Adjusting Your Inventory Accounts in SIMMS

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Using the periodic system of accounting for inventory, your inventory account’s balance remains unchanged throughout the accounting period and must be updated after a physical count determines the value of inventory at the end of the accounting period. The inventory account’s balance may be updated with adjusting entries or as part of the closing entry process. When adjusting entries are used, two separate entries are made.

First, an adjusting entry debits inventory and credits income summary for the value of inventory at the end of the accounting period:

Income Summary Account (January 31)
Credit $35,000.00 to Ending Inventory

Inventory Account (January 31)
Debit $35,000.00 to Ending Inventory

General Journal (January 31)
both entries as above

Second, an adjusting entry clears the inventory account’s beginning balance by debiting income summary and crediting inventory for an amount equal to the beginning inventory balance, e.g.:

Income Summary Account (February 1)
Debit $30,000.00 to Beginning Inventory

Inventory Account (February 1)
Credit $30,000.00 to Beginning Inventory

General Journal (February 1)
both entries as above

Combined, these two adjusting entries update the inventory account’s balance and, until closing entries are made, leave income summary with a balance that reflects the increase or decrease in inventory.

For a system that combines ease of use with accuracy of accounting, SIMMS Inventory Management software provides you with all the tools. Visit www.simmssoftware.com or email sales@kcsi.ca today to find out more of how SIMMS can be your accounting and inventory solution.

Figuring Your Ending Inventory

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Here’s a question that came up recently that may make the understanding of the importance of your cost of goods sold clearer.

If net sales are $90,000.00 and the gross profit was 40%, with the Beginning Inventory at $5,000.00 and net purchases were $51,000.00. Calculate, using the gross profit method, the Ending Inventory and the Cost of Goods Sold.

The formula to be used is as follows:

Beginning Inventory + Purchases – Ending Inventory = Costs of Goods Sold

The Beginning Inventory was $5,000 and purchases were $51,000. The COGS is simply 60% of $100,000 in revenues = $54,000 (we know this because the gross profit margin is stated to be 40%). Using the COGS that we now know, the following is true:

5,000 (Beginning Inventory)
+ 51,000 (purchases)
–      ??? (Ending Inventory)
= 54,000 (cost of goods sold)

Therefore, your Ending Inventory is $2,000.

Having $56,000 in cost of goods available for sale, and $54,000 of them were sold, your ending inventory can only have been $2,000.

For software that helps you keep on top of your profit margin and can handle your accounting accuracy with ease, visit www.simmssoftware.com or email sales@kcsi.ca today.

 

Inventory and P.O. Financing

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Inventory and purchase order financing can help supply your company with additional working capital (flow of cash) for your company to grow. This type of financing must be secured only once the costs and methods have been assessed to be beneficial for your firm.

Your inventory and purchase order financing cycles are dependent upon your company, its customers, your suppliers, and the financing company, which all become inter-dependent on each other to affect the appropriate purchase order factoring for the benefit of them all. Customers, most importantly, must be worthy of your credit terms as well as being committed to honoring your payment terms.

The assignment of your rights in the purchase order to a specialized inventory and p.o. financing firm guarantees that your supplier is paid for the goods you need to fulfill orders and contracts. A financing fee of no less than 3% is standard, and can be negotiated as the system is established.

Regardless of the costs associated with any inventory and purchase order financing, your business can develop significantly because of the access to an increased amount of capital that may not have been otherwise available. Also, purchase order and inventory finance is not debt on your balance sheet, you are simply monetizing inventory and purchase orders in an effort to raise your liquid capital.

An experienced business financing advisor can provide the information you will require to allow you to take advantage of your opportunities for growth. Their opinion regarding the information you need to apply for and complete the financing you need, any ongoing financial concerns as well as about the organization and scope of the facility you will require.

Accounting Policy Choices

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Accounting choices can most often be separated into two categories: a discretionary accrual and a set accounting policy. Examples of the first category  include the timing and amounts of extraordinary items such as write-offs and provisions for credit losses, inventory values, reorganization and so forth, wherein a manager is able to tell when and how much of expense and revenue to classify on the present income statement. The second category, accounting policies, are more formal and firm in the sense that they stipulate clearly when and how much revenue and expense to classify in a certain period. Examples of these include revenue recognition and amortization policies.

Earnings management is the manager’s choice of accounting policies that achieve some particular goal. Owners and managers keep some flexibility in their accounting policy selection that may be able to positively impact the market value of their firm or their own satisfaction.

Accruals will increase reported net income, which ultimately increase a manager’s bonus. Oppositely, companies with bonus compensations will report net income either below the break-even point above a cap that had negative average accruals.

It is every company’s choice as to what approach to accounting system they employ — it matters most which one presents the most complete and accurate results for your type of business.

Theory Behind the ABC (Pareto) Inventory Analysis

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A Pareto Analysis (also called the 80/20 rule or ABC analysis) is one method of classifying activities, events or items according to their relative importance. It is often used in stock management where it is used to group stock items into classifications based on the total annual expenditure for, or total stockholding cost of, each item. Companies can concentrate a more detailed attention on high value/important items. The Pareto Analysis is employed to decide upon the priorities of each classification.

