What Most Distributors Get Wrong About Inventory Value

5 min read

Tags: Blog, Demand forecasting, Inventory management, Purchasing & replenishment, Technology

Daniel Fritsch   July 29 2015


Understanding Inventory Values

Index

  1. Effects of Inventory Value on Profit & Loss
  2. Total Cost of Ownership When Counting Inventory Value
  3. Most Common Considerations/Challenges Facing Distributors
  4. Methods of Managing and Valuing Inventory
  5. Technology is Needed to Drive Inventory Optimization

Inventory value, related to inventory management, is the monetary value of all purchased stock that remains unsold at the end of a given accounting period. For wholesale distribution businesses, there needs to be a well-managed reserve of stock in warehouse locations to ensure an uninterrupted supply of goods to buyers, however carrying too much inventory can also hurt performance as carrying costs can eat away at profits. Also, a lack of visibility between warehouse locations can result in diminishing return on investments over time.

For most wholesale distribution companies, profit margins are narrow by nature. Stock is bought straight from manufacturers and primary suppliers and then sold to final distributors at a slightly higher price that allows for a mark-up by the final buyer. This narrow margin is mitigated in wholesale distribution by the sheer volume of stock that is sold.

forklift moving fast through warehouse

While the distribution of durable goods is less risky than that for perishable items owed to reduced wastage and spoilage, effective inventory management is still essential to the profitable running of the business.

There are 3 commonly associated terms that should be considered when evaluating inventory value:

  1. Inventory Turnover is the number of times a distributor’s investment in inventory is recouped during an accounting period. Normally a high number of inventory turns indicates sales efficiency and typically leads to a lower risk of carrying high levels of excess stock.
  2. Inventory Usage is the value of the amount or number of units of an inventory item consumed during an accounting period.
  3. Inventory Variance is the numerical difference between the actual number volume of an inventory item and the balance shown in inventory records or the companies inventory management system.

 

For wholesale distributors, carrying inventory requires acute attention to detail. A company’s ability to accelerate inventory usage and inventory turnover is paramount to ensuring a strong return on investment as it relates to the bottom line.

accounting manager balancing inventory costs

Holding inventory in stock means a business has ownership of inventory and the associated costs of holding the inventory. It is very much in the interest of a company to keep inventory velocity as high as possible, for several reasons:

  • Tied up Working Capital: When a business owns inventory, this represents a significant investment of cash. If interest rates are high, this means the company is foregoing the investment of that cash in an investment that would have potentially generated a more significant return or limits the company’s flexibility to invest into other growth areas of the business. Keeping inventory levels lower will offset some risk associated with holding too much stock.
  • Inflated Holding costs: It is expensive to hold inventory. It requires warehouses, employees, storage racks, forklifts, insurance, fire suppression systems, security system technology, security guards, tracking systems, and list goes on. By reducing the amount of inventory on hand a company can effectively lower their holding costs resulting in a higher return on investment at the end of account periods. The balance is not sacrificing order fill rates or service levels by reducing inventory levels too much.
  • Risk of Obsolescence: In industries where products age quickly, inventory must be monitored closely to identify when products with fast inventory turnover transition to the end of life decline, also measured as obsolete inventory. Without continuous monitoring, many companies will continue to reorder the same quanities of stock even as demand begins to taper off. Products with declining demand need to be sold off quickly in order to reduce the risk of a sudden decline in the value of that inventory.

Effects of Inventory Value on Profit & Loss

When it comes to evaluating inventory value from the financial perspective, the amount of unsold stock will be included as an expense at the end of any given accounting period, but will not be included in the sales figures of the business at this time.

With the profitability of a wholesale business being the total sales minus the costs incurred in purchasing stock, it can clearly be seen that any capital tied up in stock will have a detrimental effect on profits, even to the point of the company having to write off inventory as a loss if the total cost of purchased stock exceeds the value of sales.

Total Cost of Ownership When Counting Inventory Value

The value of the inventory is calculated as the inventory carrying value. This differs from the purchase cost in that it factors in depreciation since the asset was acquired and other considerations such as damage to the item or reduced value owing to obsolescence. It should be noted that this net value is never a fair indication of the market value of the stock; rather it is used to build up an accurate picture of the running costs of the business.

Most Common Considerations/Challenges Facing Distributors

With narrow profit margins on the sale of every item in wholesale distribution, effectively managing stock levels is essential. While having an excess of stock can reduce profits, an interruption in stock supply owing to a lack of items can also lead to stock outs, which can cost a company the initial sale, customer loyalty and can result in a negative brand image over time.

frustrated business man

Other factors such as the carrying costs of the goods from each location in the supply chain also have an impact on profits. Carrying costs also include warehouse staff and driver’s wages, maintenance of warehouse equipment and buildings, insurance coverage, the running of the transport fleet and general overhead. In such a fast-paced business, effective stock monitoring is the decisive factor in ensuring profitability. 

Methods of Managing and Valuing Inventory

Inventory value methods include itemizing the value of stock at cost or market rate at the end of any given accounting period.

Usually the lowest value is applied to give an accurate picture of inventory value and the performance of the business, although average cost (AVCO) of stock may be used to give a quick overview. In the wholesale distribution of durable goods industry, the FIFO (first in, first out) or LIFO (last in, first out) methods can be applied to calculate stock levels against revenue.

With the FIFO inventory method, old purchase costs are measured against current revenue, which can help to manage the rotation of stock reducing losses, breakages, depreciation and obsolescence.

However; this method does not factor in the cost of replacing goods recently sold. A FIFO inventory can exaggerate profits compared to a LIFO inventory, which gives a real-time image of costs versus revenue. 

Technology is Needed to Drive Inventory Optimization

In reality, the FIFO Inventory needs to be taken into consideration alongside the LIFO inventory method to produce a weighted average of inventory value that gives both a short-term and long-term view of profits and stock levels.

This may seem daunting, but inventory optimization software like EazyStock can help to reduce capital tied up in stock whilst maintaining a smooth and balanced supply chain. Inventory optimization software can be used along side modern warehouse management systems (WMS), enterprise resource planning (ERP) tools and other storage solutions to quickly adapt to changes in stock levels and demand.

Technology for inventory optimization helps businesses remain flexible while reducing the staffing costs associated with such intensive monitoring of stock, helping to maximize profitability at a minimal cost or investment.

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