Understanding Inventory for Small Business Owners

Inventory is the goods a business has for sale, including raw materials, items being made, and finished products.

This article provides an in-depth look at inventory and why it matters to your business. We’ll cover different types of inventory, the methods to value them, the basics of inventory accounting, challenges you may encounter, and best practices for managing inventory effectively.

Also, this guide is related to our articles on understanding prepaid expenses, operating income vs EBITDA, and how to calculate break-even point in sales.

This list includes:

– inventory definition for small businesses
– understanding inventory valuation
– inventory accounting 101
– dealing with inventory management challenges
– best practices for effective inventory management

Let’s start learning!

Types of inventory 

Inventory is the lifeblood of your small business; you need to understand inventory types so that you can maintain stock levels that align with your sales requirements.

Let’s look at the three main categories of inventory: raw materials, work-in-progress (WIP), and finished goods.

Raw materials 

Raw materials are the basic ingredients or components that you use to create your products. For a bakery, this probably includes flour, sugar, and eggs. If you’re a jewelry designer, your raw materials could be gemstones, metals, or beads.

Basically, these are items you buy to create something sellable, while not selling them directly to customers as they are. You need to keep a close eye on your raw materials as they are the first step in your production process. If you run out and can’t make your product, you lose selling opportunities.

Work-in-progress (WIP)

The next level of inventory is the work-in-progress (WIP) or partially finished goods. This is inventory that is still in the production process and has yet to become a finished, sellable product.

So, if you’re a furniture maker and you have a half-assembled table or a chair that still needs to be stained, those items would fall under WIP. You’ve invested in the raw materials and have begun the process to make them sellable, but they’re not yet ready to be sold and bring in income.

Finished foods

Finished goods are the final products that are ready for sale to your customers. These items have completed the production process and are in a condition to be sold without any further modifications.

Inventory valuation methods

Inventory has a cash value that needs to be recorded in your books. But what and how do you figure it out? There are several ways to accurately value your inventory–here are a few of the most common.

FIFO (first-in, first-out)

One inventory valuation method you might consider is FIFO, or first-in, first-out, where the oldest items in your inventory are the first to be sold. The inventory leftover at the end of the accounting period is then valued at its most recent cost. This strategy tends to give a fairly accurate representation of the current market conditions because the remaining inventory’s value is based on the most recent purchase rates.

LIFO (last-in, first-out)

Another way of calculating inventory valuation is LIFO, or last-in, first-out. As the name suggests, when using this method you’d sell the newest items first, leaving the older stock for last. However, this can distort actual inventory value since you may end up with a stockpile of older items in your inventory. If prices are rising, though, LIFO can help decrease your tax liability because your costs will appear higher and profits lower.

Weighted average cost

Finally there’s the weighted average cost method, which calculates inventory cost based on the average cost of all items bought throughout the period. With this method, you add together the cost of all units in your inventory, then divide by the total number of units. One of the benefits of doing this is that it smooths out price fluctuations, making your financial statements less volatile.

Inventory accounting

Now that we understand types of inventory, let’s dig into inventory accounting for the small business owner.

What is inventory accounting?

Inventory accounting is basically keeping track of the goods your business has. This includes recording costs, monitoring what’s in stock, and measuring how it changes over time.

How does inventory accounting work?

Inventory is classified as a current asset on your balance sheet. The accounting process begins with the acquisition of inventory. Costs at this stage step typically include the purchase cost, freight charges, and other related expenses. These costs are initially recorded in a purchases account.

When a sale is made and inventory is dispatched, your accounting system needs to reflect this. The cost of the goods sold is removed from the purchases account and shifted to the cost of goods sold’ (COGS) account.

The three accounting methods outlined above–first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost method–are how inventory cost is calculated. Each method has its pros and cons, so choosing the right one depends on your business needs and reporting requirements. Your choice can significantly affect your balance sheet and income statement, so researching other similar businesses may help you decide.

Challenges in inventory management

Before we get into our helpful tips, let’s look at some common challenges you may experience.

Overstocking 

Overstocking happens when you have too much stock on hand. You’ve invested a great deal of money in goods that now sit in your store, not getting sold. This can tie up capital, leaving less liquidity for other business expenditures. And some product types may have an expiration date, too, making overstocking a potential loss.

Understocking 

Going to the other extreme can be equally damaging. When you are understocking, you risk losing sales and disappointing your customers. If your shelves are empty, people will likely look for what they need elsewhere, damaging not only a single sale but possibly losing a repeat customer.

