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How to leverage inventory cost management to improve your company’s profitability

November 3, 2022

Contributors: Kimberley C. Schwaiger, CPA, Tom Shemanski

For many businesses, particularly manufacturers, balancing inventory costs is vital to your company’s success. It can also be a guessing game that is difficult to predict.

Inventory cost management plays a vital role in successfully managing growth based on your business strategy. With an effective system in place, you’ll find it much easier to capture appropriate costs, including your overhead expenses. This information will allow you to make better decisions related to inventory levels and sales-pricing strategies that improve your company’s profitability and growth. Here are some areas to focus on:

Right size your inventory

Much like your checking account balance, your inventory is considered to be an asset on your company’s balance sheet. With too much inventory on hand in your warehouse, you’ll have reduced purchasing flexibility, such as when you want to adapt to market demand shifts, keep ahead of your competition, increase business profitability, or purchase and use new or better products. On the other hand, maintaining insufficient inventory can lead to supply chain issues, customer dissatisfaction, loss of customers, and lowered profitability. Focus on “inventory turns” to maximize your ROI on your inventory investment and to achieve the optimal inventory level for your business. Liquidate excess or slow-moving inventory and invest the proceeds in fast sales-cycle product.

Become Data Driven

Collecting inventory cost data (purchase price, freight, duties, etc.) and manufacturing cost data (labor, supplies, overhead, etc.), along with considering supply chain and market demand, are critical if you want to leverage your inventory cost management process to the max. Understanding these insights will help you develop better business strategies and make improved company decisions.

Start by analyzing the data on your existing stock, which prevents you from accumulating carrying costs that are associated with obsolescence. This also helps you manage your storage and materials handling expenses, which are usually tied to your warehousing and moving of your inventory. Understanding the stock you have on hand also helps you avoid fraud and theft issues.

When you analyze sales data, you can better align your inventory with the current demand in the market. This ensures you’re able to meet your customers’ demands by providing timely delivery of the goods and services you create while avoiding overextending your costs. Leverage your enterprise resource planning (ERP) system to establish accurate sales forecasts and optimal purchasing patterns.

By performing regular assessments of your vendors, you can gain insights to avoid potential supply chain issues, place orders in a timely manner, and avoid possible shortages. Additionally, in conjunction with your inventory expense data, the information gathered allows you to better forecast future cost, produce more accurate revenue projections, and track your company’s performance in these areas.

Analyze and implement change

While there are several types of inventory data analysis, let’s focus on a couple that are commonly used by manufacturers:

  • Margin analysis allows you to determine each product’s margins by compiling all the associated product costs, then subtracting those expenses from the revenue the product generates. Use margin information to dictate which product lines to grow or exit, and to determine where increasing inventory makes sense.
  • ABC analysis helps reduce excess, prioritize items impacting inventory cost, and manage shortages. The analysis is calculated by multiplying the cost per unit by the number sold annually to determine annual usage value. The cumulative products sold percentage is then compared to the annual consumption value. This allows you to categorize inventory based on data:
    • “A” represents the smallest category with your highest valued products accounting for the bulk of your revenue, potentially up to 80%.
    • “B” is the middle-of-the-road category, with products of moderate value and revenue generation, approximately 15%.
    • “C” is the largest products by volume that generate the least total revenue, approximately 5%.

Because each manufacturer is different, you’ll see shifts. Inventory needs may be different between locations. Analysis may need to be broken down by location or a similar factor. The 80/20 rule is the primary principle in ABC analysis, where 80% of total output will be generated by 20% of your input. Prioritizing products in your “A” group will allow you to focus your strategy on the smallest number of products to generate the largest return. This is why ABC analysis can help you keep the right products in stock to meet demand while eliminating excess inventory and managing expenses.

Adding inventory to your tax and accounting strategy

As part of your overall tax and accounting strategy, how you manage or cost your inventory can have a big impact on your total tax liability at the end of the fiscal year. From an income tax standpoint, the Internal Revenue Code provides taxpayers options to make certain elections with regards to inventory and to reduce tax burden, in most cases. We have specialists in the manufacturing sector who can help you identify options so you can leverage any opportunities that may come your way, allowing you to reduce income taxes, increase profitability, and improve operations.