Getting to Know Your Balance Sheet: Inventory Management
Last week we covered the basics of Inventory. Inventory is a current asset. It is the value of the company’s raw materials, work in progress, and supplies used in operations and finished goods (if applicable).
This week, we’ll investigate inventory management from the owner or manager’s perspective. Recall that we are not providing accounting advice (please contact your CPA for accounting advice) but we are showing you a few concepts to help you manage your business with greater effectiveness by looking at your financial statements. We’ve simplified a few concepts so that you can apply them as you read this post. We encourage you to apply the formula below to your recent balance sheet and income statements for 2022 (and compare them to 2021). You will recall the concept much better if you put it into action.
The way your accountant or bookkeeper is recording inventory will make a difference in whether the inventory on your balance sheet will result in over or understated earnings. Do you know why? (See last week’s blog about accounting methods and/or email me). You will want to know how close your inventory is to actual market value if you are having your company valued.
For many years, the most efficient model for inventory management from a cash flow perspective (for most companies) has been to reduce inventory to the minimum amount needed to keep work moving ahead efficiently. This is called a “just in time” method. I remember learning about this “new and improved” way of inventory management in business school. Once it became possible for materials to be shipped quickly and efficiently, this method answered a lot of the prior generations’ problems. (Storage, loss, obsolescence, etc.)
All this worked very well until our recent problems that started in earnest with 2020’s pandemic (but some international trade issues had been creating pockets of problems before then.) We did have a prolonged (and still do in some cases) breakdown in some of our most important supply chains. Without the necessary materials, some jobs were on hold until materials became available. If jobs weren’t completed, billings for the completion of work couldn’t be issued. In response, many landscaping companies are keeping at least a moderate amount of their most used materials on hand. Calculating what and how much of certain types of materials to buy in advance, balanced against the increased costs of carrying those inventories has become a more important and complicated calculation.
To add to our inventory management challenges, we are now in a rising interest rate environment. Materials purchased this year cost more due to higher costs of inputs for them. Prices continue to rise based on their factors of production which are then impacting landscaping project costs.
So why not pre-buy materials early and hold them in inventory?
That might work if you have a good system for anticipating your needs over a specified period. Keep in mind that pre-purchasing will tie up the company’s cash until the projects are completed. This may be a good idea, but like so many ideas, it’s often helpful to take a minute to calculate all the pluses and minuses to see if what sounds like a good idea in principle comes true for the details.
For example, is there a volume discount available from your supplier/vendor that might be the additional incentive to make pre-purchasing work? Will you have to borrow money at a higher interest rate to pre-buy and will that extra interest offset the savings? Who will manage the pre-purchased inventory to make sure it is being used as projected and/or replaced as needed? What are the measurements you will need to evaluate how well this method is working? The goal is to keep the cash flow moving from raw materials and labor through to finished goods. If a company buys too much of a particular item that they then cannot sell or if the supplies are subject to theft, there is an additional cost of carrying those materials. This is obviously not a time to change your process and leave it changed without careful periodic review.
In most cases for landscaping companies, there will be a raw materials inventory and a work-in-progress inventory (WIP). Those are the materials that are in use to complete the project. Are these reflected properly on your balance sheet?
These are some of the factors to be considered in making the decision to purchase materials. The way the inventory is accounted for is a complicated subject that can alter the balance sheet, depending on the method used. Your CPA will help you determine the pluses and minuses of various accounting methods. Once that’s established, you may want to track Inventory Days to see how long inventory is in stock before it is converted to sales.
What to Watch – Inventory Days
Days in Inventory = Average Inventory / Cost of Goods Sold/days
Average inventory is inventory at the beginning of the year plus inventory at the end of the year divided by two.
Cost of Goods Sold is found on your Income statement for Cost of Goods Sold divided by number of days in the year (360)
The result is the number of days that inventory stays in the system.
If the Inventory Days period is growing, it may be time for management to change factors to correct that trend including
- reducing supplier costs
- having the supplier hold materials and not bill until they are sent out for the job to begin
- changing the reorder frequency or volume.
If, when comparing Inventory Days, the manager sees an excessive rise in amounts or costs, he can analyze what happened and adjust to manage for the optimal blend of work performed in a timely manner versus cash being tied up with no Return on Investment.
Would you like to discuss your financial results and how your company might maximize its value? Have you been wondering what steps a smart owner can take now to prepare for an exit from the company while achieving his/her goals? We will be happy to have a confidential complimentary conversation with you.
You can reach me via email: [email protected] or on my cell phone a: 224-688-8838.
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