Why Do Businesses Take Inventory?

GettyImages

My son used to work for a CPA firm, and every year he spent the holidays "taking inventory" at client locations.  One year, he did inventory at a large office supply company counting paper, pens, and staplers.  

Why do businesses take inventory?  And why do they do it at the end of the year?

Inventory is important to your business because it leads to sales. Businesses take inventory to answer several questions:

How Much Do We Have On Hand?

Inventory is a valuable business asset. Businesses take inventory so they know how much they have on hand at a specific point in time.  Inventory includes both finished products, work-in-process (products in various stages of completion), and products to be used to make new sales items (called cost of goods sold). 

For example, inventory for a business that makes candles and candle-holders might include finished candles in boxes ready to go out, candles that have been completed but not boxed, and wax and other materials that will be used to make new candles.

Taking inventory means that a business stops work on a specific date and everything gets counted. In a very small company, everything gets counted.  In larger companies, with many products and many parts to be made into products, inventory is spot-checked or sampled. Counting every bolt that goes into a car, for example, would take too much time, so samples are used to estimate the inventory.

How Often Does Inventory Turn Over?

Inventory turnover shows the number of times a year inventory "turns over" or is sold and replaced.  Rosemary Peavler, Business Finance expert, says that inventory turnover "measures the efficiency of a business in managing and selling its inventory."  The higher the turnover, the higher the sales, the more efficient the business.

What is the Value of Our Inventory?

The value of a company's inventory depends on the valuation method: First In-First Out (FIFO), Last In-First Out (LIFO), or Average Cost. The valuation method can make a big difference in taxes, and the IRS has rules on valuing inventory.

FIFO valuation measures inventory by assuming that items that are in inventory first are sold first (even if this isn't necessarily the case). LIFO valuation assumes that items in inventory last are sold first. Average cost is, as it says, an average of the cost of all items sold in a period of time. Whether your business uses LIFO or FIFO depends on your business type and IRS regulations. 

Is Inventory Disappearing? 

One reason for doing a physical inventory is to make sure that inventory is not disappearing, for one of several reasons: 

  • Some inventory might become obsolete and needs to be discarded. This might be the case for technological obsolescence of electronic devices and computer products. 
  • Some inventory might be unusable or damaged and needs to be discarded. 
  • Some inventory items might be disappearing due to employee theft. 
  • And some inventory might not have been recorded correctly, for various reasons. 

When discrepancies or issues arise, action needs to be taken because the value of inventory is being overstated.

Obsolete or unusable inventory needs to be removed from the records. Changes in record keeping or investigation of loss due to theft might be needed. 

What is Beginning and Ending Inventory for COGS?

Cost of good sold is an important calculation for businesses that sell products, whether they are manufactured or purchased and re-sold. Cost of goods sold, as the name implies, is a cost of doing business. 

To calculate cost of goods sold for its tax return, the business needs to know the value of beginning and ending inventory.  The higher cost of goods sold, the lower business income, so this is an important figure.

How Do Businesses Manage Inventory? 

Because inventory is an asset, it's important to manage it, just like you manage other business assets. Managing inventory means keeping track of it, not having too much or too little on hand.

 

Businesses manage inventory in one of two ways: perpetual inventory and periodic inventory. Most retailers use the periodic system, which tracks inventory by counting (like my son was doing). In the periodic system, a business takes inventory at the beginning and end of a period. 

The other inventory management system is a perpetual system, which uses point-of-sale technology to track inventory after every transaction. 

Can We Get a Loan from Our Inventory?

One final reason to take inventory is to value it for financing purposes.  You can get a loan based on the value of your business inventory.