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Inventory is one of the most expensive costs or payments that merchants face. However, if you simply consider how much your inventory costs to acquire, you’ll get a skewed image of how much you’re paying to stock up. To understand inventory costs, you must include all expenses associated with ordering, holding, and maintaining stock.
What is Inventory Cost?
Inventory is one of a company’s or manufacturer’s most valuable assets. Inventory costs include the costs of ordering and storing inventory, as well as the costs of managing documentation. This might lead to changes in client order fulfillment rates and variances in the manufacturing process flow.
Inventory costs include not just the cost of purchasing an item but also holding and maintaining it for however long it takes to sell. Inventory expenses are of three types: ordering costs, carrying costs, and shortfall costs. These are the sole expenses to be included in a company’s financial accounts.
Five Types Of Inventory Costs
Ordering Costs
These expenses include the procurement department’s salary, related payroll taxes and benefits, and perhaps equivalent labor expenditures by the industrial engineering team if they must pre-qualify new suppliers to provide parts to the firm. These expenses are often rolled into an overhead cost pool and disbursed based on the number of units produced each quarter.
Some examples of ordering costs are:
i) The cost of preparing a purchase requisition;
ii) The cost of preparing a purchase order;
iii) The cost of labor required to check items upon receipt.
No matter how modest the order, there will be some ordering fee for it. Ordering expenses incurred by a firm increase as the number of orders placed grow. You can reduce the aggregate order cost by creating big blanket orders that span many periods and issuing order releases against the blanket orders.
Inventory Holding Costs
This is just the rent a company pays for the storage space where they keep their products. It might be either the direct rent paid by the firm for all warehouses combined or a proportion of the total rent of office space used for inventory storage. Here are some examples:
i) Inventory service fees
ii) Inventory risk expenses
Inventory Carrying Costs
What is inventory carrying cost? Often known as carrying cost, inventory carrying cost is an accounting term that refers to all company expenditures incurred in retaining and storing unsold products. The overall price would include storage, wages, shipping and handling, taxes, insurance, depreciation, shrinkage, and opportunity costs.
Warehouse storage fees, taxes, insurance, personnel expenses, and opportunity costs are all carrying costs.
Shortage Costs
Shortage costs are a company’s expenses when it has no inventory. These expenses include lost revenues from clients who go elsewhere to make purchases, lost margins on incomplete transactions, and overnight shipping charges to acquire products that are not in stock. This is an essential factor to consider when selecting how much inventory to keep on hand, especially for firms that compete on high levels of customer service. Here are some examples:
i) Costs of emergency shipments
ii) Costs of production disruption
iii) Customer retention and reputation
Spoilage Costs
Because perishable inventory material can decay or deteriorate if not sold quickly, inventory control is critical to preventing spoilage. Many companies are concerned about expired products. Their products’ expiry and use-by date impact food and beverage, pharmaceutical, healthcare, and cosmetics businesses.
For example, assume that a specific inventory is expected to be held at a particular temperature, but that temperature level is not maintained owing to a power outage. It is an example of spoilage that was neither predetermined nor expected.
How to calculate inventory costs
Inventory is one of a company’s or manufacturer’s most valuable assets. Inventory costs include the costs of ordering and storing inventory, as well as the costs of managing documentation. This might lead to changes in client order fulfillment rates and variances in the manufacturing process flow.
Inventory costs include not just the cost of purchasing an item but also holding and maintaining it for however long it takes to sell. Inventory expenses are of three types: ordering costs, carrying costs, and shortfall costs. These are the sole expenses to be included in a company’s financial accounts.
Inventory vs. Cost of Goods Sold
The difference in cost of goods sold (COGS) and inventory values are indicated in accounting by where the accountant records them. Businesses value inventory at its cost to them and as part of their current assets. COGS is an abbreviation for the inventory costs of items supplied to customers.
On the balance sheet, accountants report the ending inventory balance as a current asset. When inventory grows, so do the assets on the balance sheet. When the stock falls, so do the assets on the balance sheet. Accountants also include inventory changes on the income statement.
Inventory Costing Methods
Inventory costs are calculated as the sum of purchase, ordering, holding, and shortfall costs.
The retail inventory approach
The retail approach estimates a store’s ending inventory balance by comparing inventory prices to the cost of the products. It affects how much expenditure to recognize this period against the next. The retail technique assumes you have a constant markup on all your merchandise. You take the overall worth of what you’re selling, deduct the markup, and use that figure as your cost.
