Inventory management entails knowing how well products sell, keeping the right number of products in stock, accurately and timely.
Inventory or goods is the most valuable asset for any product led or manufacturing businesses. Managing the inflow, storage, and outflow of inventory effectively is critical to the company's financial success and growth. Customers can place orders with confidence when inventory management is done correctly, stock levels are kept at optimal levels, waste is minimized, and ultimately will lead to increase in toppling of the business.
Poor inventory strategies, on the other hand, can result in undesirable stock levels, late deliveries, and loss of revenue. Remember that, while inventory is a current asset, it is still riskier than cash because inventory may not always be liquidable.
Inventory management entails knowing how well products sell, keeping the right number of products in stock, accurately and timely filling orders, and carefully controlling costs. Many businesses use inventory management software to help them manage the process. This should ideally be a "perpetual" or "continual" inventory management system that tracks inventory item movement in real-time and continuously updates the accounting system.
Effective inventory management is dependent on a number of factors. The following are some inventory strategies used by CFOs to help reduce losses and maximize profits by managing inventory levels.
Because inventory can account for a significant portion of a company's assets, it is critical to keep enough products on hand to fulfil orders while keeping inventory costs at an acceptable level.
Keeping the right amount of product on hand ensures that orders can be filled without tying up too much working capital in inventory that may not move quickly.
Consider sales projections as well as the cost of storing and maintaining inventory when deciding how much stock to keep on hand. Inventory left on the shelf for too long can actually cost you money if not properly tracked. You can also lose money (and customers) if you don't keep enough stock of high-demand items on hand to fill orders on time.
Many companies use one or more of the following ways to manage their stock levels:
Economic Order Quantity is a formula for determining ideal stock levels (EOQ). This formula has been around since Ford W. Harris discovered it in 1913, and it is still relevant for many businesses today. For a specific product:
EOQ = square root of [(2 x demand x ordering costs) ÷ carrying costs]
Companies that carry a wide range of products can often benefit from a technique that divides inventory into three categories based on popularity and the cost of stocking them:
An ABC analysis can assist a business in controlling its working capital costs by indicating which products should be reordered frequently and which can be restocked less frequently. This can improve inventory turnover, assist in the reduction of obsolete inventory, and be considered in product pricing and supplier negotiations.
This method assists businesses in analyzing profitability and determining which products require changes such as cost reductions or price increases. The analysis could also turn up "D" or "Dead" products that don't sell well enough to justify keeping them in stock at all. These unprofitable products may have to be liquidated and phased out.
Inventory that has been overpriced must be adjusted accordingly. Businesses must carry inventory at the lower of purchase cost or market value.
Many product sales experience peaks and troughs depending on factors such as the time of year, holiday shopping, or special events. At certain times, some products may take longer to obtain from suppliers. Companies must pay attention to these trends, identify patterns, and adjust inventories accordingly.
A quantity of surplus inventory kept on hand to prepare for peaks in demand and supply-chain lags is referred to as safety stock. A company may be unable to fulfil orders on time if it lacks safety stock. This could result in revenue loss as well as customer and market share loss.
However, safety stock should be kept to a minimum and closely monitored, as it can lead to overstocking and capital ties. Long-term sales patterns can help you determine when and whether to keep safety stock on hand.
The reorder point is the best time to order more inventory from a supplier. This is the point at which your inventory of a specific product has reached its minimum sustainable quantity. When circumstances change, some supply chain managers rely on their "instincts" to determine reorder points, which can lead to unexpected stock outs. Other businesses may find the following formula useful:
Reorder Point = (Average Daily Unit Sales X Average Lead Time in Days) + Safety Stock
It is critical to review vendor relationships and contracts on a regular basis. How effective are they? Is the vendor providing good services at reasonable prices, or should you look for alternatives? Is your current supply chain keeping up with market demand? Could better vendor contract terms be negotiated? The goal should be to shorten the time between when you must pay for inventory and when you receive payment for it.
What if a vendor has a one-time sale? It may be advantageous to take advantage of the enticing offer and stock up. However, this could be risky if it raises carrying costs or ties up capital that could be used elsewhere. The following factors should be considered when deciding whether to accept or decline the offer:
The most common accounting method is FIFO. In most cases, you should use FIFO to sell the oldest inventory first and rotate it. For example, if your company handles food, medicines, or other perishable goods, it is critical to avoid waste and loss of revenue by selling older items before they expire. This is less important if you sell items that do not expire or go out of style, such as bricks or hand tools.
For accounting purposes, FIFO values current inventory items at their most recent cost. This generally results in a high inventory valuation and a low cost of goods sold.
LIFO is typically associated with a lower inventory valuation and a higher cost of goods sold (COGS). Higher COGS lower net income and may result in lower taxes. However, LIFO accounting is more complicated and, once again, is not accepted internationally by the IFRS.
Average Cost calculates the weighted average of all items and revalues all inventory on a continuous basis.
Periodic cycle and/or annual physical counts should be performed to confirm system inventory levels and make necessary adjustments.
The well-known 80/20 principle states that 20% of effort yields 80% of the results. Similarly, a very small percentage of your goods generates the most revenue. As a result, it is critical to evaluate your product line on a regular basis and keep an eye out for trends. The goal should be to revise or eliminate products with low (or no) profitability while increasing the profitability of the most profitable products. Of course, any market and production constraints must be considered.
Drop-shipping is a low-cost sales model that allows online retailers to sell products without stocking them. The wholesaler typically owns, stocks, and ships the products, while the retailer determines the selling price and makes the sales. The retailer sends the orders to the supplier with the wholesale payment and keeps the difference as profit. The order is fulfilled and shipped to the customer as if it came from the retailer.
This model has advantages in terms of lowering inventory and shipping costs, but it also has disadvantages. If the wholesaler fails to provide good service, your company bears full responsibility. Many retailers choose to purchase small quantities of items on a regular basis and keep them in stock in order to monitor the wholesaler's performance and to protect themselves from issues such as the wholesaler running out of stock or shipping damaged goods.
This option allows the wholesaler to store product owned by the retailer. The retailer only receives payment for items sold. The retailer benefits from using just-in-time inventory. This inventory, however, takes up space in the retailer's warehouse. Furthermore, the retailer is usually in charge of product protection and insurance.
Successful businesses cannot afford to have their inventory costs mismanaged. Inventory management is critical to profitability and customer retention. Continuous evaluation is essential for maintaining proper inventory levels and maximizing sales revenue. Give us a call if you need assistance setting up or improving your inventory strategies. Jordensky will gladly assist you.
At Jordensky, we specialize in accounting, taxes, MIS, and CFO services for Startups and growing business and are focused on delivering an experience of unparalleled quality. When you work with Jordensky, you get a team of finance experts who take the finance work off your plate – ”so you can focus on your business.”