Definition: An itemized list or catalog of the stock of a business
There's more to inventory control than simply buying new
products. You have to know what to buy, when to buy it and how much
to buy. You also need to track your inventory--whether manually or
by computer--and use that knowledge to hone your purchasing
process.Your business's basic stock should provide a reasonable
assortment of products and should be big enough to cover the normal
sales demands of your business. When calculating basic stock, you
must also factor in lead time--the length of time between
reordering and receiving a product. For instance, if your lead time
is four weeks and a particular product line sells 10 units a week,
then you must reorder before the basic inventory level falls below
40 units. If you don't reorder until you actually need the stock,
you'll be without the product for four weeks.
Insufficient inventory means lost sales and costly,
time-consuming back orders. Running out of raw materials or parts
that are crucial to your production process means increased
operating costs, too. Your employees will be getting paid to sit
around because there's no work for them to do; when the inventory
does come in, they'll be paid for working overtime to make up for
lost production time. In some situations, you could even end up
buying emergency inventory at high prices.
One way to protect yourself from such shortfalls is by building
a safety margin into basic inventory figures. To figure out the
right safety margin for your business, try to think of all the
outside factors that could contribute to delays, such as suppliers
who tend to be late or goods being shipped from overseas. Once
you've been in business a while, you'll have a better feel for
delivery times and will find it fairly easy to calculate your
safety margin.
Avoiding excess inventory is especially important for owners of
companies with seasonal product lines, such as clothing, home
accessories, and holiday and gift items. These products have a
short "shelf life" and are hard to sell once they're no longer in
fashion. Entrepreneurs who sell more timeless products, such as
plumbing equipment, office supplies or auto products, have more
leeway because it takes longer for these items to become
obsolete.
No matter what your business is, however, excess inventory
should be avoided. It costs money in extra overhead, debt service
on loans to purchase the excess inventory, additional personal
property tax on unsold inventory and increased insurance costs. One
merchandise consultant estimates that it costs the average retailer
from 20 to 30 percent of the original inventory investment just to
maintain it.
Buying excess inventory also reduces your liquidity--something
to be avoided. Consider the example of an auto supply retailer who
finds himself with the opportunity to buy 1,000 gallons of
antifreeze at a huge discount. If he buys the antifreeze and it
turns out to be a mild winter, he'll be sitting on 1,000 gallons of
antifreeze. Even though he knows he can sell the antifreeze during
the next cold winter, it's still taking up space in his warehouse
for an entire year--space that could be devoted to more profitable
products.
When you find yourself with excess inventory, your natural
reaction will probably be to reduce the price and sell it quickly.
Although this solves the overstocking problem, it also reduces your
return on investment. All your financial projections assume that
you will receive the full price for your goods. If you slash your
prices by 15 to 25 percent just to get rid of the excess inventory,
you're losing money you'd counted on bringing in.
Some novice entrepreneurs react to excess inventory by being
overly cautious the next time they order stock. However, this puts
you at risk of having an inventory shortage. To avoid accumulating
excess inventory, set a realistic safety margin and order only what
you're sure you can sell.
You don't automatically get a deduction for purchasing inventory
for your business. You must reduce the amount paid for inventory by
the value of the inventory at the end of the year. For example, if
you paid $10,000 for merchandise in one year and your inventory at
the end of the year were $7,000, you could only deduct $3,000 for
purchases in the year, even though you paid $10,000.
How you determine a value for your inventory has tax
implications. The FIFO (first in, first out) method assumes the
items you purchased or produced first are the first items you sold
or consumed. The items in inventory at the end of the tax year are
matched with the costs of similar items that you most recently
purchased or produced. The LIFO (last in, first out) method assumes
the items of inventory you purchased or produced last are the first
items you sold or consumed. Items included in closing inventory are
considered to be from the opening inventory in the order of
acquisition and from those acquired during the tax year.
Each method produces different income results, depending on
current price levels. In times of inflation, LIFO produces a larger
cost of goods sold and a lower closing inventory. With FIFO, the
cost of goods sold will be lower, and the closing inventory will be
higher. In deflationary times, the opposite is true.
The rules for using the LIFO method are complex. Once you adopt
it, IRS approval is required to return to FIFO. Since the value of
your inventory is a major factor in determining your taxable
income, get your CPA's help so you use the method that works for
your business.