Weighted Average Inventory Cost Method
The weighted average cost inventory technique determines the cost of inventory items by dividing the total COGS by the total number of inventory items. It is also known as the weighted average inventory technique or the average cost inventory method.
Companies may gain an accurate assessment of the cost of items currently available for sale by multiplying the average price per item by the ending inventory count.
The same average cost per item can also be used to calculate COGS for the prior accounting period. Simply increase it by the number of things sold within that fiscal period.
First in, first out inventory method (FIFO)
The FIFO technique is the most frequently used inventory method since it closely corresponds to the actual flow of goods in most firms. This strategy presupposes that the first things you purchase will be the first to sell. It is a theoretically sound procedure.
This is why the first units in your inventory are acquired at the lowest possible price when prices rise. However, when these items are sold, they are sold at the current market value. As a result, the FIFO approach reduces your COGS, resulting in more significant reportable revenue and more taxes paid.
Last In, First Out Inventory Method (LIFO
The LIFO technique presupposes the items purchased most recently are sold first. That also indicates that the products in your inventory are the oldest. This is contrary to the natural movement of stock in most firms. It is also a strategy prohibited by the International Financial Reporting Standards, making it illegal in many other nations and strictly controlled in the United States.
Because your residual goods might be very old or even outdated, LIFO isn’t a solid estimate of your final inventory value. As a result, the valuation will be substantially lower than the current market pricing. The LIFO approach will result in lesser profitability because the COGS are higher, resulting in fewer taxes paid.
Inventory Valuation Adjustments and Estimates
Here are three methods to help you estimate your inventory value.
Developing a Selling Price for Your Inventory
The selling price of your merchandise should either be the retail price customers would pay, or the wholesale price merchants would pay in a wholesale market. Most buyers may provide a sales-by-item report based on this, which can be cross-referenced against the complete inventory description to establish a gross inventory fair value before the changes mentioned below.
Estimating The Cost Of Inventory Disposal
The disposal cost of your inventory is the expense of bringing merchandise to a saleable condition and/or location.
In the event of finished goods, this might simply be the transportation charges to deliver the things. You could compute the cost to complete the transaction using the company’s entire freight-out costs as a percentage of total sales.
In the case of work-in-process inventory, you must compute the labor and overhead necessary to finish the stock and subtract that amount from the calculated selling price as stated above.
Developing a Selling Price for Your Inventory
The selling price of your merchandise should either be the retail price customers would pay, or the wholesale price merchants would pay in a wholesale market. Most buyers may provide a sales-by-item report based on this, which can be cross-referenced against the complete inventory description to establish a gross inventory fair value before the changes mentioned below.
Inventory Cost Flow Assumptions
According to the inventory cost flow assumption, the cost of an inventory item fluctuates between when it is purchased or manufactured and when it is sold. Because of the cost disparity, management needs a formal method for allocating costs to inventory as it transitions to sellable commodities.
How to Choose an Inventory Cost Accounting Method
Configuring your accounting system might impact your firm long-term. The settings and procedures you use will eventually influence several aspects of your business, and each demands careful attention if you want to maximize your chances of success.
Your inventory approach is one of the most significant decisions you can make. Four inventory accounting techniques are discussed in detail below: specific identification, weighted average, LIFO, and FIFO.
To select a cost accounting technique, businesses must understand how the various approaches affect their balance sheets and income statements. Whatever direction the organization uses, it is critical to adopt the same method to show figures year after year.
This consistency principle, which requires enterprises to use the same procedure month after a period, allows them to provide the most accurate figures and pay the necessary taxes based on their reported income.
Various criteria determine the optimum inventory valuation method for your firm. This includes where your company is located if expenses are growing or decreasing, and how much your stock varies.
FIFO is the most widely used inventory accounting method because it accurately measures costs and profits. However, there is no one-size-fits-all answer.
Five Cost Reduction Strategies in Inventory Management
Use FSN (Fast-Moving, Slow-Moving, And Non-Moving) Analysis
FSN analysis categorizes items as fast, slow, or non-moving. Fast-moving products have a high turnover rate, whereas slow-moving commodities take longer to move. Finally, non-moving objects are not used within the duration of the analysis.
By categorizing stock into these three categories, it is simpler to discover difficulties and concerns related to consumption, utilization, and storage quantities. It may also be used to organize warehouses to guarantee that the three sorts of items are stored as efficiently as possible. Fast-moving products, for example, should be kept in the most easily accessible area of the warehouse, whereas non-moving material should be moved out entirely.
