An inventory is the entirety of those things owned by a company and intended for resale or the raw materials and parts to be used in producing salable goods and products.
Inventories are time-sensitive storage systems that can be divided into three categories. First are cycle stocks: the order quantity or lot size received from the plant or vendor. Second are in-transit stocks: inventory in shipment from the plant or vendor or between distribution centers. Third are safety stocks: the items in inventory that serve as a buffer against forecast error and lead time variability.
Historically, there have been two basic inventory systems: the continuous review system and the periodic review system. With continuous review systems, the level of a company’s inventory is monitored at all times.
Under these arrangements, businesses typically track inventory until it reaches a predetermined point of “low” holdings, whereupon the company makes an order (also of a generally predetermined level) to push its holdings back up to a desirable level. Since the same amount is ordered on each occasion, continuous review systems are sometimes also referred to as event-triggered systems, fixed order size systems (FOSS), or economic order quantity systems (EOQ). Periodic review systems, on the other hand, check inventory levels at fixed intervals rather than through continuous monitoring. These periodic reviews (weekly, biweekly, or monthly checks are common) are also known as time-triggered systems, fixed order interval systems (FOIS), or economic order interval systems (EOI).
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Inventory And The Growing Company
Most successful small companies find that as their economic fortunes rise, so too do the complexities of their inventory system logistics. The resulting need for increased inventory management procedures is due primarily to two factors: 1) greater volume and variety of products, and 2) increased allocation of company resources (such as physical space and financial capital) to accommodate the growth in inventory. For a small company used to ordering parts and materials in an as-needed and informal basis, the transition to a formal and documented system of purchasing and inventory management can be a significant step. It requires the creation of new job functions to identify the costs (holding, shortage) associated with inventory and to implement and manage a formal inventory system. Formal inventory systems require extensive record keeping and on a periodic basis, they must be audited by someone. In addition, this transition to a formal inventory system requires substantial coordination between different functional areas of the company. Such a transition often leads into computerization of inventory management. This can be a challenging project, particularly for companies lacking employees with appropriate backgrounds in data management.
Just-In-Time Inventory Control Just-in-time production is a straightforward idea that may be somewhat difficult to implement. The basic concept is that finished goods should be produced just in time for delivery, and raw materials should be delivered just in time for production.
When this occurs, materials or goods never sit idle. This, in turn, means that a minimum amount of money is tied up in raw materials, semi-finished goods, and finished goods. The result of a well-managed inventory system capable of supporting a just-in-time production system is sustained productivity and quality improvement with greater flexibility and delivery responsiveness. This production concept, which originated in Japan and became immensely popular in American industries in the early and mid-1990s, continues to be hailed by proponents as a viable alternative for businesses looking for a competitive edge.
Setting An Inventory Strategy
No single inventory strategy is effective for all businesses.
When a company is faced with a need to establish or reevaluate its inventory control systems, a practice commonly known as “inventory segmenting” or “inventory partitioning” is a helpful tool. This practice is, in essence, a way of breaking down and reviewing total inventory so that a thorough assessment of each category may be made. The inventory may be broken down by product classifications, inventory stages (raw materials, intermediate inventories, finished products), sales and operations groupings, and excess inventories. Proponents of this method of study say that such categorical segmentations break the company’s total inventory into much more manageable parts for analysis.
Key Considerations Inventory management is a key factor in the successful operation of any business for which inventories are an integral part. For both large and small companies, determining whether their inventory systems are successful can be done by answering one question: Does the inventory strategy insure that the company has adequate stock for production and goods shipments while at the same time minimizing inventory costs? If the answer is yes, then the company in question is far more likely to be successful. If, however, the answer is no, then the business is operating under twin burdens that can be of considerable consequence to its ability to survive, let alone flourish.
No factor is more important in ensuring successful inventory management than regular analysis of policies, practices, and results. A useful checklist of actions for those wishing to establish and maintain an effective inventory system includes:
- Regularly reviewing product offerings, including the breadth of the product line and the impact that peripheral products have on inventory.
- Ensuring that inventory strategies are in place for each product and that they are reviewed on a regular basis.
- Reviewing transportation alternatives and their impact on inventory/warehouse capacities.
- Undertaking periodic reviews to ensure that inventory is held at the level that best meets customer needs; this applies to all levels of business, including raw materials, intermediate assembly, and finished products.
- Regularly canvassing key employees for ideas and information that may inform future inventory control plans.
- Determining what level of service (lead time, etc.) is necessary to meet the demands of customers.
- Establishing a system for effectively identifying and managing excess or obsolete inventory, and determining why these goods reached such status.
- Devising a workable system wherein “safety” inventory stocks can be reached and distributed on a timely basis when the company sees an unexpected rise in product demand.
- Calculating the impact of seasonal inventory fluctuations and incorporating them into inventory management strategies.
- Reviewing the company’s forecasting mechanisms and the volatility of the marketplace, both of which can (and do) have a big impact on inventory decisions.
- Instituting a “continuous improvement” philosophy in inventory management.
- Making inventory management decisions that reflect a recognition that inventory is deeply interrelated with other areas of business operation.
To summarize, inventory management systems should be regularly reviewed from top to bottom as an essential part of the annual strategic and business planning processes.
