Taking Stock

According to many experts, understanding and managing the inventory of your business can increase the profitability of even small retail operations anywhere from 20 to 50 percent. But just what is the "inventory" of your particular business?

Inventory is the value of the operation's goods for sale, supplies used in keeping the business, and everything else that plays an income-producing role. If it brings in money, it's inventory. But there's more to maintaining inventory than simply buying new products and goods. Every gifts and home accents business owner or manager must know what to buy, when to buy, and how much to buy.

Under our federal income tax rules, inventory assessments ("inventories") are required at the beginning and end of each year in almost every situation where the production, purchase, or sale of merchandise is an income-producing factor. Inventories must also be done wherever necessary to clearly reflect income — which, more than anything, means satisfying the ever-vigilant Internal Revenue Service.

A retailer with average annual gross receipts that do not exceed $1 million is generally not required to use inventories, nor to use the more complex accrual method of accounting. Of course, even gift retailers who do not use inventories must find some method of keeping track of supplies and the products they sell.

From an accounting standpoint, if inventories are not maintained it is extremely difficult for any owner to get the full picture of the business' financial health. Quite simply, the use of the accrual method of accounting, along with inventories, more closely reflects the business' income. This is, in part, because inventories recognize unsold goods on hand at the beginning and end of the accounting period or tax year.

To remain viable, every business must provide a reasonable assortment of materials, merchandise, and products to cover the normal demands of its customers.

Insufficient inventory means lost sales, and in some cases, costly, time-consuming back orders. Running out of supplies and goods that are important to sales lead to increased costs as well. One way to protect against shortages is by building a safety margin into your basic inventory figures. Thus, when calculating basic stock, a retailer must factor in some lead-time to cover the period between reordering and receiving a product.

Many retailers find that an inventory tracking system is an invaluable tool for their business. Such a system can be self-created, set up by your accountant, or run from a simple computer software program. Inventory software programs currently on the market allow retailers to track usage, monitor change in unit dollar costs, calculate the right time to reorder, and analyze inventory levels on an item-by-item basis. A gift business can even track inventory right at the cash register with point-of-sale (POS) software systems. POS software records each sale as it happens, so inventory re-cords are always up-to-date.

Inventories must conform to the best accounting practices within the industry, and both the inventory and the method of accounting must clearly reflect the operation's income. In determining whether income is clearly reflected, a great deal of weight is given to consistency in inventory practice. But even a legitimate accounting system will be disallowed where it distorts income.

For many gift retailers inventory valuation usually means one of the following:

1) The so-called Last-In, First-Out (LIFO) method assumes that the business will sell the most recently purchased inventory first. Under LIFO, inventory is taken at cost, but items in the inventory are treated as being, firstly, those accounted for in the beginning or opening inventory (whether or not they are physically on hand), and secondly, those acquired during the year. The items treated as still in the opening inventory are taken in order of acquisition.

2) The First-In, First-Out (FIFO) method of valuation is utilized for items received that have been so commingled that they cannot be identified with specific invoices; they are considered to be the items most recently purchased or produced. The cost is the actual cost of the items purchased and produced during the period in which the quantity of items in inventory was acquired.

LIFO offers a lower amount of income during a period of rising inventory prices. In times of inflation, however, FIFO inflates profits, since the least expensive inventory is charged against the cost of current sales, resulting in higher profits. As a result, LIFO inventory valuation has become a more popular method, since it reduces current taxes by eliminating inventory profits.

Cost and market value are determined for each item, and the lower amount is included in the inventory valuation. Naturally, a business owner or manager is not permitted to inventory the entire stock at cost and at market and then use the lower of the two results. Deviations are permitted, of course, especially when it comes to goods inventoried under the LIFO method.

Whether the "cost" or "lower of cost or market" method is used, inventoried goods that are not salable because of wear and tear or obsolescence should be valued at their bona fide selling price, less cost of selling. That is, at the price those goods were actually offered at.

Inventories are a complex and confusing area of any business, but understanding and properly using them can mean additional profits for your business.