Inventory management is how a business orders, stores, and sells its inventory. Essentially, it looks at the incoming and outgoing of stock. Good inventory management strikes the right balance between maintaining healthy stock levels to meet customer demand and avoiding overordering, which wastes too much money.
By learning the basic principles and best practices of inventory accounting, you can better understand how to manage inventory for your business.
The importance of inventory management
How you manage inventory impacts how your business functions, including sales forecasting and warehouse management. Bad inventory management inflates costs, fails to meet customer needs, and saddles you with excess stock.
This affects your business’s finances and accounting since your cash flow is tied up in unsold products, leading to lost sales and a poor reputation. Instead, an effective inventory management system gives a business a much better chance of maximising revenue, minimising waste, and improving cash flow.
Inventory accounting methods
As inventory is bought, stored, and sold, it represents a current asset for businesses — meaning it must be accounted for in a company’s financial statements, bookkeeping, and reporting obligations.
- FIFO (First in, first out): FIFO is a valuation method in which a business sells its oldest inventory before newer inventory. Under FIFO, a business’s cost of goods sold (COGS) is based on its earliest costs, whereas its ending inventory is based on the most recent purchases.
- AVCO (Weighted average cost method): AVCO pools all costs and divides them by the total number of units (inventory) to obtain the average cost per unit. This is a simpler way to account for inventory, as all costs are spread evenly, whereas FIFO costs are layered by timing.
Depending on your situation, one accounting method will make more sense than the other. For instance, FIFO is predominantly used for businesses with perishable goods — think supermarkets, grocers, bakers, and pharmacies.
It’s important to note that once you choose an inventory accounting method, you can’t switch willy-nilly during a financial year, as it will seriously impact your bookkeeping. Changing will also raise a few eyebrows at the ATO, so if you are looking to change, do so in a new financial year and with a good reason.
Types Of Inventory
Inventory comes in several different types, each with distinct functions. Here are the main ones to track in your accounting:
- Raw materials: The base materials used to make a product for sale. For instance, think of clay for pottery, or flour for bread.
- Work in progress (WIP): The items partway through the production process. Think of an unfired vase ready to go in the kiln, or proofed dough ready for the oven.
- Finished goods: Products and items ready for sale. Think of the luminous vase ready to sell online, or the sourdough fresh from the oven.
- Maintenance, repair, and operating supplies (MRO): Items that support operations but don’t get sold as products. For instance, kilns and ovens.
There are other minor types of inventory to consider, such as dead stock (unsold stock that will most likely be written off), safety stock (10-20% extra stock in case of demand spikes), and merchandise (finished stock that is purchased from a supplier).
Common Inventory Management Methods
Your inventory accounting method is how you track inventory costs. (Every business needs to do that, obviously). But that is just one part of the story. Effective inventory management is about timing.
Here are the most common methods and principles for controlling inventory systems.
ABC Analysis method
The ABC method prioritises your inventory through three inventory categories:
- ‘A’ stock: High-value items in a company’s inventory, bought sparingly to keep costs low. Comprises 10-20% of physical stock on hand.
- ‘B’ Stock: Middle-range items of moderate cost. Comprises around 30-40% of a business’s entire inventory.
- ‘C’ Stock: Low-ticket items purchased in bulk at low cost. Comprise about 50% of your holding stock.
The point of using the ABC Method is to help inventory managers prioritise their stock by maintaining healthy inventory levels for each category and tight controls over their best-selling and most high-value items.
Inventory formulas like Economic Order Quantity and Inventory Days
Economic order quantity (EOQ) is a formula used to calculate the ideal order size for a business while also minimising ordering and holding costs. Inventory days (DSI) — sometimes called days inventory outstanding (DIO) — is how long you hold onto inventory before it sells. Using both formulas helps make your operations more efficient and improves cash flow, since you know how long it takes to convert stock levels into cash and how much to order before you run out and lose sales.
Just-in-time method
Just-in-time (JIT) inventory management means a business orders stock only as needed. This keeps inventory low, reduces storage costs, and doesn’t tie up capital in excess inventory. JIT isn’t without its risks, however, since it requires precise forecasting and reliable supply chains. If your forecasting is off or a supplier goes offline, you risk failing to meet customer demand — nothing is more frustrating than learning your purchase is “out of stock”.
Periodic and perpetual inventory system
Another key method used in inventory management is periodic or perpetual inventory systems:
- Periodic inventory management: Tracks stock levels after every stocktake. Best for businesses with simple inventory operations — think high-volume/low-value trading.
- Perpetual inventory management: Tracks stock levels after each sale. Works best when inventory software integrates with accounting systems, point-of-sale systems, and barcode scanners to update stock in real time.
Best practices for inventory management
For effective inventory control:
- Use software: Inventory management software makes tracking all the easier, saving you time and money while integrating with your other core operating systems, like your accounting software.
- Set reorder points (ROP): ROP sets automatic thresholds when your stock hits a certain level. Once a level is reached or falls below a certain point, your inventory system automatically places purchase orders to replenish stock. This is crucial in meeting your customer demand.
- Audit regularly: Review small sections of your inventory on a regular basis, rather than a stocktake at the end of the year. This data is crucial for ABC analysis, as it requires accurate documentation of ‘A’ stock.
- Review historical data: Review trends in your inventory to compare and refine your inventory management.
Inventory management in a nutshell
Managing your business’s inventory involves many moving parts. Effective management starts with understanding how inventory affects your business, what accounting method tracks inventory best, and which tools save time and money. Remember, inventory management is about timing — buying the right stock at the right moment at the right price, and holding onto it for the right amount of time. Once you nail that, you can meet demand.
