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Module: 14

Keeping inventory and tracking sales

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This module looks into how you keep inventory and track sales. We explain how and why you should

have an organized inventory management system. Understanding your inventory and what it means to

your business will help you make educated and knowledgeable decisions. Knowing when to reorder and

how much to reorder are essential to maintaining relevant stock that is in demand with your customers.

Being able to track the factors to determine this information and analyze the resulting outcomes are

important to making inventory based decisions. In the accounting process, inventory is classified as an

asset account and should be treated as such. Manage this asset like you would your employees. This

module will help you to understand the nature of your inventory and how you can make it work for your

business.

What you’ll learn in this module:

14.1 What Is Inventory?

14.2 Purpose of Inventory

14.3 Keeping up with Inventory – Inventory Management

14.3.1 When to Reorder Inventory

14.3.2 Understanding Demand

14.3.3 Classifying Inventory

14.3.4 Identifying Inventory Costs

14.3.5 Inventory Management Policy

14.4 Keeping Track of Sales

14.5 Balancing Cash

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14.1 What is Inventory?

Inventory refers to physical goods and materials that a business holds for the ultimate purpose of

resale or repair. It is a physical resource that a firm holds in stock with the intent of selling it or

transforming it into a more valuable state. Businesses can hold inventory that is in a number of

different states. Inventory doesn’t just mean a ream of paper, cars, or clothes. Each of those

inventory items is made up of a number of different items. So the ream of paper also represents the

inventory of trees that went in to making it. The Sawmill counted the trees that ultimately became the

paper as inventory and sold the resulting product. Office supply stores count the ream of paper as

their inventory, not the trees. Cars are also made of many parts. Every part of a car was at some

point an inventory item in a warehouse until it was used to build the car. Every item was counted,

labelled, stored, then sold and retrieved from a shelf. When the car is built it becomes one inventory

item and is counted once when it is brought in to the dealership. So you see that inventory items can

take many different forms and sizes.

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The Nature of Inventories at different stages in the production cycle:

Raw Materials – Basic inputs that are converted into finished product through the manufacturing

process

Work-in-process – Semi-manufactured products need some more work before they become finished

goods for sale

Finished Goods – refers to completely manufactured products that are ready for sale

Supplies – Office and plant materials not directly enter production but are necessary for production

process and do not involve significant investment.

14.2 Purpose of Inventory & Inventory Management

The purpose of inventory is put simply, to have something to sell. While this may sound trite, it is the

truth. If you have two stores that you can shop at that carry the same product you need at the exact

same price, how do you choose which one to spend your money in? Do you pick the store that

always has your favorite product in stock, or do you pick the stock that always has to order it for

you? Why would you wait when you could have that product in your hands today? This is the

purpose of inventory, to meet the supply and demand of the consumer market. For a retail store

being able to predict what level of inventory they will need to carry for a specific product is half the

battle, actually having that item in stock when you come in to buy it is another matter.

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The purpose of inventory management is based on a basic idea. Inventory management

gathers data from sales and purchases over time. The system helps to analyze the data and

perfect the reordering process to maximize business profit. Inventory management

systems can allow a business to make real time decisions based on up-to-date real time

information.

A salesperson sitting at a computer should be able to hit a few keys and know how many

widgets are on the shelf at any given time without having to go out to the warehouse. They

should also have all of the information to make a decision about when to order more

inventories and how many units need to be ordered.

If there is a bulk order discount available this information should also be available in the

item record or at minimum with the supplier’s file. Often a business will have a “cheat

sheet” with the manufacturers and discounts listed.

14.3 Keeping Up with Inventory – Inventory Management

There are two generally used inventory control systems, the perpetual inventory system and the

periodic inventory system. Each system has pros and cons, but the main difference is the frequency

of the inventory data being updated. This refers to how often a sold item is recorded and when items

are entered in to inventory.

A continuous or perpetual inventory system has a continuous flow of information on the inventory.

Meaning that every time an inventory item is sold or added to inventory it is recorded. This system

can also have a fixed order quantity. This means that the same quantity of an item is always ordered

with the item inventory declines to a predetermined level. For example, if Home Depot wants to have

a constant (fixed) number of fans in stock, say 100, when the inventory number falls to 50 Home

Depot should order 50 more fans automatically. Their inventory system should alert them that the

number has fallen to 50 when the digital item record is pulled. This type of inventory system is

implemented in most large companies with large quantities of inventory.

