The way you handle your inventory can mean the difference between success and failure, since its one of the crucial aspects of managing a business. To get you started, its best to sit down with a trusted accountant for advice in addition to learning the ropes yourself.
Regardless of the size of the inventory of products that you are selling, learn how to value your stock accurately so you can control your investment and more accurately measure its productivity.
This is because your merchandise inventory represents a major portion of your assets, and an incorrect valuation of it could distort your profitability and the financial position of your business. In particular, an understated ending inventory could overstate your cost of sales, thus also understating your gross profit. This is because you compute your cost of sales by adding your beginning inventory to your total net purchases less your ending inventory, after which you compute your gross profits as your total sales less your cost of sales.
For example, assume that you started your business with a beginning inventory of P100,000. During the month, however, you purchased additional items worth P50,000, putting your total merchandise available for sale at P150,000 ( beginning inventory of P100,000 + purchases of P50,000). At the end of the month, you found that your ending inventory is worth P70,000. You then deduct this amount from the total inventory to come up with a cost of sales of P80,000 ( P150,000 - P70,000). Now, imagine that you have understated your ending inventory by P10,000. Your cost of sales will then become P90,000 (P150,000 - P60,000) instead of P80,000. The effect of this erroneous ending inventory will understate your gross profit by the same amount.
There are two methods you can use when valuing inventory: the cost method and the retail method. The cost method values merchandise at cost, using either the physical count system or the book inventory system. Under the physical count system, you record the cost of each item that you purchase, and at the end of the period, you physically check each item in your store and stock room to determine the ending inventory. This practice is ideal when your business has low inventory turnover; for example, if you are in the car dealership, condominium unit, or jewelry business.
If you are in a business with a high inventory turnover, however, you may find this system time consuming and inefficient.
To solve this problem, it is advisable to combine this system with the book inventory system, which, by recording all purchases and items sold at cost, will allow you to maintain a running total of inventory costs in a ledger at any point in time. The book inventory system enables you to compute what the ending inventory should be, and to determine possible inventory shrinkage or overage, you can compare this with the ending inventory as computed using the physical count system.
There are two other methods that you should consider when you are using the book inventory system. One is the FIFO, or First In First Out method, which logically provides that old merchandise should be sold first, while newer items should remain in inventory. The other one is the LIFO or Last In First Out, which provides that newly purchased items should be sold first, while the older stock should remain in inventory. The consequence of using FIFO is that your ending inventory will reflect the current costs of your merchandise, while LIFO will reflect the old costs. Your choice of inventory method will, of course, depend on the industry practice of your business. Sometimes, management can also choose a specific method for creative accounting purposes, such as a tax minimizing strategy.
The cost method of inventory is common among bakeries, restaurants, food carts, furniture shops, and other businesses that have more manageable inventory levels. However, if you have huge amounts of inventory under your disposal, such as if you are running a supermarket, bookstore, or hardware store, then you would be better off using the retail method of inventory. Under this method, you value your ending inventory at retail prices, then convert it at cost by applying a cost factor ratio.
The cost factor ratio is the average relationship between the cost and retail value of your total merchandise for sale. For example, you computed that the cost of your total inventory for sale is P200,000, with an equivalent retail price value of, say, P350,000. The average cost factor ratio would then be 57 percent (P200,000/P350,000). Now, by the end of the month, for instance, you determined that your ending inventory using the book inventory system is P75,000 at retail price. By multiplying the ending inventory with the 57 percent factor, you will come up with an inventory at cost of P42,750 (57 percent x P75,000).
The benefit of using the retail method is that valuation errors are reduced when conducting physical inventory because the value of merchandise recorded is at retail prices, so there is no need to decode every item at cost. Moreover, this method also allows you to easily set up a profit-and-loss statement based on book inventory by estimating the cost and gross profit. The limitation of this method, however, is that because all merchandise items need to be recorded both at retail and at cost, it relies heavily on the accuracy of recording data.
Computerizing the process of valuing your inventory may help lessen discrepancies and enable you to have better control.
This article was originally published in the September 2007 issue of Entrepreneur Philippines.