Ineffective reporting and inventory management can lead to impaired business profits and bloated working capital—and best practices for inventory management may have recently changed in industries that rely on overseas suppliers.
Now may be a good time to review your current practices and make needed adjustments.
Choosing the right reporting method
Keeping accurate records is key to effectively managing your inventory.
Generally speaking, there are two main inventory accounting methods you can use for tax and financial accounting:
1. First in, first out (FIFO)
FIFO refers to selling the oldest stock first. This method tends to work best with perishable items, dated goods, and collectibles. This approach also tends to result in higher income in inflationary markets, since older purchases with lower costs are included in cost of sales. (The opposite tends to hold true in deflationary markets.)
2. Last in, first out (LIFO)
LIFO may be your best option if you tend to retain inventory items like durable goods and repair parts for long periods. Using LIFO allows you to allocate the most recent—and thus, higher—costs first, which can maximize your cost of goods sold and minimize taxable income.
FIFO is the more frequently used of the two because it better reflects the usual flow of goods and is easier to account for. By comparison, LIFO can be highly complex since it deals with inventory costs that may be several years old, rather than the actual inventory.
Is it worth it to change your approach?
You may be able to change your company’s method if you’re dissatisfied with it. However, the process for doing so tends to be complex.
If your business wishes to change its inventory accounting method for tax purposes, you’ll first need to request permission from the IRS. And if you wish to change methods for financial accounting purposes, you’ll need to have a valid reason. Because of this, changes in accounting for inventory aren’t easy or routine.
How effective is your inventory management?
Inventory represents a significant item on the balance sheet for many companies—including manufacturers, retailers, and contractors.
On one hand, keeping too much inventory can diminish your working capital (your current assets minus your current liabilities), and that may make it hard for your company to pursue value-added business endeavors like purchasing machines, launching new products, or hiring salespeople to bring in additional revenue.
On the other hand, leaner “just-in-time” inventory practices may reduce your security and storage costs, which can free up cash while allowing you to keep a closer tabs on what you have in stock. However, this may require you to upgrade your company’s current inventory tracking and ordering systems. Newer systems give you the ability to forecast demand and minimize overstocking. Whenever it’s appropriate, you can even make supply and demand estimates more accurate by sharing data with customers and suppliers.
There’s a limit to how “lean” your company can operate, though—many companies learned during the pandemic that carrying a reasonable amount of “safety stock” can help them avoid the fallout of a supply chain crisis. In the face of current supply chain risks, it may be time to adjust previous assumptions about optimal inventory levels and reorder points.
Optimize your inventory management
When you review your company’s inventory practices, start by identifying sources of inefficiency—then you can work on finding the best solutions. If you need further guidance
on inventory reporting methods and best practices in your industry, contact us.