Businesses that buy merchandise for resale or who use material to produce a product must account for that material before it is delivered to the customer. All of this physical material, including supplies that are part of the final product, is classified as:

  • Merchandise – goods acquired by wholesalers or retailers for resale including goods held for sale in display rooms or out on consignment
  • Raw Material – items that will be a component of a produced good
  • Work-In-Process – the accumulated costs of partially completed units
  • Finished Goods – completed units, available for sale to customers

The small business entrepreneur needs a basic understanding of inventory accounting:

  • methods of tracking and verifying inventory item quantities (perpetual inventory recording of receipts and issuances, annual physical inventory, cycle counting)
  • methods of valuing inventory items: specific identification of actual cost, FIFO, LIFO, retail – all methods are validated as being the lower of cost or market
  • calculating the cost of goods sold during an accounting period by adjusting for the increase or decrease in the value of the inventory over that period
  • methods of handling inventory for your type of business (based on the customers you serve, the kind and volumes of goods you sell, vendor delivery schedules, customer response times, forecasted sales by product line)

For tax information regarding inventory, see IRS Publication #334, "Tax Guide for Small Business”

Chapter 2, Accounting Periods and Methods, has a general discussion of inventories, and Chapter 6, How to Figure Cost of Goods Sold, explains how inventory translates into product costing.

For a technical discussion of costing and valuing inventory, see the section on Inventories in IRS Publication #538.

The purpose of inventory control is to organize items so that sufficient units are on hand and readily available to satisfy customer orders within a reasonable timetable, while avoiding the costs of either oversupply or undersupply. Good customer relations are impacted significantly by how well or poorly you meet these challenges.

Having large quantities of goods on-hand would seem to reduce direct production costs by minimizing disruptions caused by shortages, breakdown, changing customer demands, etc. Instead, for many years, many manufacturers have minimized their working capital investment in inventory by emulating the Japanese kanban system with some form of just-in-time method. A just-in-time outlook is applied not only on-hand inventory, but also to all phases of the manufacturing process (product design, Materials Requirements Planning, materials management, production scheduling, quality assurance).

In developing a business plan, the entrepreneur needs to give sufficient attention and devote enough resources to stock control. A successful undertaking – whether manufacturing, retail, or wholesale will benefit significantly from the impact of good inventory management on your customer relationships and your cash flow.

If you have a considerable amount of slow-moving stock on your shelves due to poor planning, you have significant dollars sitting on your shelves not available as working capital. An inventory reserve should be budgeted to provide for the cost of inventory items that may eventually have to be scrapped when they become obsolete due to deterioration from age or material design changes in product requirements.

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Key Topics

Inventory Accounting and Control - SCORE 4.51