Tracking Inventory

1. Tracking Costs and Accounting

In the service industry, inventory management may involve a retailer seeking to acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and related costs are kept in check. In manufacturing, inventory control involves systems and processes that identify production needs, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of materials. This would include the monitoring of material moved into and out of storage locations and the reconciling of the inventory balances.

In both worlds, inventory management requires up-to-date and accurate measurements, which in turn requires a stable system for tracking materials or goods as they arrive, and again when they are used or sold. It also means having quality control measures in place to take actual measures of inventory to compare against records. In this tutorial, we will discuss a few of these methods. These methods are not necessarily discrete; an organization might use a combination of these strategies to manage inventory. This list is also not comprehensive, but these are the most used inventory management strategies.

2. Specific Identification and Periodic Tracking

Specific identification is a method of finding out exact inventory value. This requires an exact physical count of each item so that the company knows exactly how many of each good is in inventory. The count of goods can then be multiplied by their cost to the company, along with holding costs, to get a precise value of inventory. Because this requires attention to detail, it is only used for more expensive items, such as vehicles that arrive with a unique vehicle identification number, appliances, home electronics, etc. This method is hard to use on interchangeable goods, where specific shipping and storing costs for each item cannot be differentiated. This usually means items bought in bulk.

Specific identification is often accompanied by periodic tracking, where physical inventory is counted and confirmed on a regular (if not predictable) schedule. This ensures that records are accurate and may reveal any sources of loss, especially theft. A car lot is again a good example of a business that might do this, to make sure all recorded inventory is still present and resolve any discrepancies.

EXAMPLE

Consider an appliance store that sells washers, dryers, refrigerators, etc. They would keep a running log of appliances as they are received and sold, along with their wholesale and retail prices. Once a month they would take a physical count of appliances and compare it to their records to ensure accuracy and discover any thefts or losses. The same store sells some less expensive products to be used with their appliances, like filters for the dryers and ice cube trays for freezers. These would not be tracked so meticulously.

terms to know

Specific Identification

An exact count of each item so that the company knows exactly how many of each good is in inventory.

Periodic Tracking

Periodic (though not always predictable) count of physical inventory to ensure accuracy of records and security of inventory.

3. Lot Tracking, Minimum Order Quantity, and Maximum Order Quantity

For items that are bought and sold in bulk, an organization may use lot tracking instead of specific identification. This is similar in that specific ID numbers are assigned to items in inventory, but lot tracking assigns the number to a batch, such as a crate or box that the item is received in. This is crucial to restaurants, grocery stores, and other services with perishable goods so they can quickly track which items must be used or discarded before they spoil.

Another strategy for perishable goods is to set minimum order quantity and maximum order quantity for each item. In this system, the specific count of goods is less important than knowing they are balancing needs while avoiding overstocking and spoilage; the materials manager will use a rough count or estimate to determine how much of each item is needed, and work within parameters of always ordering at least a certain amount and no more than a certain amount. A good understanding of past trends and usage should help the materials manager set the minimum and maximum order quantities for each item.

EXAMPLE

A restaurant manager may never know exactly how many eggs, or even cartons of eggs, are in stock but knows to order at least three cases (each with 180 eggs) and no more than five cases every week. A quick walk-through of the storage areas will help determine which number in this range is best, but the range will always give an appropriate balance of meeting needs without overstocking; any errors in judgment can be corrected in the next order.

terms to know

Lot Tracking

Counting of items in batches, such as the crates they are received in.

Minimum Order Quantity/Maximum Order Quantity

Strategy for maintaining inventory within a range by specifying a minimum and maximum number that can be ordered at a time instead of keeping an exact count of items in inventory.

4. FIFO and LIFO

FIFO stands for “first in, first out,” meaning that the oldest inventory items are recorded as sold first. Often, this method is used for perishable goods.

EXAMPLE

A bakery would likely use the flour with the soonest expiration date prior to using more recently ordered flour. You probably do this at home too, in that you might eat the milk or yogurt with the soonest expiration date first, before opening the new container.

LIFO stands for “last in, first out.” In terms of actual inventory, this is common when the items have a long shelf life, because it is easier to access the most recently acquired stock.

EXAMPLE

An employee at a bakery will take a pastry box off the top of a pile; in this case, it wouldn’t matter that it is newer than the one on the bottom.

However, both FIFO and LIFO may not represent the actual items in inventory—just the way they are tracked. Say a clothing store adds each item to a list as it arrives and checks items off the list as they are sold, from top down. The item the customer takes away is not the oldest in inventory, but the clerk is using a FIFO tracking technique. This is quite common in cases where the items are interchangeable and stable over time.

LIFO may also be done as a tracking technique regardless of which item in inventory is actually taken away first. One reason for doing this is that the cost of new inventory to the business is higher than old inventory but is sold at the same price (or the goods it is used to make is sold at the same price). By marking the newer items as used first, the business can show lower profits for tax purposes without affecting actual revenue. This is legally acceptable in the United States but illegal in other countries.

LIFO tracking is also done when the cost of goods sold (COGS) is volatile; if the cost of acquiring and transforming products rises and falls, so will the value of inventory, which could make for a seemingly unstable business if FIFO tracking is done.

IN CONTEXT: VOLATILE INDUSTRIES

Oil and gas companies will always cycle their actual products so that the oldest is sold first, since gas and oil deteriorate over time, but often use LIFO tracking to show the most recently acquired products as sold first. The advantage to this method is to show a more stable profit margin in a volatile market.

