What Is Inventory? | Understanding This Important Business Term

Unless you own a service-based business, you likely have inventory. Knowing how much inventory you have is crucial for managing accurate small business accounting books, ordering new stock, and making pricing decisions. So, what is inventory?

Inventory meaning

Inventory represents the goods your small business has for sale or in storage. Your small business’s inventory includes raw materials used to create finished products, items in the production process, and finished goods.

Small business inventory is one type of asset. An asset is property that adds value to your business. Record inventory as a current asset on your small business balance sheet. Current assets are assets that can be converted into cash within one year.

When you sell inventory, you record the revenue on your income statement. You must also calculate the cost of goods sold (COGS) and record it on your income statement. COGS refers to how much it costs to produce your goods (e.g., purchasing inventory, turning raw materials into the goods you sell, etc.).

Inventory losses

Inventory can be expensive. Not only do you need to purchase inventory and hope it sells, but you also need to worry about inventory loss.

Inventory loss, called inventory shrinkage, is when the amount of inventory you have decreased due to items getting damaged, expiring, or being stolen.

Let’s say you buy 100 light bulbs, but 30 fall off the shelves and break. You have inventory shrinkage of 30 bulbs. Inventory shrinkage is expensive because you paid for the items but cannot sell them. Try to limit inventory shrinkage to decrease your expenses.

Inventory management for small business

Turning inventory into cash and turning some of the cash back into inventory is basically the life cycle of your business. When it comes down to it, inventory represents the value of your company’s possible revenue.

Because inventory plays such an essential role in your business, you need to know how to manage it. The main purpose of inventory management is to increase earnings at a low cost.

Inventory management for small business involves making wise purchasing decisions, tracking new purchases of raw materials, monitoring inventory throughout the production process, selling off inventory, and limiting shrinkage.

For effective inventory management, you need to have enough inventory on hand, decrease shrinkage, and prevent inventory from sitting around in a back room, warehouse, or storefront.

Use an inventory tracker and record inventory when it comes into your business. When you are cautious about tracking inventory, you know when to order new materials. As a result, you can avoid having insufficient inventory.

To decrease shrinkage, double-check your numbers. Delegate inventory management to two or more employees to discourage employee theft. Train employees on how to properly handle inventory to avoid damages. Implement new handling procedures if damage rates are high. And, prevent shoplifting by monitoring suspicious customer behaviors.

If outdated inventory is piling up in your small business, you know you need to get rid of it. To sell off old inventory and make room for new inventory, offer discounts, like a buy one get one free deal.

Inventory management in accounting

You must record inventory in your accounting books. To maintain accurate records of your inventory, you must update your accounting books when you purchase new inventory, lose inventory to shrinkage, and sell finished products.

The IRS sets inventory recordkeeping requirements for most businesses. If you are required to use accrual accounting, you need to regularly value your inventory. Businesses that use the cash-basis accounting method must also account for and value inventory, but the requirements vary.

Under IRS requirements, you must value your inventory at the beginning and the end of the year. You need to use these assessments to determine your cost of goods sold. Record your beginning and ending inventory in your accounting books.

To value your inventory, come up with a consistent system using generally accepted accounting principles (GAAP). For more information on inventory management requirements, consult IRS Publication 334.

Deducting inventory expenses

Expenses of a business include inventory costs. You can deduct some inventory expenses on your business tax return. You deduct inventory expenses as costs of goods sold. Costs of goods sold are expenses directly involved in producing products or providing services.

You can also deduct expenses if you use part of your home as permanent storage for inventory. You deduct a percentage of your monthly rent or mortgage payment. The percentage represents the square feet of your home that you use for storing inventory. Check the rules for the home office deduction before you claim it on your tax return.

Keep detailed records of inventory expenses. You must prove you sold the items during the tax year filed to deduct business expenses.

In addition to deductions for allowable business expenses, detailed records can help you make an excess inventory calculation. Excess inventory calculations help you when you have too much product on hand and need to make a change.

How to avoid excess inventory

Excess inventory can happen to any business, especially seasonal businesses. Gather information about your inventory, including:

A forecast of your sales and expenses
The lead-time of your vendors

Review past inventory data in your accounting books. Make note of items in your inventory with the highest sales. Knowing your top-selling inventory helps you place orders and avoid running out of items.

Also, look at the inventory with the lowest sales. You may be able to cut back on less popular items. Spending less on items that do not bring in significant revenue will save you costs.

Track the turnaround rate of your inventory. In other words, how long does inventory sit in your business? The longer your inventory stays on your shelves, the harder it becomes to sell.

If you have excess inventory at the end of your season, you should mark down items. When you change the price of a product to a lower amount, you still have to cover everyday expenses.

Let’s say you own a fireworks store. At the end of New Year celebrations or the Fourth of July, your sales slow. But, you still have to pay overhead costs, such as rent and utilities. You could mark down fireworks at the end of the season. The marked-down items you sell can help cover overhead costs.

Overhead expenses and the cost of payroll programs can add up. That is why you want to move inventory through your business as fast as possible.

Past sales, expenses, and turnaround rates help you forecast sales and expenses. If you don’t change your business, it’s likely that your seasonal business cash flow will be similar to the previous season. Use the projections for next season to determine how much inventory you need.

When to place orders

Line up your inventory orders before the busy season starts. Check on the lead time of your vendors. Lead time is the number of days a vendor takes to deliver goods to you after you place an order. Lead times vary among vendors.

Determine how much of each inventory item you need to order and when you need to place orders. Decide how much inventory will cost you. Write the expenses into your business budget.

To comply with IRS requirements, you must maintain accurate accounting records for business transactions. Why make it complicated? Manage your books with Patriot’s online accounting software. Get your free trial now!

This article has been updated from its original publication date of April 2, 2015.

This is not intended as legal advice; for more information, please click here.