A properly managed inventory system not only reduces costs by increasing turnover and freeing up capital, it also gives you the opportunity to negotiate the best prices.
Storing excess inventory can be costly to your firm in many ways. Personal property taxes, warehouse expenses, insurance costs and other inventory expenses add up quickly, often making it unprofitable to keep too much inventory on hand.
Inventory costs run about 2 percent a month. While that doesn’t sound like much, it’s 24 percent per year. In other words, $100,000 worth of inventory purchased on Jan. 1 has a real cost of $124,000 on Dec. 31.
To turn a profit on this inventory after one year, you must sell it for $124,000; after two years, for $153,760.
Although managing inventory is a major cost for many companies, when done effectively, it can have a real impact on cash flow.
Typically, companies shy away from properly managing inventory when there are large quantities of items and a wide product mix. A company with 10,000 items in inventory may hesitate to develop an effective system because of the sheer number of items involved. But there is a relatively simple process that can be employed.
First, separate your inventory into three categories: most expensive, moderately expensive, and least expensive. The most expensive category should contain less than 10 percent of all the items you own, and represent approximately 75 percent of your total inventory costs. These items represent less than 10 percent of total shortages.
The moderately expensive category should contain 20 percent of your inventory units, and represent 20 percent of the entire inventory cost. Inventory shortages in this category should approximate 20 percent of all inventory shortages.
The least expensive category should represent about 70 percent of inventory units, and less than 10 percent of total inventory cost. These items cover 75 percent of total shortages.
When properly purchased and adequately controlled, the more expensive inventory can provide significant savings to your company, so work toward managing these items first. If you focus on the most expensive and moderately expensive categories, you will probably be working with a very manageable 30 percent of your inventory units, although they may represent as much as 95 percent of your total costs.
The least expensive category represents the majority of inventory items, but costs the least amount of money.
Because of the relatively low inventory costs, these less-expensive items can be purchased more infrequently. Generally, it is these low-cost items that cause the greatest shortages. The additional paperwork involved in buying low-priced items repeatedly can also become quite expensive, and when you run out of these low-priced items, it can hold up an entire manufacturing process. Therefore, when you measure the relatively low cost of shortages in this category against the major expense of repeated ordering and stocking, you can see that less attention needs to be focused in this area.
The objective in controlling inventory is to segregate the items with the highest cost, and make sure those are the items that turn over the most. Never leave expensive inventory sitting on the shelves, and always be sure to buy new inventory in a timely and effective manner. Aim to have new shipments of expensive inventory coming into your operation the day before old inventory runs out. This represents the concept of economic order points and just-in-time inventory.
A good system should monitor your inventory so that you receive shipments just as the existing inventory is depleted, freeing precious capital that would otherwise be tied up in inventory.
As an example, an automobile dealer decided to do away with her stockpile of shop and office supplies. She made arrangements with vendors to deliver supplies within 24 hours, as long as the order exceeded $250. The dealer eliminated unnecessary expenditures for inventorying supplies and controlled potential pilferage. In addition, she saved substantial labor costs since employees didn’t have to load goods onto shelves or maintain laborious inventory logs. She also eliminated another source of lost profits supplies aging beyond usefulness. The dealer estimated that just-in-time ordering saved thousands of dollars per year.
So how do you get rid of excess inventory? One excellent way is by donating it to charity. As a partnership, sole proprietorship or S corporation, you can deduct the cost of the donated property. If you are a C corporation, the tax deduction is even larger. Rather than simply getting rid of unwanted inventory, both you and the charity win.
To qualify for this tax deduction, the property must be donated to qualified public charities or private operating foundations that use it for their exempt purpose caring for the needy, infants or the ill. Charities may not sell, exchange or barter inventory.
The National Association for the Exchange of Industrial Resources (NAEIR) collects donated inventory and redistributes it through a network of thousands of non-profit organizations around the country, at no cost to you. NAEIR also provides you with the documentation needed to justify the deduction.
Accept the challenge of managing your inventory more effectively. The benefits will be worth the effort.
David W. Free is a partner at Singer, Lewak, Greenbaum & Goldstein LLP, a certified public accounting and management consulting firm in Westwood.
Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1941 with feedback and topic suggestions.