Look For More Vendors Of The Same Things
Exploring new suppliers is sometimes overlooked as a way to save your company money. It’s simple to choose a supplier for critical products, then set and forget it as long as the product is delivered on time. Yet, taking a step back and reevaluating market sources might be beneficial.
New entrants, a changing economic climate, or a simplified system frequently contribute to lower pricing and simple savings. There may also be the chance to negotiate volume-based discounts. A little desktop research may quickly increase the bottom line of a corporation.
Rely On A 3PL
Working with a 3PL (third-party logistics) partner can be an excellent investment, especially if your company is small and has limited labor and warehouse capacity. A third-party logistics partner may handle all warehouse and logistical needs, significantly relieving the in-house labor force.
In a 3PL model, the external party receives inventory and orders as they are produced at the primary points of sale. You can do this manually or automatically using a notification system. The 3PL then picks and packs the items and arranges for them to be delivered.
Working with a third-party supplier will incur an initial cost, which is critical to calculating the return on investment ahead of time.
Getting Rid Of Outmoded Inventory
Obsolete inventory goods are no longer in demand by customers. As a result, a new model replaces an existing product, or preferences and trends change, and the demand reduction is not successfully controlled.
To minimize stockpiles, it is critical to understand where each of your inventory goods is in the product’s life cycle, like growth, maturity, or entering decline. As items near the end of their product life cycle, slow-moving items can be handled by implementing stock reduction measures.
These might include introducing sales promotions to increase demand, expanding into other areas where the product remains popular, or simply modifying reordering criteria to reduce the quantity of stock purchased with diminishing demand.
Inventory Reduction Approaches At Several Levels
Businesses with multi-tiered supply chains may struggle to maximize inventory levels at each stage, especially if ordering is decentralized and based on independent projections and planning models.
Typically, planners anticipate and order solely for their portion of the supply chain, resulting in a ‘bull-whip’ effect. This occurs when a tiny change in demand at the top of the supply chain amplifies on-demand predictions farther down, as each planner purchases “a little more” and inflates their forecasts to account for the danger of run-out. However, when done at each level of the supply chain, these “small extras” add up to the surplus stock.
Inventory Management Difficulties
Managing Warehouse Area
Effectively managing space in a warehouse is a daunting endeavor. Using inventory management solutions to plan and construct warehouse facilities allows you to better regulate the timing of new stock delivery. It takes into consideration critical elements such as available space.
Supply Chain Complexity
Global supply networks change regularly, putting a strain on inventory planning and management operations. Manufacturers and wholesale distributors who choose when, where, and how your merchandise is sent demand flexibility and have unexpected lead times.
Employing The Wrong Vendors
The most prevalent inventory management difficulty is not employing good vendors.
This may appear a simple option, but it is also a common problem. Finding a good merchant is a delicate balance between finding someone trustworthy and getting someone who does not charge a fortune.
Fortunately, there are a few survey sites today where you may find genuine merchant audits before deciding whether or not to proceed with them. If a single merchant fails to satisfy your quality or administration standards, delays shipments, or interferes with your stock management, you must eliminate them.
Inefficient Processes
When inventory is small and there is just one warehouse site to maintain, low-tech, manual inventory management methods may not appear to be a big problem. However, when sales volume and inventory grow, inefficient, labor-intensive, and low-tech standard operating procedures become challenging to scale.
Conclusion
Conquering the central inventory management issues and solutions in inventory management is a never-ending cycle. The significance of inventory management cannot be overstated, particularly for e-commerce and online retail firms. Brands can fulfill orders more quickly and correctly with proper inventory tracking.
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FAQs
A company’s dead stock is inventory it has retained for a long time and is unlikely to sell. Companies may use techniques such as giving discounts or grouping deadstock with better-selling items to eliminate dead stock.
Inventory management is critical for retail businesses since it allows them to boost earnings. They are more likely to have enough inventory to cover every potential sale while avoiding overstock and cutting costs.
Inventory cost is [starting inventory + inventory purchases] minus ending inventory.
Beginning inventory + net purchases – COGS (cost of goods sold) = ending list is the fundamental formula for calculating ending inventory. Your starting inventory is the same as your finishing inventory from the previous period. Net purchases are products purchased and added to your inventory count.
A company’s financial statements account for the three significant kinds of inventory: raw materials, semi-finished items, and completed goods.