EBITDA and Other Scary Words: Scary Word No. 5 – Inventory
"This article originally appeared on Financial Poise and is reprinted here with permission."
Let’s go back to our recent article about accounts receivable. A guy walks into the bar and asks the bartender for a drink. The bartender gives him the drink and tells him how much he owes him and the guy says, “Put it on my tab.” This brought us to our previous scary word “Accounts Receivable.” This time we’ll look at the transaction from a different perspective: behind the bar.
Imagine you were the owner of your neighborhood bar. You hire a friendly bartender who knows how to make everyone’s favorite drink and pour their favorite beer. The bar has a lot of televisions and even makes some decent food. However, the largest current asset is the alcohol in the bottles behind the bar and on the shelves. The vast majority of the revenue and accounts receivable come from the sale of inventory (beer, wine, liquor, etc.).
As the owner of the bar, managing inventory will determine if the bar is profitable or will soon be going out of business. The goal is to find a balance between having too much inventory (you’re renting extra space just to store the inventory and now you have no cash for payroll) versus not having enough inventory and missing out on valuable sales.
The physical aspect of inventory is pretty simple. The bar either has the item on the shelf or it doesn’t. Calculating the value of the inventory behind the bar gets more complex.
As an example, you bought three cases of beer from three separate sources. You bought one case directly from the manufacturer at $0.75 per can. One case was an emergency fill-in that you stopped by and picked up at your local warehouse club, at a price of $0.85 per can. You got a great deal on the third case from the distributor because the product was only weeks away from its expiration date; you paid $0.60 per can. You opened the cases and put all 72 cans loosely in the cooler under the counter.
Over the next week, you sold two cases worth of beer (48 cans) and have one case (24 cans) left. What is the value of the remaining inventory?
The correct answer is “it depends.”
- If the inventory is valued on either the First In First Out (FIFO) or Last In First Out (LIFO) method, the value of your remaining inventory would depend on the order in which you purchased the three cases.
- If the inventory is valued using the Average Cost method, the value of the inventory would be $0.73 per can, assuming you bought all three cases before you sold any cans. If you bought some, sold some, bought some more, sold some more, etc., the value would need to have been recalculated after every purchase transaction and would depend on both the order in which your purchases were made and how many sales you had between each purchase.
- If you somehow marked each can as to which purchase lot it came from and used a specific cost method to value your inventory, the value of your remaining inventory would be the specific amount that you paid for each of the remaining cans.
- If the cans remaining in your inventory are the ones with the expired dating, you have to reduce the value of the inventory to reflect the impairment, because whatever method you use to value your inventory it is also subject to the lower of cost or net realizable value principal. If your bar is next to a college there’s a good chance you can still sell the expired beer at full price. On the other hand, if you are selling a premium IPA to a bunch of beer snobs, your expired inventory is probably worthless.
As you can see, the value of the cans remaining in inventory can be absolutely any number between $0.00 per can and $0.85 per can, depending on the order and timing of your transactions, market conditions, and the method you use to calculate inventory value.
There are three components to inventory that need to be reconciled on a periodic basis – the inventory dollars in your accounting system, the inventory units in your perpetual inventory system (the system you use to manage the physical units of inventory), and the actual physical units of inventory that you possess.
If you think all of this is complicated, take a moment to consider the manufacturer of the alcohol. A manufacturer’s inventory consists of raw material (water, sugar, yeast, etc.), work-in-process (WIP), and finished goods. The WIP and finished goods include the raw materials plus direct labor costs, and manufacturing overhead costs (supervision, supplies, utilities, equipment charges, facility charges, etc.).
When it comes to the evaluation of inventory, ratios are one good way to compare your business to other companies and to identify possible areas for improvement. The inventory turnover ratio and days sales in inventory are closely linked. When the inventory turnover is low, management does not have a good handle on the inventory. If you have one or two products in your inventory, you should have a good idea how much inventory you should have to cover your expected near-term sales. If Product A needs 10 days to have the raw materials show up at your company, and you need five days to produce a finished product, your inventory turnover should be close to 24 times a year for Product A. If Product A has a turnover of 12 times a year, you are ordering too much. You can reduce the days in inventory by buying less product or material. By understanding the days each product is in your warehouse, you can decrease the “cash gap“ (see our previous article “Scary Word No.3: Cash”) just by having the right amount of inventory to meet your customers’ needs as well as reducing the amount you owe to your vendors. The next time you go out for a drink, take a moment and think about all of the accounting transactions that are taking place just for your one drink. Or just have a good time and save the accounting for later.