The Periodic inventory system is a fixed inventory system meaning that the inventory is not recorded

as having changed throughout the business cycle. Companies determine the ending inventory

balance, by conducting a physical inventory count. When using the periodic inventory system,

companies do not track inventory changes during the period. They their inventory holdings at the

period end. This system may be useful for small companies that do not plan to increase their

inventory dramatically.

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Critical Elements of an In-house Inventory System

A good starting count – obtaining an accurate count is tantamount to beginning your inventory tracking

system

Good policies in place – each decision that needs to be made pertaining to inventory should be laid out

clearly and concisely in writing that everyone will understand

Competent people who know how to follow policy – selecting and building a good team will help make

the system run smoothly and have stable longevity

Well-organized location names – take the time think about how you will organize your inventory and

where each piece will be placed. This is will greatly aid your staff when they need to look for something.

Money and time are lost when the inventory isn’t organized well. This of course will ultimately affect

your bottom line but is very hard to track and quantify.

Location labels that are easy to read – make sure that every label used to denote a space for the

inventory is easy to read and only has the required information. Often businesses have too much

information on their labels and the one piece that is needed is too small to see.

Unique, short, and unmistakeable Item numbers – find and a sequence of numbers that are

easily identifiable as inventory numbers. They should stick out and be distinguishable from

dollar amounts

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Units of Measure – terms that give clear meaning to various quantities of inventory. Examples

are cases, lbs, baskets, each (ea.), carton (ctn), kilograms (kg) etc. Deciding early on how you

will measure your inventory will make physical counts and keeping track of inventory easier

down the line.

Software that tracks all inventory activity – investing in a full package software will make

your inventory management that much more efficient and accurate. Some companies may not

make the investment in the beginning due to cash flow. It is recommended to make the switch as

soon as possible, especially if you plan to expand your inventory quickly.

14.3.1 When to Reorder

The reorder point is the particular level of inventory that requires a new order to be placed. The

reorder point, while it can be completely up to the business, can also be calculated based on

different variables. Most large companies rely on their software systems to determine the reorder

point. With a good inventory management system it can all be automated. The basic principles of

calculating when to reorder are contained within the economic order quantity (EOQ) models.

The basic purpose of the Economic Order Quantity (EOQ) Models is used to help determine what

the optimal number of units to order is, so the business minimizes the total cost associate with the

purchase, delivery and storage of the product.

There are assumptions that are made in the basic EOQ model:

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Demand is known, constant, and independent

The lead time is known and constant

The order quantity received is instantaneous and complete

No shortages are allowed

The production quantity model can also be used to determine the reorder point.

It is an inventory system in which an order is received gradually, as inventory is simultaneously being

depleted.

This type of system is also known as the non-instantaneous receipt model.

It is a variation on the basic EOQ model.

When considering inventory quantity discounts, generally the price per unit decreases as order

quantity increases. Quantity discounts are not dependent on when you order only how much you

order.

14.3.2 Understanding Demand

There are two forms of demand dependent and independent. Dependent demand is related to

inventory that is not used by the customer directly. The demand is for items that are used to produce

final products like trees in the earlier example. Another example is tires stored at plant waiting to be

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used in a car. Independent Demand is relevant to items that are used by external customers. These

include cars, computers, and houses.

The bullwhip effect in relation to demand is something that is:

Observed in the forecast-driven distribution channels which are production driven solely on how much

a company or industry thinks the market will demand. The inventory held is farther and farthest from

the customer, think about the trees and oil.

The demand data in these distribution sectors (like oil) of inventory distribution is distorted.

The supply and demand of raw materials for example can be affected by any number of factors that are

out of human control and are sometimes caused by humans leading to catastrophic losses and

consequences.

The demand information is distorted as it moves away from the end-use customer (forecast). As a result,

in general, higher safety stock inventories are stored to compensate for these unforeseeable fluctuations

in inventory.

Seasonal or cyclical demand refers to how the consumer demand presents itself. Seasonal demand

is short term and is affected by different seasons or holidays throughout the year.