Vilfredo Pareto, an Italian economist, wrote in 1907 the Pareto Law, which states that about 80 percent of Italy’s wealth was in fact held by about 20 percent of its population. This 80/20 rule is as true for inventory as it is for mostly every concept relating to value. In terms of stock value and sales value, 80 percent of the sales will be represented by 20 percent of the items in stock. Hence, an analysis of stock was derived based upon this law and the analysis is known as an ABC Analysis of Inventory.

Stock is first categorized into the three groups, A, B and C, which encourages a more efficient management of these categories of products. Type A are high rotation items that represent the most popular items, while Type B represent the next most active items. Type C items are, lastly, the slowest movers. In terms of percentages based on ABC Analysis: A items will represent about 12% of the total inventory and roughly 75% of the sales; B items will represent 25% of the total inventory; C items will represent the last 63%. It remains as a matter of strategy that a critically focused control on all your A-type items is vital, since these will account for a large majority of sales and are thus a very manageable percentage.

Higher cycle counts should be performed on these items since they account for the most movement. Other strategies such as holding lower quantities and placing more frequent orders can also reduce not only the amount of capital invested in inventory, but also can reduce the amount of risk involved in holding the asset. It should be noted that this should be done only if you have a very clear customer service level number analyzed. A slipshod execution of a high rotation strategy will likely lead to bad service levels and thus will negatively impact the business.

While the ABC Analysis remains only one method that can be employed by companies, its timeless reflection of the boldest practices within an existing sales process.

Calculating Inventory On-Hand

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Days of inventory on hand tells the average amount of time a company will hold inventory before the inventory is sold. A high days of inventory on hand ratio shows the company is not moving inventory fast. This could be a sign of low demand for the product. A low days of inventory on hand could lead to the company running out of inventory. If the company runs out of inventory, its profits will most likely decrease.

1) First, determine the cost of goods sold and the average inventory. Cost of goods sold is on the company's income statement and the average inventory is on the company's balance sheet. For example, a company has $500,000 for cost of goods sold. At the beginning of the year, the company had $300,000 of inventory and at the end of the year, the company has $350,000 of inventory. The average inventory is then $325,000.

2) Next, divide the cost of goods sold by the average inventory. In the example, $500,000 divided by $325,000 equals 1.538461538.

3) Next, divide 365 by the number calculated in Step 2. In the example, 365 divided by 1.538461538 equals 237.25 days.

Since inventory carrying costs require significant investment, a business must try to reduce the level of inventory. Lower level of inventory will result in lower days’ inventory on hand ratio. Therefore lower values of this ratio are generally favorable and higher values are unfavorable.

However, inventory must be kept at safe level so that no sales are lost due to stock-outs. Thus low value of days of inventory ratio of a company which finds it difficult to satisfy demand is not favorable.

Days’ sales in inventory varies significantly between different industries. For example, business which sell perishable goods such as fruits and vegetables have very low values of days’ sales in inventory whereas companies selling non-perishable goods like automobiles have high values of days of inventory.

Carrying Costs of Inventory

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The Inventory Carrying Cost is the cost a business pays to carry inventory, essentially measuring the overhead that it carries to support its inventory. In addition to the money originally spent to purchase it, more money will be spent on upkeep while inventory sits in your possession. The longer the inventory is there, the more it will cost in upkeep. The carrying cost is usually expressed as a percentage that representing the pennies per dollar that will be spent on inventory overhead each year.

Costs can be either classed as either fixed or variable. Fixed cost factors do not change directly as the dollar level of inventory changes; they can change, and often do when organizations make significant changes to their inventory levels, but the change occurs as a step function when certain inventory levels are reached. Variable cost factors change with the dollar level of the inventory in a direct manner.

Fixed cost factors include the cost of capital equipment, personnel and space.
– The cost of space is the overhead cost to operate a facility and is often stated on a per-square-foot basis. If an organization operates a warehouse, there is significant cost involved in the establishment and maintenance of that facility. It would not be there if the inventory were not there. A small change in the level of inventory will not cause any change in this fixed cost. However, if the change is large enough that significant square feet are vacated, the cost would change as the empty space is reallocated to another use or vacated. Whether the cost changes or not, it is a part of the overhead required to support the inventory and should be included as an element of carrying cost.
– Capital equipment indicates the money invested in support systems, from small investments such as fork lift trucks, scales, racks, etc. to investments as large as automated material handling systems. As long as the capital investment still has value on the books, that value should be included as an element of carrying cost. To determine the factor in percent, divide the total capital investment dollars by the average total inventory dollars.
– Personnel includes those people whose job description is primarily the management and handling of inventory such as inventory managers, stock-keepers, material handlers, cycle counters, inventory controllers, etc. The level of staffing varies with the level of inventory, but not in a direct ratio. As significant changes to the level of inventory occur, changes to the level of staff required to support it can be made.

