By Entrepreneur Staff


Inventory 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.

More from Operations

Capital Equipment

Equipment that you use to manufacture a product, provide a service or use to sell, store and deliver merchandise. This equipment has an extended life so that it is properly regarded as a fixed asset.

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The process of receiving, packaging and shipping orders for goods

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The process of bringing goods from one country for the purpose of reselling them in another country

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An expense item set up to express the diminishing life expectancy and value of any equipment (including vehicles). Depreciation is set up over a fixed period of time based on current tax regulation. Items fully depreciated are no longer carried as assets on the company books.

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