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Seasonal demand is driven by the consumers need for certain items at a specific time of year. It is

contained within a calendar year. Cyclical demand can last for much longer and is not contained to the

calendar year. Cyclical effects can be changed by things like employment and international events. These

effects can have a prolonged effect on consumer demand.

To meet seasonal demand businesses having inventory can be independent from their vendors. This is

also the case with cyclical effects.

Understanding and potentially forecasting demand can help businesses confidently take advantage

of price discounts when available and know that they will be able to move their inventory. Inventory

provides independence between the different seasonal and cyclical stages. It can also avoid work

stoppages and minimize Work in Process (see 4.1 for physical definition) inventories. Work in

Process has two meanings when it comes to inventory. It can refer to the state of the physical

inventory (needs more work to become a finished product) and/or refer to the accounting state of the

inventory. Often companies will track this inventory in a WIP account until it is complete or sold.

14.3.3 Classifying Inventory

It is helpful to take the time to appropriately and accurately classify inventory items using the ABC

classification system. The ABC classification system proposes that not every item is equal in

importance within the larger group of inventory. A small screw may not have the same value as a fan

say to home improvement store. In any retail organization there are large numbers of inventories to

be maintained. It is not practical to have very stringent inventory control system for each & every

item. The need for classification is real and tangible. To this end the ABC Inventory classification

system will help you achieve a solid classification of all your inventory items.

The ABC system classifies items into three categories class A, class B, and class C.

Class A has a high consumption value Class B has a medium consumption value Class C has a low consumption value

The ABC analysis divides inventory in to the three classes based on this equation:

Consumption Value = (Unit price of an item) X (No. of units consumed per annum)

This equation should be completed for every inventory item to accurately classify your inventory. The

resulting values will give you the information you need to determine what your inventory breakdown

should be. This of course is a guideline and educated estimate. The business will make the final decision

as to what is ordered and kept in stock regardless of what the numbers say. This is a sample breakdown

of inventory distribution.

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Understanding this classification system will help you implement a strong inventory management policy

which will be covered later in this module.

14.3.4 Identifying Inventory Costs

As with many things pertaining to money there are generally accepted rules as to how things are

sorted in the accounting process. This helps to ensure that everyone is on the same so to speak with

the accounting process. There are three generally accepted methods to identify inventory costs.

It is recommended that you use the "specific identification" method when possible. This method

identifies the cost of each stock item separately which may seem cumbersome, but is really only

appropriate for high-ticket or high-value items, such as cars and furs. Most businesses will not be able to

use this identification method.

If you can’t specifically identify each individual inventory item then you should adopt a cost flow

method:

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"First in, first out," called FIFO – the first of an inventory item that comes in, goes out first. Hopefully

minimizing its time on the shelf.

"Last in, first out," called LIFO – the last of an inventory item that comes in, goes out first.

These particular methods address the sequence in which you assign the costs to goods sold, not the

actual physical flow of goods. LIFO has various sub-methods that give you different ways to account for

costs. Prices generally rise under normal circumstances, so choosing the LIFO method usually results in

the highest cost of goods sold and the lowest taxable income. This of course is good for the company’s

bottom line.

It must be noted that there are various costs associated with buying, storing and not having inventory.

The following are some examples of these costs:

Carrying cost – which is the cost of holding an item in inventory or stock

Ordering cost – which is the cost of replenishing inventory when it becomes depleted

Shortage cost – which is the temporary or permanent loss of sales when the demand cannot be met

14.3.5 Inventory Management Policy

An inventory management policy uses the ABC classification system to identify how each inventory

item should be managed and maintained. Along with the ABC system you can also use lean

inventory management (VED) to help further define your inventory and establish your inventory

control policies. VED stands for vital, essential, & desirable. VED is used when you need more

effective control of your inventory based on whether or not the inventory item is critical.

Implementing a cohesive, clear, and concise inventory management policy that is easy for everyone

to follow will make great strides in keeping your inventory together.

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In the ABC system inventory management policy:

A Items - very tight control, complete and accurate records, must have frequent reviews via EOQ model

(see 4.3.1).