Indeed, even cursory examinations of inventory statistics can provide business owners with valuable insights into how things are going generally. Business consultants and managers alike note that if an individual business has an inventory turnover ratio that is low in relation to the average for the industry in which it operates, this may be a sign that the business is carrying a surplus of obsolete or otherwise unsalable inventory. Conversely, if a business is experiencing unusually high inventory turnover when compared with industry or business averages, then the company may be losing out on sales because of a lack of adequate stock on hand. Determining and tracking the turnover rate of all items in inventory helps in building up an inventory assessment.
The way in which a company accounts for its inventory can have a visible effect on its financial statements.
Inventory is a current asset on the balance sheet. One may think that inventory valuation is relatively simple.
For a retailer, inventory should be valued for what it cost to acquire that inventory. When an inventory item is sold, the inventory account should be reduced (credited) and cost of goods sold should be increased (debited) for the amount paid for each inventory item. This works if a company is operating under the Specific Identification Method. That is, a company knows the cost of every individual item that is sold. This method works well when the amount of inventory a company has is limited and each inventory item is unique. Examples would include car dealerships, jewelers, and art galleries.
The Specific Identification Method, however, is cumbersome in situations where a company owns a great deal of inventory and the items within that inventory are not easily distinguished one from another. As a result, other inventory valuation methods have been developed.
The best known of these are the FIFO (first-in, first out) and LIFO (last-in, first-out) methods.
FIFO First-in, first-out is a method of inventory accounting in which the oldest stock items in a company’s inventory are assumed to have been the first items sold.
Therefore, the inventory that remains is from the most recent purchases. In a period of rising prices, this accounting method yields a higher ending inventory, a lower cost of goods sold, a higher gross profit, and a higher taxable income.
The FIFO method may come the closest to matching the actual physical flow of inventory. Since FIFO assumes that the oldest inventory is always sold first, the valuation of inventory still on hand is at the most recent price. Assuming inflation, this will mean that cost of goods sold will be at its lowest possible amount.
Therefore, a major advantage of FIFO is that it has the effect of maximizing net income within an inflationary environment.
LIFO Last-in, first-out, on the other hand, is an accounting approach that assumes that the most recently acquired items are the first ones sold. Therefore, the inventory that remains is always the oldest inventory.
During economic periods in which prices are rising, this inventory accounting method yields a lower ending inventory, a higher cost of goods sold, a lower gross profit, and a lower taxable income. The LIFO method is preferred by many companies because it has the effect of reducing a company’s taxes, thus increasing cash flow.
However, these attributes of LIFO are only present in an inflationary environment.
The other major advantage of LIFO is that it can have an income smoothing effect. Again, assuming inflation and a company that is doing well, one would expect inventory levels to expand. Therefore, a company is purchasing inventory, but under LIFO, the majority of the cost of these purchases will be on the income statement as part of cost of goods sold. Thus, the most recent and, assuming an inflationary period, most expensive purchases will be the first items sold. As they are sold, the cost of goods sold will rise and net income will be reduced. Net income is still high, but it does not reach the levels that it would if the company used the FIFO method.
Given the important differences that exist between the various inventory accounting methods, it is important that the inventory footnote be read carefully in financial statements, for this part of the document will inform the reader of the method of inventory valuation chosen by a company. Assuming inflation, FIFO will result in higher net income during growth periods and a higher, and more realistic inventory balance. In periods of growth, LIFO will result in lower net income and lower income tax payments, thus enhancing a company’s cash flow. During periods of contraction, LIFO will result in higher income levels, but it will also undervalue inventory over time.
Small business owners weighing a switch to a LIFO inventory valuation method should note that while making the change is a relatively simple process (the company files IRS Form 970 with its tax return), switching away from LIFO is not so easy. Once a company adopts the LIFO method, it can not switch to FIFO without securing IRS approval.
Donating Excess Inventory
In recent years, many small (and large) businesses have gained valuable tax deductions by donating obsolete or excess inventory to charitable organizations, churches, and disaster relief efforts. The type of deduction that can be claimed depends on the business structure of the donating company. “If you’re organized as an S corporation, a partnership, or a sole proprietorship and you donate inventory to a charity that uses the goods to assist the sick, the poor, or children, you’re generally able to take a tax deduction for the cost of producing the inventory,” stated Joan Szabo in Entrepreneur. C Corporations, meanwhile, can deduct the cost of the inventory plus half the difference between the production cost and the inventory’s fair market value, provided the deduction does not exceed twice the cost of the donated goods.
A number of organizations have been established for the express purpose of distributing donated inventory.
Gifts in Kind International (based in Alexandria, Virginia) distributes used computers, high-tech equipment, and other donated inventory to approximately 50,000 domestic and international charities. The Galesburg, Illinois-based National Association for the Exchange of Industrial Resources (NAEIR), meanwhile, distributes excess inventory to more than 5,000 schools, churches, homeless shelters, and other charitable organizations. Office supplies comprise much of the NAEIR goods, but clothing, janitorial supplies, and computer equipment are also distributed. The NAEIR estimates that it has distributed more than $1 billion in corporate inventory donations to American schools and nonprofit organizations since 1977.