Businesses that have inventory have a number of considerations to make when it comes to keeping track of their actual vs book inventory.
Very few businesses don’t use computer systems today and most have robust inventory control software that is integrated in either point of sale or other billing software. Hopefully the value of your inventory automatically flows into your balance sheet so you have an accurate up to date balance sheet.
My belief is that the average business should be able to produce an accurate balance sheet, income statement, accounts receivable and payable aging very shortly after each month has ended. Quickbooks and other modern accounting software systems certainly allow for this to be possible. The key is keeping the inventory accurate, entering accounts payable into the system as soon as the payable has been accrued, and making sure credits and customer payments are posted in a timely manner.
In terms of inventory, the IRS requires a business to state its inventory value to be declared on its annual tax return. There is an expectation that inventory will be physically counted and the number of units will be multiplied by the cost of good. The IRS only requires that the inventory count be a done in a manner that produces an accurate result.
For small businesses that maintain a small inventory, a single annual physical inventory count makes sense. However, if your business maintains a large number of items (SKUs) in inventory, it may be more accurate to use a cycle counting method rather than one single large inventory.
Cycle counting inventory is a method that divides the inventory into say 12 segments where each segment of inventory gets counted once a year.
There are a number of advantages to using the cycle counting method over the annual physical inventory method. First of all, a number of studies have proven that less error is likely in a cycle counting program vs a single annual inventory. The reasons most often cited is that the complexity of doing an annual physical inventory are much greater and therefore there is more chance for causing error.
Using a cycle counting method also allows you to look at the sales history of each item counted and increase or reduce the stocking quantity depending on sales. If an item has no sales during the past 12 months management may elect not to stock it again when it sales. Decision making about inventory popularity and desired quantity on hand requires a “hands-on” approach to managing inventory. Using a cycle counting method allows management to be more involved on a SKU level.
When cycle counting is done properly, the process includes the following steps:
- Using your inventory control system ranking feature calculate the popularity of a particular item once a year.
- Determine which inventory should have the stocking quantity set to 0 based on the last year’s historical sales. If your vendor will take it back and exchange it for faster moving inventory, pull the inventory you want to send back and set the quantities on hand to 0.
- Count the inventory by vendor or product line, depending on what makes since for your business. Divide the entire inventory into 12 logical segments and determine which month you plan on counting a particular segment.
- After your count is done, look at your history of lost sales during the year. If you determine that an item’s popularity has increased during the year, consider raising the stocking quantity value so you will stock more of the most popular SKUs.
There are several important considerations to remember. When you are receiving in inventory into QuickBooks or a similar system, separate freight and other non inventory charges from the inventory, otherwise the value of your inventory will be inflated. This is especially important if you use a separate point of sale or inventory control system.
In the past 12 months cost of goods sold has significantly increased for many industries. Make sure your SKU current cost is accurate in your system always. When possible, recalculate the selling price to achieve your company’s target gross margin for that item.
Businesses that use this approach find they have more accurate inventory book value, lose fewer sales, and have a higher gross margin than those that don’t.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
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