What is the True Cost of Inventory?

Written by the Controller | CFO Advisor Team

As noted in the article on the Cash Cycle, inventory should eventually turn into cash.  That is why we acquired it in the first place.  Inventory is the least liquid current asset and therefore it should provide the highest yield to justify the investment.  Inventory is usually divided into three basic categories: raw material, used in the product; work in process, which reflects partially finished products; and finished goods, which are ready for sale.  All these forms of inventory must be financed and their efficient management can increase a firm’s profitability.

In the 1990’s JIT – Just in Time Inventory became the rage.  The thought was “do not use cash on inventory until we need to”.  The costs of carrying inventory are often overlooked by the small business owner.  The value of inventory does not end at the initial price paid to the supplier but continues as the shelf life lingers on.  As long as an investor can garner a positive return on idle dollars, distinctions must be made between money paid today and money paid in the future. Therefore true inventory costs include the time value of money.  It is measured by the time between when initially paid to when it is eventually sold as part of a finished product at the current borrowing rate of the company.  The greater the time spread the larger the additional cost.  The business owner is paying as inventory collects dust on the warehouse shelves.  Additional costs include the actual cost of maintaining the warehouse that these goods are shelved in.  Can we operate in a smaller warehouse if we carry less inventory?  A business must weigh these costs against the risk of being caught “short”… not having goods to complete a finished product to the client.  Safety Stock - producing or ordering extra product is a way of hedging your inventory levels.  This will aid in having the available inventory when it is needed.  The key is to not hold excess inventory beyond your normal requirements.

A useful tool the business owner can utilize is developing an inventory turns analysis. An inventory turns report can identify slow moving inventory.  Recognizing slow moving inventory can help prevent future write-offs of potential obsolete material.  Another useful strategy is keeping the material in its lowest value form.  The business owner should not add value to the inventory by its assembly process until an order has been received from the customer.  Keeping the product at its lower value keeps the door open to return to the supplier if it is no longer needed.  More than likely you will not receive full value but ending this cost cycle still has benefits to the company.

Another consideration is that if inventory is overvalued from obsolescence, shrinkage or valuation errors it will overstate the company’s profits.  Inventory held for greater than six months without an existing market for resale can result in unanticipated write-offs in later years.  Adjustments to overstated assets result in expenses to the profit and loss statement.  Erroneous figures on the Balance Sheet will impact the true current profit and loss results.

BIK’s outsourced Controller|CFO Advisors can review the true cost of your company’s inventory.

The BIK Controller|CFO Advisors:

Tony Battaglia
Tim Beck
Al Knox
Larry Schmitt

Together we can perform a variety of accounting and financial services to help your business run more efficiently and economically.  Our objective will be to improve your bottom line through better processes and procedures. Contact us today at cfoservices@bikcpa.com or call 847-281-3209. 

Visit our web-site at www.bikcfoservices.com.