Inventory

There’s more to inventory control than simply buying newproducts. You have to know what to buy, when to buy it and how muchto buy. You also need to track your inventory–whether manually orby computer–and use that knowledge to hone your purchasingprocess.Your business’s basic stock should provide a reasonableassortment of products and should be big enough to cover the normalsales demands of your business. When calculating basic stock, youmust also factor in lead time–the length of time betweenreordering and receiving a product. For instance, if your lead timeis four weeks and a particular product line sells 10 units a week,then you must reorder before the basic inventory level falls below40 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 partsthat are crucial to your production process means increasedoperating costs, too. Your employees will be getting paid to sitaround because there’s no work for them to do; when the inventorydoes come in, they’ll be paid for working overtime to make up forlost production time. In some situations, you could even end upbuying emergency inventory at high prices.

One way to protect yourself from such shortfalls is by buildinga safety margin into basic inventory figures. To figure out theright safety margin for your business, try to think of all theoutside factors that could contribute to delays, such as supplierswho tend to be late or goods being shipped from overseas. Onceyou’ve been in business a while, you’ll have a better feel fordelivery times and will find it fairly easy to calculate yoursafety margin.

Avoiding excess inventory is especially important for owners ofcompanies with seasonal product lines, such as clothing, homeaccessories, and holiday and gift items. These products have ashort “shelf life” and are hard to sell once they’re no longer infashion. Entrepreneurs who sell more timeless products, such asplumbing equipment, office supplies or auto products, have moreleeway because it takes longer for these items to becomeobsolete.

No matter what your business is, however, excess inventoryshould be avoided. It costs money in extra overhead, debt serviceon loans to purchase the excess inventory, additional personalproperty tax on unsold inventory and increased insurance costs. Onemerchandise consultant estimates that it costs the average retailerfrom 20 to 30 percent of the original inventory investment just tomaintain it.

Buying excess inventory also reduces your liquidity–somethingto be avoided. Consider the example of an auto supply retailer whofinds himself with the opportunity to buy 1,000 gallons ofantifreeze at a huge discount. If he buys the antifreeze and itturns out to be a mild winter, he’ll be sitting on 1,000 gallons ofantifreeze. Even though he knows he can sell the antifreeze duringthe next cold winter, it’s still taking up space in his warehousefor an entire year–space that could be devoted to more profitableproducts.

When you find yourself with excess inventory, your naturalreaction will probably be to reduce the price and sell it quickly.Although this solves the overstocking problem, it also reduces yourreturn on investment. All your financial projections assume thatyou will receive the full price for your goods. If you slash yourprices 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 beingoverly cautious the next time they order stock. However, this putsyou at risk of having an inventory shortage. To avoid accumulatingexcess inventory, set a realistic safety margin and order only whatyou’re sure you can sell.

You don’t automatically get a deduction for purchasing inventoryfor your business. You must reduce the amount paid for inventory bythe value of the inventory at the end of the year. For example, ifyou paid $10,000 for merchandise in one year and your inventory atthe end of the year were $7,000, you could only deduct $3,000 forpurchases in the year, even though you paid $10,000.

How you determine a value for your inventory has taximplications. The FIFO (first in, first out) method assumes theitems you purchased or produced first are the first items you soldor consumed. The items in inventory at the end of the tax year arematched with the costs of similar items that you most recentlypurchased or produced. The LIFO (last in, first out) method assumesthe items of inventory you purchased or produced last are the firstitems you sold or consumed. Items included in closing inventory areconsidered to be from the opening inventory in the order ofacquisition and from those acquired during the tax year.

Each method produces different income results, depending oncurrent price levels. In times of inflation, LIFO produces a largercost of goods sold and a lower closing inventory. With FIFO, thecost of goods sold will be lower, and the closing inventory will behigher. In deflationary times, the opposite is true.

The rules for using the LIFO method are complex. Once you adoptit, IRS approval is required to return to FIFO. Since the value ofyour inventory is a major factor in determining your taxableincome, get your CPA’s help so you use the method that works foryour business.