An inventory is a detailed, itemized list or record of goods and materials in a company's possession. "The main components of inventory, " wrote Transportation and Distribution contributors David Waller and Barbara Rosenbaum, "are cycle stock: the order quantity or lot size received from the plant or vendor; in-transit stock: inventory in shipment from the plant or vendor or between distribution centers; [and] safety stock: each distribution center's inventory buffer against forecast error and lead time variability."
Writing in Production and Operations Management, Howard J. Weiss and Mark E. Gershon observed that, 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).
Most successful small companies find that as their economic fortunes rise, so too do the complexity of inventory logistics. This increase in inventory management is primarily due 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 accomodate that growth in inventory. "The transition from seat-of-the-pants ordering policies and little or no record keeping to a formal inventory system that includes specific ordering policies and a formalized inventory record file is a difficult one for most companies to make, " stated Weiss and Gershon. "It is but one of the many sources of growing pains that emerging companies experience, especially those in the fast-growing industries, such as fast food or high technology. This transition requires the creation of new job functions to identify the costs (holding, shortage) associated with inventory and to implement the inventory analysis. The inventory record file also must be maintained by someone, and, on a periodic basis, it must be audited by someone. In addition, the transition requires more coordination between different company functions." This transition, they note, often leads into computerization of inventory management. This can be a daunting prospect, particularly for companies lacking employees with appropriate data management backgrounds.
JUST-IN-TIME INVENTORY CONTROL "Just-in-time production is a simple idea that may be difficult to implement, " wrote Gershon and Weiss. "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, which means that a minimum amount of money is tied up in raw materials, semifinished goods, and finished goods…. The just-in-time approach calls for slashing production and purchase lot sizes and also buffer stocks—but incrementally, a little at a time, month after month, year after year. The result 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.
No single inventory strategy is equally effective for all businesses. Indeed, there are many different factors that can impact the usefulness of a given inventory strategy, including positioning of inventory, rationalization, segmentation, and continuous improvement efforts. Moreover, small businesses in particular often face financial and logistical limitations when erecting their inventory systems. And of course, different industries have different inventory needs. Consumer goods producers, for instance, need to have well-balanced inventories at the point of sale, while producers of industrial and commercial products typically do not have clients that require the same degree of delivery lead time.
When a company is faced with a need to establish or reevaluate its inventory control systems, business experts often counsel their corporate clients to engage in a practice commonly known as "inventory segmenting" or "inventory partitioning." This practice is in essence a breakdown and review of total inventory by 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 segmentation 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 fledgling businesses and long-time industry veterans alike. For both kinds of companies, determining whether their inventory systems are successful or not is predicated on one fundamental 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 a successful one. Conversely, if 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.
According to business experts, perhaps no factor is more important in ensuring successful inventory management than regular analysis of policies, practices, and results. Companies that hope to establish or maintain an effective inventory system should make sure that they do the following on a regular basis:
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 sometimes provide business owners with valuable insights into the company's foundations. 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, or if it is low in comparison with the average ratio for the business, it is pretty likely that the business is carrying a surplus of obsolete or otherwise unsalable stock inventory. Conversely, they note that 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. "It will be helpful to determine the turnover rate of each stock item so that you can evaluate how well each is moving, " noted The Entrepreneur Magazine Small Business Advisor. "You may even want to base your inventory turnover on more frequent periods than a year. For perishable items, calculating turnover periods based on daily, weekly, or monthly periods may be necessary to ensure the freshness of the product. This is especially important for food-service operations."
The way in which a company accounts for its inventory can have a dramatic affect on its financial statements. Inventory is a current asset on the balance sheet. Therefore, the valuation of inventory directly affects the inventory, total current asset, and total asset balances. Companies intend to sell their inventory, and when they do, it increases the cost of goods sold, which is often a significant expense on the income statement. Therefore, how a company values its inventory will determine the cost of goods sold amount, which in turn affects gross profit (margin), net income before taxes, taxes owed, and ultimately net income. It is clear, then, that a company's inventory valuation approach can cause a ripple effect throughout its financial picture.
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 dealrships, jewelers, and art galleries.
The Specific Identification Method, however, is cumbersome in situations where a company owns a great deal of inventory and each specific inventory item is relatively indistinguishable from each other. 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. The downside of that effect is that income taxes will be at their greatest.
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 most expensive purchases will increase cost of goods sold, thus lowering net income before taxes, and hence net income. Net income is still high, but it does not reach the levels that it would if the company used the FIFO method.
Given the importance differences that exist between the various inventory accounting methodologies, it is imperative 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.
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.
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