It’s time-consuming and expensive to keep track of your inventory. You know you need to optimize the process, but there are so many metrics to manage—you can’t even begin to think of ways to cut costs. And more importantly: you aren’t even sure if your current inventory tracking process is right for your business. How can you possibly manage it all? Don’t worry: there’s inventory management software out there that can help. But we’ll touch more on that later. First, we need to explore the context behind the solution. Let’s talk about inventory costing methods.
What Are Inventory Costing Methods?
1. First-Out First Sold
The first-out-first-sold (FIFO) method is a cost assumption that uses a company’s oldest purchases to calculate COGS and EI. This method is the most common inventory costing method and is preferred by the IRS: it results in higher profit and, consequently, more taxable income.
Let’s walk through an example: Let’s say a furniture company sells 150 units of a chair. Their current inventory consists of a total of 300 units purchased on three separate dates: March 3rd (100 units), April 15th (150 units), and May 25th (50 units). The chairs were purchased at $250 per unit ($25,000 total cost), $300 per unit ($45,000 total cost), and $400 ($20,000 total cost) per unit, respectively. Which of the following units and total costs should the company use to calculate their COGS and ending inventory after the sale? According to the FIFO method, the company would use the oldest chairs in its inventory. So the 150 units sold would come from the 100 units purchased on March 3rd and 50 of the units purchased on April 15th, resulting in a COGS of $40,0000 and an EI of 150 units.
2. Last-In First Sold
The last-in-first-sold method (LIFO) is the inverse of the FIFO method: the cost assumption uses a company’s newest purchases to calculate COGS and EI. LIFO is not recognized by the general accepted accounting principles (GAAP) and is typically more challenging for companies from both a legal and technical standpoint. One caveat here is that LIFO is useful when maximum profit is important: for instance, to pass the cost of inflation along the supply chain. Now let’s break down what LIFO looks like practically. To use the previous example:
This time the furniture company would pull from the most recently purchased units in their inventory (the purchase of 50 units at $400 on May 25th and 100 of the $300 units from the purchase on April 15th.). A sale of 150 units using the LIFO method would result in a COGS of $50,000 and an EI of 150 units. As you can see, the sale might be higher for LIFO, but the EI is lower to reflect the change in the purchase price.
3. Specific Identification
The specific identification method is not a cost assumption: it involves identifying the exact, originally purchased units in order to calculate COGS and EI from a sale. This method is very time-consuming—it works better for small inventories or companies that use serial numbers to identify exact dates and costs.
4. Weighted Average Cost
The Weighted Average Cost (WAC) is by far the easiest method to use and, as the name suggests, provides companies with an average COGS and EI in between FIFO and LIFO. Let’s refer back to our furniture example one last time:
In order to calculate the weighted average, we would simply add the total costs ($25,000 + $30,000 + $40,000 = $95,000), then the total units (100 + 150 + 50) and divide the total costs by the total units.
So: $95,000 / 300 = $316.67 average cost.
Now if we wanted to know our COGS, we would simply multiply $316.67 by units sold:
$316.66 x 150 units = $47,499.
Which is right in the middle of our FIFO and LIFO calculated COGS.
4 Proven Ways to Cut Down Your Inventory Ordering and Holding Costs
Now that you know how to monitor your inventory, let’s talk about how to cut your costs. There are two primary inventory risks: shortages and stockouts. Manufacturers and Retailers alike are often well aware of these risks, but they fail to keep a close eye on how much ordering and carrying inventory is cutting into their profits. Knowing how much your supply chain is costing you can reveal some big opportunities to improve the financial health of your business.
Here are four strategies that work for getting your logistics under control and growing your bottom line:
1. Eliminate Costly Data Errors
This one’s simple: don’t use excel spreadsheets. Like most data-entry programs, excel is manual and therefore susceptible to human error. Actually, over 90% of spreadsheets have data errors and they’re costly. Instead, use an inventory management system to organize your data.
2. Automate Your Ordering and Inventory Management Process
If you’re working with multiple sales channels, you need an automated inventory management system.
You’ll be able to:
- Manage your inventory in real-time
- Simplify workflows
- Save time and money
- Avoid manual data errors
Luckily, Megaventory is a very straightforward solution. Their powerful all-in-one management system can help facilitate just about any area of your business: inventory, order fulfillment, manufacturing tracking, data administration, and more. So take off the twenty different hats you’ve been wearing at work—Megaventory’s got it covered.
3. Optimize The Receiving Process
One of the most overlooked sources of spiraling costs is the loading dock. Loads that arrive simultaneously, day in and day out, usually result in three things:
- Long wait times
- Detention charges
- Inefficient use of resource
None of these are optimal for your company. So what’s the solution? Transforming your supplier and carrier relationships. How? Well, that’s the easy part:
There’s an easy-to-use platform that makes appointments at your facility (and holds them accountable for hitting those times!). And yes—it’s true that many carriers will probably continue to arrive hours off-schedule. But you have the upper hand now. You can show them data that supports how much faster trucks get unloaded when they arrive on time. This compelling information will prompt them to work with you for that win-win scenario.
4. Make Shorter Order Cycles Work for You
If you’ve already implemented the first three steps, you’re on the right track. Now you can order inventory that’s more frequent and in smaller quantities. Why? Because your costs of ordering and receiving are already relatively low. This also puts you in a good position to hold less inventory. Or, at least, to avoid having to invest in additional warehousing. Now you can avoid those additional costs as your business grows.
Here’s the thing: small inventories and short order cycles don’t work for every type of business. If you’re in an industry where:
- The value of products increases significantly overtime
- Holding inventory is an advantage
- You need a smaller tax bill
Consider switching to a LIFO accounting method for inventory costs. Keep in mind: not all business regulators support this. But if you’re in a position to use one, a LIFO method will make your profits on paper much closer to your real profits (which results in that smaller tax bill).
Start Reducing Your Inventory Costs Today
Inventory management is different for every business. But there’s one thing every business can benefit from reducing costs. The obvious reward is saving money, but it also unlocks many more options for controlling your cost of holding. So, remember: The key to success is a keen eye for tracking metrics, and using the right software. And if you’re looking for your own inventory management software, check out Megaventory today.
Nick Rakovsky is the Founder of DataDocks–a secure online platform that allows both your team and your customers the ability to book logistics appointments for your docks.