Inventory Management Essentials

Inventory management is perhaps the most troubling area of accounting for accountants and business owners. Keeping track of materials and finished goods for sale is a tedious, cumbersome task.

Every year in the U.S. from 1.5% to 2.0% of gross sales of all businesses collectively are lost to employee theft; that amounts to over $30 billion of lost revenue. Inventory management is the accounting function that is charged with the responsibility to support management efforts to control inventory loss.

Inventory is all products to be sold to customers. The inventory account is the account in accounting that tracks inventory.

Businesses that stock hard goods necessarily must have a good inventory management program. Without effective inventory management controls a business can go bankrupt very quickly.

The first thing that needs to be done prior to getting your first item of inventory is to select the inventory valuation method that fits your business model. The five models are the following.

  • LIFO
  • FIFO
  • Averaging
  • Specific Identification
  • LCM

LIFO (Last-In, First-out) assumes that the last items put on the shelves, the newest items, are the first to be sold. Retail stores that sell non-perishable goods typically use this inventory valuation method. There is no need to move product items around to make room for newer items or to put newer items in the back of the shelves. Such products as hardware tools and auto parts would fit this category.

FIFO(First-In, First-out) assumes that the oldest products are sold first. Stores that sell perishable goods such as dairy products and produce would typically use this inventory valuation method. These types of products are dated. They have to be sold by a "sell by" date or they will have to be thrown away, i.e., destroyed.

Averaging is where you average the cost of goods received. As a result, there is no need to worry about which items are sold last or first. This inventory method is commonly used in any retail or services environment where prices are constantly fluctuating, and the business owner finds that an average cost works best for managing their Cost of Goods Sold.

Specific Identification is where you maintain cost figures for each inventory item individually. Retail stores that sell big-ticket items such as automobiles and farm machinery commonly used this inventory valuation method. In this method there is usually a less cumbersome inventory management process.

LCM (Lower of Cost or Market) is where you set inventory value based on whichever is lower: the amount you paid originally for the inventory item (its cost or fair market value), or its current fair market value.

Businesses that deal in precious metals, commodities, or publicly traded securities frequently use this method because the prices of their products can fluctuate wildly, often in a short period of time. Publicly traded stocks, for example, can see their market values change from hour to hour in one day.

The inventory valuation method you choose must be used every year on your financial reports and tax filings. If you ever change the inventory valuation method you are required by IRS rules to explain the change to the IRS. Also, you need to explain the change in your financial reports and to financial backers affected.

When you do change your inventory valuation method you need to go back to prior financial reports affected and show how the change impacts those reports. And, you need to adjust your profit margins in o prior years (minimum of two, maximum of five) to reflect the change.

Reporting of the new inventory valuation method needs to show how the change affects your long term profit history. One major reason for doing this is the conservatism principle in accounting.

The conservatism principle requires you to choose the accounting method that will not overstate revenues and understate expenses. Overstating revenues or understating expenses can potentially project higher profits and/or lower tax obligations respectively, than actually occurred.

The conservatism principle purpose is to set a standard whereby the public can be secure in the thought that your business is reporting accurate data about its financial performance. This way everyone concerned is protected from false financial reporting.

The inventory management valuation method you choose has a major impact on your profit or loss reported in the income statement. And, it also impacts the amount of taxes you are required to pay.

FIFO, because it assumes that the oldest (and most likely the lowest priced) items are sold first, yields a lower Cost of Goods Sold figure on the income statement. Thus, your reported profit will be higher.

Prices normally rise over time. So, the oldest items in inventory are normally cheaper compared to the same products purchased at a later date.

LIFO assumes that the latest inventory bought is purchased at a higher price than earlier inventory yields a higher Cost of Goods Sold number. Therefore, profit will be less and, taxes will be lower.

The averaging inventory valuation method smooths out the highs and lows experienced by the FIFO and LIFO methods. So, your profits and taxes normally fall somewhere between FIFO and LIFO methods.

Since accounting is normally done today on computer software you need to make sure that your accounting software is compatible with the inventory valuation method you use. Some small business accounting software computes inventory values using the averaging inventory valuation method.

Hopefully you have gained some meaningful understanding of inventory management. Effective, efficient inventory management demands aggressive attention by all persons concerned within your organization.

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