Variable cost factors include the cost of money, insurance, obsolescence reserve, and taxes.
– The cost of money is the interest rate your organization pays for borrowed money, or if you have no business loans, the interest rate that the money invested in inventory could be earning if it were invested elsewhere.
– Insurance covers the replacement value of the inventory in the event of a catastrophic loss such as fire or natural disaster. Insurance premiums can vary with the value of the assets. Organizations that are self-insured do not pay premiums, but they typically have a financial reserve established to cover any loss. The value of that reserve should be considered in the same manner as obsolescence reserve.
– Obsolescence reserve is a financial reserve set aside to cover any forecasted inventory losses such as write-offs or shrinkage.
– Some political jurisdictions tax inventory; if that is true for any inventory storage points, then that tax is calculated as part of the carrying cost.

All of these factors are established and defined within finance. A financial analyst can provide the numbers for an organization. Since these factors can differ significantly from organization to organization, each organization should use its own numbers and not take a carrying cost number from another source and believe that it applies to them.

Additional factors might apply to some organizations depending on the inventory that is being stored. These include secondary quality costs and computation costs. Secondary quality costs measure the cost of re-inspection (this does not include the cost of original inspection upon arrival). Inventory that is fragile or easily damaged, has revision levels that change frequently or has a short shelf-life may require a significant level of re-inspection before use to insure that the goods are still useable. If that is true for your inventory, then the cost of secondary inspection should be included as a carrying cost factor since it is created as a result of long storage.

Computation cost applies to organizations for which the hardware and software costs involved with inventory tracking systems are significant. Inventory is the largest and most active data base in many organizations. If the cost of the inventory tracking system is large, not a part of the overall operating software or a recent investment, then it should be considered as an overhead expense carried by the inventory.

Most organizations use the variable factors to calculate the carrying cost of inventory. Two reasons for this are: (1) they vary in direct proportion to the dollars of inventory and (2) their values already exist in finance and require no new calculations. However, ignoring fixed factors results in a falsely low carrying cost and can result in sub-optimal management decisions.

Companies that do not look at the true cost of inventory’s overhead are at risk for increased inventory levels and decisions that increase their fixed investment. A low carrying cost of inventory sends a message to people within the organization that inventory is cheap which makes it an easy solution for other problems.

Remember: the more important it is to reduce inventory, the higher your carrying cost should be. If inventory is cheap, you will have a lot of it.

The Inventory Exceptions Report

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An Exception Report is a type of summary report that identifies any events that are outside the scope of what is considered a normal range. Reports of this kind are employed in a number of settings, including the process of stock reconciliation, project management investigation, and even employee assessments. The goal of the report is to identify any factors that are not considered to be within acceptable parameters, making it possible to take actions that help to minimize or eliminate exceptions and increase overall efficiency.

As it relates to inventory reconciliation, an Exception Report is often essential to the task of identifying differences between a physical inventory and the inventory that is presented in inventory databases. Over time, errors can occur in almost any type of inventory, making it necessary to make adjustments that reflect the actual amount of goods on hand. Doing so not only makes it easier to adjust ordering of new items so that an adequate amount of supplies are kept on hand, but also makes it possible to keep the inventory accurate for the assessing of taxes.

In addition to helping to reconcile different types of inventories, an Exception Report can also be helpful in the task of project management. In this scenario, the report spotlights pending tasks that are still outstanding, even if the projected completion date for that task has passed. By noting the exception, it is possible to revamp the schedule of tasks for the project to compensate for the discrepancy and get the project back on track.

Even in the area of employee assessments, Exception Reports can be helpful. Here, the idea is to identify any events related to the employee that fall outside the scope of the basic expectations associated with the job position. The exceptions may relate to performance failures or to performance that goes above and beyond the usual job position. For example, the detail of the exception report may indicate the employee needs further training in certain areas, or identify situations in which the employee was able to take on extra duties while a coworker was ill, effectively aiding the business operation to continue with little to no change in productivity. Depending on the nature of the issues documented on the Exception Report, the employee may be recommended for remedial training, or be presented with a commendation for providing additional services to an employer while still managing his or her assigned duties effectively.

The Need for Inventory Analysts

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An inventory analyst, also called an inventory control analyst, is usually employed by a company to develop and implement all best practices, policies, procedures, systems and with regard to inventory, for the purpose of maintaining accurate financial information. Following a thorough analysis of a company’s current inventory policies, he or she identifies any deficiencies and inefficiencies, making correctional recommendations. Once those recommendations have been approved by management, he or she oversees their implementation.

An inventory analyst partners with his employer’s accounts payable department to ensure that all transactions are accounted for. He or she resolves any discrepancies in a timely manner. Monitoring all inventory levels, he recommends any necessary changes to management. In concert with the operations department, he or she monitors the accuracy of all inventory levels, resolving any errors as required. Developing and implementing an inventory management system, he or she sees that product movement flows seamlessly. Additionally, he or she maintains inventory control records, reporting them to management on a regular basis.