Using Inventory Cost Management to Improve Profitability

A manufacturing worker is assessing inventory cost management from the floor.

Using Inventory Cost Management to Improve Profitability

A manufacturing worker is assessing inventory cost management from the floor.

For manufacturers, inventory cost management plays an integral role in successfully maintaining a business strategy that fosters financial growth. When you have an effective overall inventory management system in place, you can capture appropriate costs, including overhead, so you can implement pricing and sales strategies that will increase your company’s profitability. 

Balancing Inventory & Sales

Like cash, inventory is an asset on your balance sheet. However, unlike cash, inventory can become a liability in terms of liquidity. If you have too much inventory, you have less flexibility to purchase and house new or improved products, adapt to changes in market demand, stay ahead of your competitors, and increase your profits. If you do not maintain enough inventory, it can lead to poor customer satisfaction, customer losses, and lower profits. So it’s vital for manufacturers to carefully balance what’s on hand with what’s going to sell. 

Collecting Inventory Data 

To leverage the most from your inventory cost management procedures, you need to be able to collect data not only on your current stock and inventory costs, but also on market demand and your supply chain. Understanding these insights can help you make better business decisions and strategic plans. 

Analyzing data on your current stock can help you prevent the accumulation of carrying costs associated with obsolescence and manage your storage and handling costs related to housing and moving your inventory. Understanding the details about what’s on hand can also help you prevent fraud and theft. Analyzing data on your sales helps you align your inventory with market demand and ensure your ability to meet your customers’ needs with timely delivery of goods and services without overextending on cost. 

If you perform periodic assessments of your vendors, you can glean insights that help you stay ahead of supply chain issues, place timely orders, and avoid shortages. And, in conjunction with data on inventory costs, all of this information helps you track performance, forecast future costs, and produce accurate revenue projections. 

Analyzing Inventory Data  

Margin Analysis helps manufacturers determine the margin of each product by compiling all product-associated costs and subtracting them from the product’s revenue. By comparing actual material, labor, and overhead costs incurred to budgeted costs, manufacturers can use variance analysis to uncover the cause behind any discrepancies.

ABC Analysis helps manufacturers manage shortages, reduce excess, and prioritize items that significantly impact inventory cost. To perform this analysis, first multiply the annual number sold by the cost per unit for each product to determine the annual usage value. Next, calculate the cumulative percentage of products sold and the percentage of annual consumption value. Based on this data, inventory can be categorized as follows:

  • Category “A” is the smallest category, consisting of your highest valued products that account for the most revenue generation (around 80%)
  • Category “B” is the middle of the road, consisting of products of moderate value that generate moderate revenues (around 15%). 
  • Category “C” consists of your largest products by volume that add the least in total revenue (around 5%).

Every manufacturing company is different. If you have more than one location, your  inventory needs can differ from location to location. You may need to perform your analysis by location or further disaggregate. The main principle behind ABC Analysis is the 80/20 rule (80% percent of your output is determined by 20% of your input). By prioritizing products in the “A” group, you can focus your efforts on the smallest number of products in order to receive the biggest return. ABC Analysis helps you keep the right products on hand to meet demand, manage costs, and eliminate excess inventory. 

Integrating Inventory Into Your Accounting & Tax Strategy 

ARB’s Manufacturing Advisory Services Team specializes in the industry, so we’re here to help you understand your options and leverage opportunities to improve your operations, avoid risks, and increase profitability. ARB helps manufacturers develop strategic plans that take every aspect of their financial, regulatory, and operational needs into account, including inventory cost management. If you’d like to talk about your manufacturing company’s accounting, tax, and advisory needs, contact us today!

by Gisèle Couturier, CPA 

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Gisèle Couturier is a manager at ARB. She specializes in providing audit, accounting, compliance, and advisory services and primarily works with manufacturing companies, nonprofit organizations, credit unions, construction companies, and employee benefit plans.

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