.

Apply inventory valuation methods consistently

Every business that carries inventory makes a decision on which inventory valuation method they will use to record their inventory. When items are purchased to sell for a different month or year, the cost for them will usually fluctuate. Thus, the most recent cost of an item may be higher or lower than it was in an earlier purchase. When this occurs, businesses need to consistently apply their chosen valuation method when they compute their cost of goods sold (COGS).

  • LIFO (last in, first out): The most recent purchase costs are used to calculate inventory.
  • FIFO (first in, last out): The oldest purchase costs are used to calculate inventory.
  • WAC (weighted average cost): The total costs paid for the inventory are divided by the number of units, with the result being used to calculate inventory.

Though not a calculation, specific identification can also be used to value inventory when each item is unique and identifiable. Other methods are available, but only FIFO and WAC are specifically noted for financial statements governed by U.S. generally accepted accounting principles (GAAP). And, only FIFO is allowed for those following international financial reporting standards (IFRS).

The frequency of applying the valuation method (daily or periodically) also affects inventory value. Regardless of which method you choose, disclosure of your choice method is required within your financial statements.

Examine tax advantages of LIFO

While LIFO isn’t expressly permitted by U.S. GAAP, its usage is implied and accepted under the matching principle where it requires that inventory be carried at the lower of cost or market value. Given that the most recent price paid for goods is the market value, the LIFO method remains permitted in the U.S. IFRS bans it, and the prohibition is one of the factors delaying the merging of the two sets of standards.

Mining and manufacturing sectors are traditionally those that most often use LIFO in valuing their inventory, but others may adopt it as well. Since LIFO uses lower costs from earlier purchases, it results in higher COGS and lower profits. The tax liability for companies switching to LIFO is also lower. During times of inflation, this tax advantage should be examined, and if the change is warranted and all IRS guidelines and financial statement presentations are followed, companies can apply to change to LIFO with the IRS using form 970 and if accepted, use form 3115 to change their inventory accounting method.

Plan carefully when changing valuation methods

How you approach inventory management impacts the asset value of your inventory, the cost of goods sold and, ultimately, your profit. Conduct periodic analysis to ensure that processes remain efficient and the chosen valuation method is appropriate and reflective of the current economic climate.

You should only change your valuation method under careful consideration and planning. Financial statements may need to be restated. This retrospective approach allows users to compare activity and balances from different financial years and apply the same criteria. If a prospective approach is taken, only future periods are affected. Those who read the financial statements must clearly understand the intent, such as a new product line or merger that prompts the change. In both cases, prominent disclosure of the change is required.

Proper inventory costing is vital to financial statements

The act of assigning costs to individual products is called inventory costing, or inventory cost accounting. Inventory costs include the product and raw materials, shipping and transportation, warehouse storage, manufacturing and other overhead costs. How you cost your inventory will directly affect the numbers on your financial statements.

In addition to identifying the initial cost of the product or raw materials, accountants must also identify, calculate and allocate the other associated costs. They are initially priced for the inventory as a whole and then segmented into labor and production costs. Storage location, product line and product level are used to properly allocate the cost attributable to individual items.

Once the inclusive product cost is determined, accountants record the COGS for the income statement. Accuracy in these valuations is important for investors and other stakeholders who rely on these statements to make their decisions.

Remember that it all counts in an inventory audit

To accurately value your inventory, you must ensure that all products, in all stages and locations, are included in the count. Be certain to include items in transit, stock on display or on consignment and items at remote locations (e.g., items your sales team uses for demonstrations).

If your staffing level permits, make sure that those counting the inventory do not have a stake in the outcome. This segregation of duties can also play a role in achieving a more accurate valuation.

Conduct physical—and random—inventory counts

Companies use both periodic and perpetual inventory systems to regularly count stock. Periodic systems count inventory at set intervals, unlike perpetual systems, which count stock continuously as inventory is purchased or sold.

Regardless of the system you use, both systems require random physical counts to validate accuracy. For perpetual inventory systems, there should be some slight variations in scheduled dates so that an element of surprise exists to thwart those who may try to cover up shortages.

Address shrinkage

Companies that sell perishable goods are not the only ones who are required to make inventory accounting adjustments due to spoilage. The same concept applies to obsolescence, damage and theft. When these losses occur, they are considered inventory shrinkage.

When shrinkage occurs, it is necessary to record journal entries to write down the inventory by reducing the asset value and expensing the loss to eliminate the variance. These adjusting journal entries should be conducted routinely to ensure that the losses are captured within the financial statement period when they occur or are identified.

Use the right tools: hi-tech, lo-tech or no-tech?

A systematized approach to managing your inventory is essential. The devices and processes you use to count, track and record your inventory is variable. Tools such as basic $20 bar code scanners can speed up the process of counting items that have UPC (universal product codes) labels on them. Phone apps are available to do the job as well, but they may introduce an unwanted distraction.

Pen and paper remain popular choices businesses use to count and track their inventory, but integrated and standalone software should be considered as product volume and manufacturing complexity increase. This will reduce error and save time on inventory-related tasks.

Be aware of economic impact on your industry

As noted with LIFO, inflation plays an important role in inventory valuation. Supply and demand also heavily influence the volatility and cost of individual products and market segments. Be aware of economic impacts on your inventory valuation. Examples include lumber and shipping container shortages, global transit delays and other supply chain disturbances that can affect multiple industries and their associated inventories.

The inventory management challenge

While fairly presenting your inventory value on financial statements is important, the day-to-day efficiency and management of inventory is equally critical. Having finished product in the right place at the right time is essential to keeping companies healthy.

If inventory management and accounting is a challenge for your organization, Paro offers expert financial controller services for developing more efficient processes to monitor, track and value your inventory assets to improve your profitability.