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Managing inventory
In the same way you keep an eye on accounts receivable, managing your inventory helps you to improve cash flows of your business.
Like accounts receivable, inventory is a short-term asset. Generally, short-term assets get used up during the operating cycle of a business, which is generally one year. If you are a manufacturer, your inventory consists of three basic types of inventories: raw materials, work in progress, and finished inventory.
Each of these types represents the various stages of completion of your product as it works its way through the manufacturing and assembly process. If you are a retailer or wholesaler, you just deal with finished inventory.
You can monitor the performance of your inventory by doing a periodic ratio analysis. The two main ratios for evaluating how well you manage your inventory are the inventory turnover ratio and average number of days of inventory (days inventory):
- Inventory turnover ratio. The inventory turnover ratio measures the number of times your business "turns over" its inventory in a year. It is a measure of the operating efficiency of your business. Since the more frequently you turn over your inventory the better, a higher ratio is preferable.
To calculate inventory turnover, divide cost of goods sold (COGS) by average inventory. Use only finished inventory to simplify the calculation. The following table shows how Alpha Beta Co. improves its inventory turnover ratio to 6.0 from 3.6 over the five-year period ending in 2003:
| Alpha Beta Co. |
2003 |
2002 |
2001 |
2000 |
1999 |
| COGS ($000) |
$3,000 |
$2,600 |
$2.300 |
$2,100 |
$1,900 |
| Ave. inventory ($000) |
$500 |
$480 |
$465 |
$495 |
$530 |
| Turnover (times) |
6.0 |
5.4 |
4.9 |
4.2 |
3.6 |
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- Average number of days of inventory. Average number of days of inventory (days inventory) measures the number of days it takes, on average, to sell your finished inventory. This ratio is simply the inverse of the inventory turnover ratio.
To calculate days inventory, divide the number of days in a year (365) by the inventory turnover ratio. Since you only use finished goods in calculating inventory turnover, days inventory also reflects only finished goods. Since the fewer the number of days that finished goods sit on the shelves the better, a lower figure is preferable. The following table shows how Alpha Beta improves its days inventory over the same five-year period:
| Alpha Beta Co. |
2003 |
2002 |
2001 |
2000 |
1999 |
| Turnover (times) |
6.0 |
5.4 |
4.9 |
4.2 |
3.6 |
| Days inventory |
60.8 |
67.6 |
74.5 |
86.9 |
101.4 |
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The accounting method that you choose to value your inventory will affect the value of your cost of goods sold. The basic equation to measure the value of inventory is:
- Beginning inventory + Purchases - Cost of goods
sold = Ending inventory.
Rearranged, this equation also says:
- Beginning inventory + Purchases - Ending Inventory
= Cost of Goods Sold
Beginning inventory is the amount of inventory at the end of the previous period. Ending inventory is the amount of inventory at the end of the current reporting period. Both items are taken from the balance sheet. Purchases are inventories bought over the period anchored by beginning and ending inventory.
Inventory valuation affects cost of goods sold, which, in turn, affects gross profit. The primary methods for valuing inventory are the first-in first-out (FIFO) and last-in first-out (LIFO) methods:
- FIFO. The FIFO method assumes that the inventory you sell is the inventory you purchased earliest. Generally, this inventory was cheaper than the layers of inventory purchased later. As a result of having a higher cost assigned to it (a method called costing), ending (yet-to-be-sold) inventory is larger than it would otherwise be.
Since ending inventory is larger, COGS is lower. (Ending inventory is subtracted from cost of goods sold, from the second formula, above.) A lower COGS means gross profit is higher. Higher gross profit generally results in higher taxable income and income taxes.
When inflation exists, a company using FIFO will report higher income and pay more in taxes. This is because sales are occurring at higher prices but the inventory that is costed to the sold goods was bought at long-ago prices.
- LIFO. LIFO assumes that the inventory you sell is the inventory you most recently purchased. Generally, this inventory costs more than earlier layers of inventory. As a result, ending inventory is smaller than it otherwise would be.
Since ending inventory is smaller, COGS is higher. (Ending inventory is subtracted from COGS). Higher COGS means lower gross profit. A lower gross profit generally results in lower taxable income, and lower income taxes.
When inflation is increasing, a company using LIFO will report lower income and pay less in taxes.
As you can see, in periods of inflation, FIFO results in reporting higher taxable income than LIFO. However, which method you use depends on you. In some cases, you are allowed to switch methods. You may wish to consult a professional accountant to discuss which method to use.
Like accounts receivable, you occasionally have to write off some of your inventory. A write-off tends to occur if you have inventory that is no longer salable or worth the price paid for it.
This is where monitoring your inventory turnover ratio and days inventory help you. By keeping an eye on these ratios, you improve inventory management, averting write-offs associated with stale inventory.
Next Topic: Using trade financing
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