How Does Inventory Control Affect Operating Expenses?

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Inventory Control Terminology

The language of inventory control is very useful to know and not difficult. These terms may be considered favorable, unfavorable or neutral by how they affect your ability to make a profit.

Favorable ASSET—Something that has book value today and will create profit soon CASH—The most liquid and desirable kind of asset REVENUE—The money customers pay for their purchases

Unfavorable WRITE-OFF—The worst news a business can get; it means that something on the balance sheet that used to have value no longer does; it is an immediate loss of profit EXCESS INVENTORY—Too much inventory means tied-up cash and a likely write-off OBSOLETE INVENTORY—Old inventory that has become worthless and must be written off SHRINKAGE—Poorly controlled or pilfered inventory that no longer exists and must be written off EXPENSE—The everyday cost of running a business that reduces profit in any given period INVENTORY—The products necessary to create something to sell; inventory was once liquid cash

Neutral BOOK OR BOOKS—Slang for the income statement and balance sheet; before computers, company finances actually were recorded in a set of books INCOME STATEMENT—A monthly and annual report that shows how much money a business has made or lost (like a moving picture) (aka P & L; profit and loss statement) BALANCE STATEMENT—A monthly and annual report that shows how much a business is worth (like a snapshot) BOOK VALUE—The amount of money an asset is said to be worth on the balance sheet COST-OF-SALES—The total of everything spent to create whatever was sold in that period AUDIT—The process of oversight and reporting provided by a public accounting firm

Optimal Inventory Levels Preserve Cash and Reduce Expenses

Businesses are created to make money. In many businesses, the largest drain on cash is inventory. Inventory used to be cash until it was used to buy materials needed to create products for sale. Buying less inventory means more cash on hand to use for other things and to keep a business going in tough times.

The smallest inventory necessary to create sales also minimizes the risk that the inventory will never generate any sales because, 1) there is too much of it on hand, 2) it becomes obsolete and valueless, and 3) it is pilfered or untracked. Inventory also requires a place to stay and a babysitter. The warehousing of inventory and paying people to track it represent significant operating costs. These operating expenses are necessary to protect the company’s investment, but less inventory means lower operating expenses for inventory control.

Japanese industrialists used this concept of optimization to near perfection in the 1980s with their JIT (Just In Time) inventory system. It required a wide network of like-minded managers who cooperated so well that manufacturers knew with great precision how much inventory would be needed each day to create products for sale and suppliers were willing to deliver just that amount daily. Operating expenses for inventory control were virtually eliminated. Loss of profits due to write-offs for excess, obsolete, or shrunken inventory were no longer a problem..

We Americans tend to operate a little too independently for a JIT system to work here. But investing as little cash in inventory as possible, housing it in a secure facility, and tracking its movements or lack of them can significantly increase profits by preserving liquid assets, reducing write-offs, and getting the most utility possible from what few operating costs for inventory control are necessary.

Inventory Control: An Expense That Pays for Itself

There are three kinds of inventory: expensed, fixed and valued. Expensed inventory is typically purchased in trivial amounts subject to budgetary controls. It is recognized as a reduction of profit in the period it is purchased. This kind of inventory is sometimes caged and dispensed as needed to prevent theft and discourage casual use, but it has no book value. Fixed assets are expensive items like computers and furnishings that have a long useful life. Their cost is expensed over a period of months or years as depreciation until they no longer have any book value. Valued inventory is different. It is purchased in order to become sales merchandise or finished goods. It is assigned a value when it is received and accrues value as it evolves from raw materials to work in process to finished goods. It is kept on the books as an asset until it is shipped out and flows through the income statement as the cost of goods sold. Unless, of course, it does not get sold. Then it must be written off as a direct hit to the bottom line. This typically occurs when an outside audit determines that it is absent or worthless.

So every dollar in cash that is spent for valued inventory is a dollar tied up and a dollar waiting to become a write-off. Less inventory means more cash on hand and less financial risk. The inventory that must be acquired to generate sales is an investment in the future of the company that must be protected against loss. An increase in operating expenses and overhead to fund an inventory control system is an inevitable part of any loss prevention strategy.

Less inventory on hand means less inventory to control. Yet carrying some inventory is necessary. It is an asset worth protecting. Protection costs money. And in this case, saves money, too.

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