It feels good to have a warehouse full of inventory, but you have to pay for your stock, often before you are able to turn around and resell it. Effective inventory control helps you to keep what you need on hand without buying more than you can afford or manage. This makes your business run smoothly, keeps your cash liquid and keeps your shelves full but not too full.
TL;DR (Too Long; Didn't Read)
The purpose of inventory management is to keep inventory levels sustainable so your business can be more profitable.
Is Inventory an Asset?
You'd think that it would be a good thing to have plenty of inventory. Everything you have on hand to resell or use as raw materials in something you manufacture has the potential to bring in revenue. You can't sell $1,000 worth of goods if you don't have the $1,000 worth of stock on hand to sell. In fact, traditional accounting lists inventory as an asset on your balance sheet, increasing the paper value of your company.
In practice, however, inventory can be a liability as much as an asset. Cash that is tied up in stock that is sitting on your shelves is cash that is not available for you to spend on more pressing expenses such as rent or payroll. Customer tastes change and the backlog of items that you purchased this month may not be in demand next year. You'll end up wasting money if you buy inventory you won't eventually sell, even if you save money by buying in bulk, because you may not be able to sell everything you buy.
The Purpose of Stock Control
The purpose of stock control is to have as much as you need on hand without having too much inventory to manage or sell. Inventory management gathers and evaluates data about demand, turnover rates and inventory levels, giving you the information you require to place orders when necessary and sell down existing stock when you can.
Inventory control is often done digitally, using inventory management systems that track when an item is ordered and restocked. Your inventory control system may even have an automatic ordering feature that alerts you or even places your order once stock gets below a certain level. But inventory control programs are only as good as the information you enter into them, which can change regularly. If demand for a product increases, your established reorder point may turn out to be too low, and if demand declines, that same reorder point may turn out to be too high.
The Importance of Inventory Management
Effective inventory management is beneficial for both your cash flow and your production systems. In addition to the importance of keeping inventory as lean as possible so you'll have more cash available, inventory control should also be coordinated with finance and accounts payable for the purpose of making strategic decisions.
If you know each vendor's terms, you can make inventory purchases that your accounts payable department won't have much difficulty paying. It makes more sense to put off ordering from a company that requires you to pay for each order upfront than one that gives you 30 days to pay, especially when cash is tight.
Similarly, inventory management depends on how urgently your production department needs an item and whether there are alternate sources for obtaining this inventory. If you know the timelines for order and delivery and you understand the rhythm of how each material used, you can time inventory purchases so you have what you need when you need it, but you don't have an excessive supply on hand. Also, you can cut things closer for items that you can obtain quickly or through multiple sources than for inventory purchases with long lead times.
Types of Inventory
Different businesses use different types of inventory, which require different management strategies.
- Raw materials. If you run a manufacturing business, you must manage your inventory of parts used throughout the production process. This includes knowing what you need, when you will need it and how critical each item is to the production process. It's more important to always be well-stocked for a critical item that you use early in the process than something that can easily be attached at the very end. A shortage of the former will bring production to a standstill while a shortage of the latter can easily be fixed down the line.
- Parts manufactured in-house. If your business manufactures in-house the components it uses in its own products, your inventory management should be geared towards coordinating the department that manufactures the components with the departments that manufacture the finished products. Unlike raw materials that you buy from an outside vendor, you may have the flexibility of avoiding time-consuming slowdowns for deliveries.
- Inventory for resale. If your business purchases goods from vendors and then resells them to customers, you must have enough of a selection on hand for your customers to have a choice. Your inventory management may depend on tracking and also anticipating customer tastes.
Having options on hand for customers is more important for a brick-and-mortar business than for an online retailer because an internet business can sometimes even order the item from its suppliers after a customer has placed an order. In fact, internet retailers who work with dropshipped products don't need to carry inventory at all but can forward orders to their vendors for direct fulfillment.
- Finished goods inventory. These are the items that your production department has finished manufacturing but has not yet sold. The ideal amount of finished goods inventory for a business will depend on how long it takes to produce an item, how much lead time customers expect to wait and how much demand there is for your finished products. If you are producing products as quickly as you are selling them, it may make sense to build up some finished goods inventory to avoid falling behind if anything goes wrong.
Inventory Management and Accounting
Your inventory management figures come into play in your bookkeeping system in a variety of ways. Cost of goods sold, or the cost of producing or acquiring the items you sell to your customers, is calculated by factoring in your inventory at the beginning of a reporting period and factoring out the inventory you have on hand at the close of that period. These equations allow you to determine the exact amount of inventory you actually sold and compare it to the revenue you received from selling it.
When calculating gross and net profit, you must also subtract out the inventory you have on hand because you have not yet used these items in the course of doing business even though you have spent money on them. Your inventory levels affect the amount you will pay in taxes because items that have been purchased but have not yet been used cannot be subtracted from your gross revenue. As a result, your net income will be higher and you will owe more in taxes.
The importance of inventory management for your accounting department lies in its ability to have numbers available when you need them. If you have been managing and keeping track of your stock levels on a regular basis, you will have these figures conveniently accessible and you may not need to count each item individually.
- Handshake: What is Inventory Control?
- Accounting Coach: What is Inventory?
- Accounting Tools: Accounting Inventory Methods
- Projectline: 5 Inventory Management Strategies to Improve Efficiency
- Masao Nakamura, Sadao Sakakibara and Roger Schroeder. "Adoption of Just-in-Time Manufacturing Methods at U.S.- and Japanese-Owned Plants: Some Empirical Evidence," pages 230-231. IEEE Transactions on Engineering Management, 1988.
- Electronic Code of Federal Regulations. "Regulation S-X, 17 CFR Part 210: Sec. 210.5-02 Balance sheets." Accessed Aug. 1, 2020.
Devra Gartenstein founded her first food business in 1987. In 2013 she transformed her most recent venture, a farmers market concession and catering company, into a worker-owned cooperative. She does one-on-one mentoring and consulting focused on entrepreneurship and practical business skills.