Inventory management can have a very direct impact not only on your profit but also the cash flow of your business. Inaccurate inventory will directly affect your business profit. If the inventory is too high, you may be paying tax on higher profits than you actually have. If it is too low, you run the risk of understating taxable income and, if audited, the IRS can hit you with back taxes and penalties.
Perpetual Inventory Systems
A perpetual inventory system keeps track of inventory items on an ongoing basis. A good perpetual inventory system should provide timely and accurate information on inventory costing, activity/turnover, quantity levels and obsolescence. If these characteristics are in place, the inventory system should provide the following benefits:
- Allow management to monitor inventory levels on hand and establish reorder quantities. This will allow you to maintain necessary levels of inventory items and to purchase items more cost-effectively, since you will know how much more you’ll need and when you’ll need it.
- Allow you to generate valuable information such as turnover rates, details of slow-moving or overstocked items, and it may provide better accounting control over quantities.
An important complement to a perpetual inventory system is taking an actual physical count of inventory items periodically. How often you take an actual physical count depends upon the reliability of your perpetual system. By comparing items actually counted to your perpetual records, you can correct errors and also identify potential problem areas where the system is not accurately tracking the number of items in inventory due to clerical mistakes or shrinkage.
To get a good, accurate inventory count, make sure that the area is clean and inventory items are well-organized. Also shut down operation, if possible, so there is not movement of inventory items during the count. Count sheets that are arranged by inventory item numbers should be used and items should be tagged as they are counted to be sure that nothing is missed OR counted twice! A good cut-off should be used. That is, if it is on location and counted in inventory, then the amount due for those items should also be included in your accounts payable to the vendor. Likewise, if items have been removed from inventory to be shipped to a customer, the sale and account receivable should be recorded in the same accounting period.
Inventory Valuation Methods
Once you have an accurate inventory count (either by a physical count or through your perpetual system), the items need to be valued. Most businesses use the concept of First In, First Out (FIFO) to value inventory. This means that you consider the first items purchased into inventory to be the first ones that are sold. Using this method, you would value your inventory by taking the latest invoice paid for each item and multiplying its cost by the quantity on hand.
Ohio Inventory Valuation Assistance
Having good systems and information to manage inventory is extremely important in running a profitable business with positive cash flow and proper income reporting to the IRS! Setting up and maintaining proper inventory management and inventory valuation systems is a big project, and one that might require outside help. If your business needs a new or improved inventory management system, contact Rea & Associates. Specializing in manufacturing accounting services, our Ohio accountants will help your team design and implement an inventory system that’s right for your business.