Say an oil distribution company acquires 100 barrels of oil at $80 each one week and sells 100 barrels at $90 each. The following week, the price goes up; they now acquire 100 barrels at $85 each and sell 100 barrels for $95. In the second week, they are actually shipping the barrels they acquired the previous week, so using FIFO tracking would show a profit of $15 barrel.

Now let’s say the prices drop again. In the third week, they again acquire 100 barrels at $80 each and sell 100 barrels for $90 each. These are the barrels they acquired at $85, so by FIFO tracking, they would show a sudden collapse in profit margin from $15 a barrel to $5 a barrel. Such volatility would make investors nervous.

Using a LIFO tracking method, they would show a stable profit of $10 a barrel, which is a more reliable indicator of their stability over time. Remember, though, that they would still ship their oldest products first, but by using FIFO tracking, they can adjust each week’s revenue to the market rate and give a more accurate representation of their business.

The selection between FIFO and LIFO depends on industry; those with more price volatility (as in the example) will be more likely to use LIFO tracking. The method a company chooses bears on both taxes and their statements to investors; while both FIFO and LIFO are legal, businesses are required to use the same method for both tax purposes and financial statements. That is, they cannot report the lower of the two on their taxes and the higher of the two on their reports to investors.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

terms to know

FIFO

First in, first out; represents a store or business using items in the order they are received. FIFO usually refers to actual items in inventory but may refer to simply tracking the oldest items as sold first.

LIFO

Last in, first out; may represent an actual inventory process of using the most recently received items first but more often refers to an inventory tracking method and not the actual products received and sold.

Cost of Goods Sold (COGS)

The price to the company to acquire and transform a product, including the wholesale price, labor, and storage.

LIFO Reserve

The difference in cost of inventory as calculated by LIFO and FIFO. While the actual inventory is the same, using LIFO usually shows the inventory as having less value and is thus preferred for tax reporting.

5. Weighted Average Costs and Moving Average Costs

Effective inventory control necessitates a method for assigning costs to goods. Two common costing methods are weighted average cost (WAC) and moving average cost (MAC). WAC considers the total cost of all units available and the total number of units to arrive at a single average cost per unit. This cost is updated with each purchase, reflecting a blend of previous and current purchase prices. MAC, on the other hand, calculates an average cost after every purchase. This average incorporates the cost and quantity of the new purchase with the existing inventory data.

Weighted average cost is a method of calculating ending inventory cost. It takes the total cost of goods available for sale and divides it by the total amount of goods from the beginning inventory. This gives a weighted average cost per unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by the weighted average per unit to give an estimate of ending inventory cost.

EXAMPLE

A bicycle shop counts the total number of bikes in stock, then divides by the total value of inventory, to get a WAC of $500. Though their actual prices vary, this gives them a quick way to calculate the value of stock at the end of a busy weekend sale—they can count the remaining bicycles and multiply by 500.

Moving average cost is a similar method of calculating ending inventory cost. Assume that both beginning inventory and beginning inventory cost are known. From these, the manager can calculate the average cost per unit. As new goods are purchased, the purchase cost is added to the beginning inventory cost, and the number of goods is added to the beginning inventory. Also, during the year, multiple sales happen, and as they do, the cost and quantity of inventory are subtracted from the beginning inventory cost and numbers. This allows the inventory manager to more reliably give the value of inventory at any time.

EXAMPLE

The bicycle store owner described above will know the value of inventory at the beginning of the sale, and simply subtract 500 every time a cycle is sold; she may also need to add 500 if more units arrive or are returned. This would give her the ability to approximate the value of inventory at any time without careful auditing.

Both average cost systems presume that the value of goods have a relatively limited range and that sales are high enough for any variability between goods for the average to even out and give a reliable unit average; otherwise, more advanced methods are needed.

EXAMPLE

The methods described above would not work for the bicycle shop if they also counted sale of low-price items like locks and gloves; it may be sufficient if they use it only for the actual bicycles, and the bicycles have a limited range in price.

The choice between WAC and MAC depends on factors like inventory turnover and price fluctuations. WAC offers a more stable estimate of inventory value but might not reflect the latest price trends. Conversely, MAC provides a more dynamic estimate but can be more susceptible to short-term price variation.

terms to know

Weighted Average Cost

A method of calculating inventory cost by determining the average value of an item in inventory at a starting point, then periodically doing physical counts of items in inventory and multiplying by that average.

Moving Average Cost

A method of calculating inventory cost by determining the average value of an item in inventory, adding to that value as items are received, and subtracting that value as items are used or sold.

6. High Volume Methods

While many smaller companies, like the bike shop described above, will use physical counts and other hand-performed methods of tracking inventory, companies such as Amazon use sophisticated technology to track inventory. For example, besides the use of barcoding and RFID codes to track inventory, Amazon also uses:

• Warehouse Management Systems (WMS): These systems optimize warehouse operations, including receiving, storage, picking, packing, and shipping. They provide immediate insight into inventory levels and movements of goods.
• Robotic Automation: Robots work alongside warehouse workers to pick items, transport items, and fulfill customer orders. They are equipped with sensors to track what items are “picked” out of inventory for shipment.
• Inventory Management Software: These systems correspond with transportation management systems and many other integrations to track inventory.
• Real-Time Analytics: These technology tools monitor inventory performance, identify bottlenecks, and can provide insights into turnover, stockouts, too much inventory, and other metrics to make inventory management more efficient.