Inventory & Profit
Most storeowners, especially of smaller stores, can do what is called an “eyeball” inventory. It is easy to feel as if this is sufficient because, after all, it is easy to see when a box of stones is empty, when you’re getting short of a particular book, or running low on anything else you carry in your store. This form of inventory maintenance may be sufficient to keep your store well supplied, but it really isn’t enough for cash management and the determination of profitability.
Instead of just the eyeball approach to inventory maintenance, it is very important to count your inventory, not only to make sure your store stays well supplied, but also to get an accurate picture of your profit (or loss.) Not only that, if you find yourself cash short, counting inventory will tell you if and how much your profit is tied up in inventory instead of being available to fund your business expenses and provide for an adequate capital reserve. If your cash is tied up in inventory, this is a problem easily remedied.
Increased Inventory Increased Profit. Decreases Inventory Decreases Profit
A business truism is that the more your inventory increases, the more your profit increases. This is because inventory is just another form of cash. When you purchase inventory, you are not losing cash, just re-allocating it into another form… goods instead of coin. Likewise, when your inventory decreases, your profitability decreases. This is true even if your sales have increased and you have more cash on hand. By decreasing inventory, you have again re-allocated your cash. Rather than spending cash from profit, by over-selling inventory, you instead spent the cash invested in the goods. You may initially seem to show a profit because you now have some cash on hand, but if your inventory has dropped more than you made, you have actually lost money. If you don’t initially seem to show a profit, but your inventory has increased more than your loss, you have actually made a profit.
This is shown in your Profit & Loss Statement in the following manner: In a Profit & Loss Statement, you first notate your sales (that can be broken down by category.) Then you subtract or add an inventory decrease or increase as an inventory adjustment from your cost of sales. Then after also subtracting your other costs of sales (ie.material costs, labor, and freight in), you are able to see your true gross profit. Of course, then you then have to subtract your other expenses, like advertising, accounting, phones, postage etc. from your gross profit to arrive at your net profit, the profit that you have when all expenditures in every form are accounted for. In short, you cannot know your true net profit without some form of inventory adjustment that takes into account an increase or decrease in inventory.
Learn How to Read and Understand a Profit & Loss Statement
How often your inventory should have an actual count varies depending on your need for accuracy in purchasing as well as your accuracy in determining profitability. It more often than not also depends on the size of your business. When my business was smaller, it was enough just to do a final inventory count at the end of the year since we had a small enough product line that was accurately priced, so we had plenty of cash on hand for purchasing. We knew we were more or less profitable since we always had enough cash for all expenses, adequate purchasing, and to pay our employees and ourselves. It was primarily for tax reporting and our own curiosity that we needed an accurate inventory count for reliable profitability determination.
As my company continued to grow we had to count inventory more often. We eventually carried approximately 1000 items with an average of 10 parts needed per item. We needed an accurate inventory count, not only to determine profitability, but also so that we could keep purchasing enough to keep everything in stock. There was no way we could eyeball all of these parts. Plus, some of the parts could take as much as three months to get to us, so by counting we were also able to predict the number of each item that was likely to sell as well as the parts we would likely need.
We knew, for example, that we needed to keep at least 500 amethyst 6mm round cabochon stones on hand every month. If we counted and had only 500 and had orders placed for 200 more that were arriving in three weeks, we would need to order approximately 800 more to cover the orders for the next two months. If we had just eyeballed the 6mm amethyst cabochon supply instead of counting, the 500 would have looked like enough and our production would have halted in about a month and a half or so for items needing this stone. (Of course, giving and receiving terms makes this process a little more difficult, but the idea is the same.) To make sure that we had enough supply, then, we counted inventory monthly.
We also counted inventory to not only give us an accurate profitability picture every month, but also to accurately guide the direction of our business. If our inventory grew too much, even though we knew that it increased our profit, we knew that we had too much money tied up in the inventory. With too much money spent for inventory, we wouldn’t have enough to pay all of our expenses and we would enter into a cash short position that would slow or even have the potential to halt our business. After all, unsold inventory doesn’t pay the bills. Now, other considerations like pricing and sales levels determine profitability other than inventory levels, but a careful and consistent count of inventory is also vitally important.
There is often a tendency in business to overbuy, thinking that the more you have the more you will sell. However, more is not necessarily better. A carefully targeted and streamlined inventory is much more important than having lots of everything. Careful sales forecasting and knowledge of your customers’ buying habits and financial positions are also more important than just having copious amount of product. Knowing your customer helps you purchase more accurately so that you don’t unnecessarily build up your inventory and deplete your available cash.
If you find yourself in the position of being cash short, then, take a look at your inventory. Count it. If you find that your cash is too tied up in inventory, decrease your inventory with accurate analysis. Do you really need the number of variations of a product, for example? Do you sell enough of a particular product to warrant carrying it in your store? If you drop it, will it affect your overall sales that much? Do you have “dead” inventory in your back room that you can put on sale and turn into cash?
The opposite inventory issue is also something to be noted and considered. If your inventory has dropped so much that you are not showing a profit (all other expenses being equal), and you never seem to have enough money to adequately purchase the inventory you need, you need to figure out where the cash is going. Are your prices too low and do you have the demand to raise them? Your pricing determinations should not only consider demand, but also if what you can charge will cover your expenses and the re-purchase of necessary inventory, as well as an adequate profit. If not, every time you sell an item you will lose money and need to keep drawing down your inventory.
If everything is in line with pricing, margins and sales, yet your inventory keeps dropping, find out if there is theft in your store, (I hate to mention this, but it is a reality.) When you have a downward trend in inventory that isn’t covered by sales, theft is a likely possibility. At Uma Inc. we carefully tracked each item sold and subtracted each part from inventory. If our actual inventory count didn’t match that, we had a problem.
Inventory counting can be quite time consuming as well as a “pain in the neck.” Sometimes you even have to close your business for a day in order to do a count. (We had to close for three days.) In order to avoid shutting down our business more than quarterly, we had a revolving inventory. Each container of stones, finished items and parts had an initial inventory count on the front of it. When we used any of the stones or parts, or shipped any of the items, the stockers and shippers changed the number on front of the box to reflect how many they took out or added. This meant that on our monthly count, we had only to look at the number on the front of the box to know what we had in the box. When we added it all together, we had a total count. In a store you could do this at the cashier’s counter with a simple chart. Or you could have a revolving count discretely on the shelf. Any way you do it is fine. The point is to have a revolving way of counting that adjusts inventory with each sale.
Very importantly, is even though you have a revolving inventory, you will still need to do an actual count. Depending on the size of your store, you may need to do this yearly, bi-annually, quarterly or monthly. Even though you may take great pains to keep an accurate revolving inventory count, more often than not you will find some discrepancy in an actual count. If it’s a tiny amount, don’t worry. Just correct your count. If it’s a large amount, you have some sleuthing to do to find out the reason and correct it.
Another way to help with an inventory count is to use a scale. Obviously, this is only useful with smaller parts like stones etc. When we did our actual count once a month, we were able to weigh all of our smaller parts in order to get our count. This saved an enormous amount of time. Basically, we weighed one stone of a category, for example, and then to get an inventory count later of the total number of that stone, we weighed the entire batch, divided by the weight of one stone and got our actual count. As long as several items fit on any size (accurate) scale, you can do this. There are scales made expressly for this purpose.
Whether hand counting or weighing, then, maintaining an accurate inventory count will give you a true picture of your business’s profitability. Increased inventory will mean more profit. Decreased inventory will mean decreased profit. Knowing these numbers will ultimately help you run your business with less stress and more profit because you will be able to use you cash with more efficiency based on precise information.