Inventory obsolescence 

Sometimes items in your inventory become outdated or obsolete–unsellable. It could be because of a shift in trends or simply product degradation. Inventory obsolescence can cause significant financial loss, as the money you’ve spent on these items might be gone forever.

Strategies to address these challenges

Now that you’re aware of the common inventory challenges, you may be wondering what, if anything, you can do about them. Happily, there are!

Overcoming overstocking 

The antidote to overstocking is foresight and planning. Try to predict your sales as accurately as possible, using historical sales data and considered predictions. You want to have an adequate amount of stock, but not too much.

You need to understand the demands and buying habits of your customer base, and regularly updating and analyzing your sales data will help you avoid overstocking.

Tackling understocking 

Just as planning can prevent overstocking, it can also prevent understocking. Forecasting future sales based on past trends and considering upcoming seasons or special events can help you maintain a balanced inventory.

Regularly review your sales data and take note of sold-out items. Always order new stock before you run out to avoid being left empty-handed.

Managing inventory obsolescence 

The best strategy to deal with obsolescence is to stay abreast of market trends and shifts in consumer behavior. Regularly review your inventory for items that haven’t been selling in a while–taking into account seasonal swings, of course. These low- or no-selling products could be on their way to becoming obsolete and shouldn’t be re-ordered out of habit, without checking the data.

Best practices for effective inventory management

Here are some more ideas to help you make the most of your inventory as a small business owner.

1. Keep your inventory organized

You need an organized inventory system. Knowing precisely what you have, and where it is, saves time and reduces headaches. Create a system that works for you and your team.

You could use warehouse or store layouts, specific shelving systems, or inventory management software. Remember, the more accessible your stuff, the easier it is to manage, access, and sell.

2. Use forecasting and customer demand

Forecasting can be a game-changer for your inventory management. By predicting the demand for your product, you’ll be better at knowing what, when, and how much to order. Look at your past sales, current market trends, and special factors like holidays or events that may affect demand. A good forecasting system can significantly reduce the likelihood of getting caught with too much or too little stock on hand.

3. Opt for just-in-time inventory

Just-in-time (JIT) inventory management can help you cut costs and boost efficiency. The idea here is to keep your stock levels as low as possible, ordering exactly what you need, when you need it. You save on storage costs and run less risk of waste from perishable or outdated items.

To do this, though, you need good relationships with reliable suppliers, so it’s worth investing in those connections.

4. Implement a first-in, first-out approach

The first-in, first-out (FIFO) approach is helpful, particularly with perishable products. As explained earlier, this is when you sell the items you stocked first, first, so that nothing gets out of date or spoiled. This simple rule can reduce waste, save money, and make your stock control much more efficient.

Inventory metrics and key performance indicators (KPIs)

Inventory metrics and key performance indicators (KPIs) are measurements that help you understand how your business is doing. They give you a clear picture of things like how fast your products are selling, how much it costs to keep your inventory, and how accurate your orders are.

Turnover rate

First, let’s talk about turnover rate: how often or how quickly your inventory sells out. If your turnover rate is high, it means your products are getting sold and replaced swiftly. However, if your turnover rate is low, it may mean you’re dealing with overstock, which can lead to high carrying costs and even cause a cash flow crunch.

Keep a close eye on your turnover rate. If it’s lower than you’d like it to be, you might want to consider promotions or discounts to sell excess stock or maybe reevaluate some of your product offerings altogether.

Carrying cost

Next up is the carrying cost, which is the cost of holding and storing your inventory. This includes things like warehousing, transportation, and insurance. Reducing carrying cost directly impacts your bottom line.

To keep carrying costs down, examine and modify your inventory management strategy. Consider practices like just-in-time inventory, where you only order and keep what you need, when you need it.

Order accuracy

The last important metric we’ll discuss is order accuracy: how accurately your orders are picked, packed, and shipped compared to the original sales order. Incorrect orders can lead to returns and complaints, which can decrease customer satisfaction and even damage your brand reputation. Regularly review and record any errors in your orders and take immediate corrective action. Look at the possible root causes of these errors and work to eliminate them.

Conclusion

Understanding and managing inventory effectively is a game-changer for small businesses. By getting a hold on your inventory, you can make smart decisions about what to stock up on and what to let go of, potentially saving you a lot in the long run. Plus, when you have what your customers want, when they want it, it boosts both satisfaction and sales–a win-win!

Next, check out our articles on operating income vs. net income, cash flow vs. revenue, and how to do bank reconciliations.

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Author: Julia Kelly

Co-founder at Rigits

I write about how small business owners can better understand and utilize their financials for growth.

Julia Kelly