For most stock-based businesses, inventory is likely to be the business’ biggest asset. Even if a business has some other, high value, assets such as factory plant, inventory is likely to be essential to the business’ ability to trade profitably. Because inventory is so critical to a business’ success, it is useful for business owners and managers to understand the cost of each item stocked in the store or the warehouse. Unfortunately, many businesses fail to accurately record inventory costs, leaving them in the dark when it’s time to make difficult decisions.
Why is accurate inventory costing so important?
Inventory costing impacts on almost every facet of the business. Perhaps the most obvious impact is on product pricing. While a number of factors, including supply and consumer demand in the market, will determine the price your business charges for its products, one of the most important factors is inventory cost.
If your business can produce 2,000 litres of freshly squeezed fruit juice for $5000, you know that you will need to charge $2.50 litre to break even – and more than that if you want to turn a profit. If you are failing to count some of the costs of production – a minor ingredient, inventory carrying costs or depreciation, for example – you may be pricing your product for sale at a loss. Likewise, if you think that you are making a substantial profit at the market price but in reality failing to capture all of your costs, then you will probably bottle more product than you would at a lower price.
Inventory costing also has significant tax implications. If you are failing to capture all of your inventory costs, you are likely paying more in tax each year than you are required to. In the unlikely event that you are materially overestimating inventory costs, then you may be paying too little tax.
Finally, inventory costing is important to make smarter business decisions. Comprehensively determining inventory cost allows you to identify opportunities for efficiency gains, which can increase margins or boost sales volume.
How can businesses fully capture inventory costs?
A business’ total cost of production can be broken down into three basic categories:
- Ordering costs
- Carrying costs – the costs of holding inventory
- Shortage costs – the costs associated with running out of inventory
Ordering costs are reasonably straightforward, although businesses sometimes don’t think to capture small things such as currency conversion fees and staff time. It is also important to factor in fixed costs – for example, if you travel overseas to negotiate with suppliers and inspect factories at the start of a contract, the associated costs need to be spread across each item of inventory.
Businesses often fail to factor carrying costs into the cost of goods sold. These costs include obvious expenses such as rent and insurance but extend to shrinkage, obsolescence and time spent handling boxes and crates in a warehouse.
Shortage costs can be difficult to determine – they’re not always ‘accounting’ costs, and they involve looking towards the future to determine the impact of a stock-out on the business.
The best way to ensure that inventory costing is accurate is to work through each of these categories. For ordering and holding costs, a good look at past period’s accounts should provide some guidance. One way to estimate shortage costs is to look at the impact of previous stock-outs on the business. Another approach is to base shortage costs on your budget for supply chain risk management. Whatever approach you take, the important thing is to be as comprehensive as possible so that the headline inventory cost figure reflects the true cost to your business.