I have seen inventory misstated in almost every company I’ve consulted. It’s probably the most difficult piece of accounting for small businesses that offer physical products. So, how is inventory financial management supposed to work for a small business?
Purchasing raw materials, paying for packaging, or paying for the processing of raw ingredients into finished products are all inventory costs. Using the number of finished goods created, you can do a little math and determine the cost per unit/item. When one unit is sold, the cost per unit is removed from inventory and recorded to the cost of goods sold on the profit and loss. Many times, I see businesses recording the raw materials and processing costs directly to the cost of goods sold, which underreports profit in the current period. It also overreports profits in the future, when the items are sold.
Know your inventory! What do you have? What are your best-selling items? If you’re selling 2,000 units a month of an item and it takes you 60 days to create new inventory, you need to start by ordering at least 4,000 units to cover the first two months of sales. Then, you can slow down and order 2,000 units per month.
Part of understanding inventory management is having a profit strategy. Which inventory items have you had the longest? It could be that certain items are just not desired by your customer, not priced right, ineffectively placed in your retail space, or that the marketing needs to be adjusted. Whatever the reason, you need to clear this inventory out—liquidate it into cash. You can do this by creating better marketing or retail placement for these items to increase the desire or need to buy. Alternatively, you can lower the price and just get it off your shelves and out of your warehouse. Don’t be fooled thinking that holding inventory for three months isn’t costing you a thing. Storage and shelf space aren’t free, and these are part of your inventory costs.
Just knowing your best-selling items and your items with the highest profit margins could result in an increase in sales. These are the items you place at the front of your retail business for impulse sales, put in a prime shelf position, and instruct salespeople to recommend (assuming it is what the customer is asking for).
Do you offer samples and giveaways? That’s great—if they’re actually leading to sales. Regardless of whether your samples and giveaways are currently leading to sales, you need to acknowledge that you’re not getting 100% of your revenue. You’re not receiving revenue on 100% of your products, because you’re giving up the revenue on the samples. This means that the cost of goods sold is not just the cost to produce one unit. The true cost to produce and sell one unit is the cost of one unit plus the sample. Your sales price needs to cover that sample cost plus margin. When I asked one winery owner what percentage of revenue he’s realizing, he looked at me with a funny face and responded with, “100%”. I then had him look at how many bottles of cabernet were used for sampling in the tasting room and how many bottle sales that resulted in. Sure enough, he was only realizing about 43% of the total revenue that could have been earned if all bottles were sold at full price. How many sales are you making from those samples, or are they losing revenue?
Do you know the margin on each item you have in inventory? I find that business owners calculate margin by looking at the retail price less the direct costs to manufacture the item. However, the cost of inventory should include the delivery charges, shipping, and storage costs. Additionally, if you’re giving out samples or discounting your items, then you’re not receiving 100% of your retail revenue and your profit margin is no longer what you thought it would be. If you’re not calculating your true cost per unit correctly, including costs of inventory, you could be underpricing items or potentially losing money when you think you’re making it. For a business with inventory, inventory costing is arguably the most important element of your accounting.
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