Inventories and Cost of Goods Sold (3)

Using the Periodic system
If you use a Periodic inventory system, you value your inventory only once a year - at the end of the year! So the job is fairly easy, and you should have little problem making the calculation. You apply a cost flow assumption once at the end of the year, and it pertains only to the physical merchandise still on hand at the end of the year.

It doesn't matter when sales take place, or when inventory is purchased. We ignore all that when we use the Periodic system. All we have to care about is what inventory is on hand at the end of the year.

Using the Perpetual System
If you use the Perpetual system you have to track each and every purchase and sale of inventory. Time is definitely of the essence. We will use a cost flow and apply it continuously, updating the Sales, Inventory and COGS accounts daily, as merchandise is purchased and sold.

This can be a daunting task, and usually is done by sophisticated and expensive computerized systems. When you go to a grocery or department store, notice that all the products have a bar code, which is scanned by an electronic cash register. All the merchandise is scanned into the the computer inventory records when it arrives at the store, and is scanned out as it is sold. The inventory records are continuously updated, along with the inventory value.

The type of system a company uses will depend on how much it can afford to spend. Obviously, not all companies can or need to spend $50,000 to $100,000 for each scanning cash register, plus the cost of the computer and software itself. Installing such a system can easily cost $1 million or more per store. That's a high price tag, so most companies use a Periodic system, and update their inventory only once a year.

Estimating Inventory
Let's say a company uses the Periodic system. In the middle of the year they go to the bank seeking a loan for expansion. The banker asks to see a set of financial statements. Taking a complete physical inventory can be a huge, time-consuming task. The company may simply not have time to drop everything and take a physical inventory at this time. Do they have any options?

In fact, they do. They can estimate the inventory on hand. They can reconstruct the inventory based on their purchase and sales records for the year to date. There are a couple of methods used to do this. They are both similar.

The Gross Profit method is one method. The store needs to know it's gross profit rate or cost ratio (the inverse of gross profit rate). They start with the beginning inventory balance, add purchases, and deduct for sales made using the cost ratio. The result is an estimate of the merchandise on hand.

This method is especially useful when there has been a loss due to theft, fire, flood and so forth. The Gross Profit or Retail methods can be used to substantiate an insurance claim for loss in these situations.

Inventory Turnover
Inventory turnover is not some sort of exotic pastry. It also does not mean we physically pick up our inventory and turn it over or upside down. Having dispensed with those misconceptions, just what is inventory turnover?

Each time you sell your entire inventory, you are said to have "turned" or "turned over" your inventory. We measure this as the number of times per year that this happens. We also measure it in a dollar amount, not by the actual physical objects. A store might have a year-old can of "Uncle Simon's Nasty Stuff That Only Your Aunt Ethel Will Eat". Not selling that can will have not effect on inventory turnover, in the larger sense of the word.

[Managers are definitely interested in micro-inventory management: looking at the sales pattern of individual items. Walmart has been an aggressive pioneer in this area. Right now we are dealing with macro-inventory management: looking at the dollar value of the entire inventory, taken as a whole.]

Earlier I discussed how a grocery store stocks milk. The buy enough for one week. There are 52 weeks in a year, so we would expect their inventory turnover, for milk, to be roughly 52. We usually calculate this using dollars, rather than tracking actual cartons of milk.

Number of Days in Inventory is the concept expressed in number of days. It tells us how many days, on average, inventory stays on a shelf before it is sold. Since there are 365 days in a year, we can divide 365 by the inventory turnover rate and get the number of days in inventory.

365 / 52 = 7 (rounded) or roughly 1 week

There are 52 weeks in the year, and the store wants to stock enough for 1 week at a time. Their weekly milk inventory is sold 52 times a year (turnover), or once every 7 days (days in inventory).

Let's look at a table and see some typical correlation's. Notice the inverse relationship between turnover rate and days in inventory. As one goes up, the other goes down.

Turnover Rate	Days in Inventory	Frequency
52	7	weekly
12	30.4	monthly
6	60.8	2 months
4	91.25	quarter (3 months)
2	182.5	half year
1	365	one year

What I'm hoping you'll get from this is a little common sense. Eggs would not have a turnover rate of 4. Perishable items will have a high turnover rate and low number of days in inventory.

Automobiles, diamond rings, and works of art would probably not have a turnover rate of 52. It can take much longer to sell these expensive items. They will have a low turnover rate, and a high number of days in inventory.

How Turnover relates to Gross Profit
Profits depend on several things. One of the most important is the relationship between turnover and gross profit. Higher turnover brings greater profit. Lets look at a simple example.

A store buys Item X for $20, and sells it for $30. The Gross Profit from each item is $10.

Annual Turnover Rate	Sales	COGS	GP
1	30	20	10
2	60	40	20
4	120	80	40

Guess what, we can just multiply the annual turnover rate and the GP per unit ($10). That would be an easier calculation!

Annual Turnover Rate	$GP x TO Rate	Total $GP
1	$10 x 1	$10
2	$10 x 2	$20
4	$10 x 4	$40
6	$10 x 6	$60
12	$10 x 12	$120
52	$10 x 52	$520

If you sell 1 unit per year, you will only make $10 per year.
If you sell 1 unit per week you make $520 per year.

Which is better?

(I sincerely hope you chose $520 per year. If not, please consult a physician. You may need professional help.)

Turnover is essential to profits. Higher turnover = higher profits.

Let's look at an example
Jim buys pocket knives from the manufacturers and resells them on e-bay. He buys by the case and pays $5 for each knife. At the both the start and end of the year he had 30 knives on hand (to make this example a little easier).

Jim bought and sold 800 knives during the year. He had 32 knives on hand at the start and end of the year, so his average inventory is 32 (32+32/2 = 32).

Cost Component	Units	$ Cost
COGS @ $5	800	$ 4,000
Avg Inventory @ $5	32	$ 160
Results
Turnover rate	$4000 / $160 =	25
Days in inventory	365 / 25 =	14.6

What this is telling us:
His average inventory was 32 knives last year.
He sells 32 knives every 25 days.
Each batch of 32 knives is in inventory 14.6 days.
If he sells 800 knives every year, that's about 800 / 365 = 2.19 knives per day.
This is consistent with our results. 32 knives / 14.6 days = 2.19 knives per day.
He sells about 2 x 32 = 64 knives each month (avg 66.6 knives per month).

Inventory Management - a delicate balance
By now you should be seeing the correlation between Gross Profit and sales. No matter what your gross profit is, making more sales will always mean making more GP. Since each and every unit of product you sell earns you a GP, you will always do better selling more, rather than less.

Inventory turnover is a measure of ow often your average inventory is sold. Since business managers have access to all the detailed operating information of their company, they can manage inventory on a product by product basis. They can effectively look at the turnover of a single product, and more accurately gauge their real average inventory held for that item.

There is one very important thing that all businesses have to deal with: carrying the right amount of inventory - not too much, not too little.

If you carry too little inventory you will lose sales, and that will reduce your GP.

If you carry too much inventory the surplus will tie up your cash flow. You will have to warehouse, protect and insure the excess inventory. And you run a high risk of spoilage, obsolescence, theft and damage.

A company will maximize its profits by carrying the correct amount of each item in its inventory. This amount is determined by careful analysis and tracking of customer's buying patters. Stores have to pay attention to the seasonal and cyclic buying trends their customers display. Effective inventory management requires both day-to-day attention, and ongoing analysis of customer preferences and buying habits.