B Items - less tightly controlled, good records, regular review

C Items - simplest controls possible, minimal records, large inventories, periodic review and reorder

Some time with the view of doing

Lean inventory management (VED):

V (Vital) - is the inventory where neither Substitute (quantity other than the predetermined quantity)

nor Variation Gap (variation in specified quantity) is allowed

E (Essential) - is the inventory which allows either of the one to be changed (substitute or variation gap)

D (Desirable) - can have variation in both of the parameters

Establishing an inventory management policy using the principles above will give your business a solid

base to build from. Economic growth is achieved through good policies, good people, and good business

sense. Making the decision to implement your own inventory management policy will make every one of

those factors a reachable goal.

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14.4 Keeping Track of Sales

Throughout this module we have discussed what inventory is, how you can manage it among other

things. Now we come to the crux of it. All of these pieces and parts culminate in understanding how

your inventory works for you. In the end it is the sale of an inventory item that is the highlight of this

story. Everything in the previous sections leads to this moment.

Imagine for a moment that you haven’t done any of the things discussed in this module, you have no

system, no labelling, and no clue as to what you have where. A customer walks in and asks to buy a

pallet of widgets. Now a pallet of widgets is something that you should be able to find pretty easily

because of how big a pallet’s worth of widgets is physically. But let’s say a customer comes in and

wants to buy one widget. Now you have a problem. Unless that widget is on your desk or already in

your hand, good luck finding it among the rows and rows of unorganized stuff. Because that is really

what an unorganized warehouse is full of, stuff. It is not a good asset because it takes so much time

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to find anything. So with that picture in mind let’s talk about keeping track of your sales of your

widgets.

Every widget that is sold represents a virtual data mine. From the moment that widget is thought of

being ordered by an employee, it becomes part of the cyclical motion of inventory. It represents time,

money, and brainpower. By having a system in place to capture all of that data, it will help improve

your ability to arrive at the moment of sale more often. Keeping track of those sales is just as

important. The sale affects how much inventory you have in stock thus affecting your reorder point

and affecting the cash flow in the business. Keeping track of your sales should be a top priority.

Your inventory management system should capture your sales and inventory data using one of the

three following options:

Manual – generally kept on a spreadsheet. Time consuming, increases errors, lots of work to convert to a

digital tracking system later. Manual systems allow the small business owner to manage inventory with

very little investment in complicated inventory management systems or extensive employee training.

Maintaining data integrity and accuracy is a major downside to managing inventory using a spreadsheet.

A single data entry or formula error in the spreadsheet can cause major inaccuracies in the data output.

Barcode – inventory items are electronically scanned coming in and going out. It increases accuracy and

efficiency over the manual method. These days all major retailers will use barcode technology as part of

an overall comprehensive inventory management program. When a barcode is electronically read at the

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point-of-sale (the computerized cash register), the inventory sales data are immediately read and sent to

a broader system that maintains item usage statistics. The company’s purchasing department then uses

this data to make buying decisions based on sales and existing inventory levels.

Radio Frequency Identification (RFID) – uses two types of technology, active and passive. Active is used

when an item is moving through the warehouse and the data pertaining to the item is read periodically

by stationary readers. Passive is used in handheld scanners carried by employees. All of the data is

collected and downloaded with startling speed and accuracy. RFID is usually used in places where there

are hundreds of thousands of item moving in and out of the warehouse. It can also be implemented in

places where security is a problem.

14.5 Balancing Cash

One of the accounts affected by a change in inventory is the cash account. Good inventory

management is an integral part of balancing cash. When inventory is purchased or increased, cash

flows of out the company or decreases. Generally when inventory is sold or decreased, cash flows in

to the company or increases. Inventory is the basis on which a company can market their business,

increase their cash flow, and ultimately grow their client base and sales.

Being able to balance their cash requires a company to accurately track the changes in their

inventory. Also important is tracking how those changes occurred. To do this it is imperative that a

business have a comprehensive inventory management system in place. Every person who interacts

with the inventory should be familiar with and understand the system as well as the policies that are

in place. Without the follow through from your staff, the inventory management system will not be

worth anything regardless of how much you paid for it. Proper staff training and comprehensive

implementation will assure your investment will not go to waste.