Inventory-based businesses require accurate and efficient accounting practices to ensure their success. Effective inventory management can help businesses optimize their operations, minimize waste and loss, and maximize profits. However, without proper accounting procedures, inventory-based businesses can struggle to track their inventory levels and financial performance accurately.
In this blog post, we will discuss 15 essential accounting terms that are critical for inventory-based businesses to understand and use. We will cover everything from the cost of goods sold to inventory valuation methods and provide practical tips for implementing effective inventory management practices.
Accounting Terms
Accounting terms are the language of business. They are the building blocks of financial statements and the key to understanding a company's financial health. Whether you are an entrepreneur starting a new business or a seasoned business owner looking to optimize your operations, understanding accounting terms is essential. These terms allow businesses to track revenue and expenses, manage inventory levels, and make informed decisions about their financial future.
1. Cost of Goods Sold (COGS)
Definition: The direct costs of producing the goods that a company sells, including the cost of materials, labor, and overhead.
Importance in inventory-based businesses: COGS is essential for calculating gross profit margin and determining the profitability of a business's sales.
Calculation: Beginning inventory + purchases - ending inventory = COGS
Example: A coffee shop sells 1,000 cups of coffee in a month, with a total cost of goods sold of $4,000. The COGS per cup of coffee is $4.00 ($4,000/1,000 cups).
2. Inventory Turnover
Definition: The number of times a company sells and replaces its inventory within a given period.
Importance in inventory-based businesses: Inventory turnover is an indicator of how efficiently a company is managing its inventory and generating sales.
Calculation: Cost of goods sold / average inventory value = inventory turnover
Example: A retailer has a cost of goods sold of $100,000 and an average inventory value of $20,000. The inventory turnover is 5 ($100,000/$20,000).
3. Gross Profit Margin
Definition: The percentage of sales revenue that remains after deducting the cost of goods sold.
Importance in inventory-based businesses: Gross profit margin indicates the profitability of a company's sales and helps identify areas where cost reductions may be necessary.
Calculation: (Revenue - cost of goods sold) / revenue = gross profit margin
Example: A clothing store has $500,000 in revenue and a cost of goods sold of $300,000. The gross profit margin is 40% (($500,000 - $300,000) / $500,000).
4. Days Sales of Inventory (DSI)
Definition: The number of days it takes for a company to sell its entire inventory.
Importance in inventory-based businesses: DSI is an indicator of how efficiently a company is managing its inventory and generating sales.
Calculation: (Average inventory value / cost of goods sold) x 365 = DSI
Example: A hardware store has an average inventory value of $50,000 and a cost of goods sold of $250,000. The DSI is 73 days (($50,000 / $250,000) x 365).
5. Average Cost Method
Definition: An inventory valuation method that calculates the average cost of all items in inventory.
Importance in inventory-based businesses: The average cost method provides a more accurate cost of goods sold for products with a consistent price.
Calculation: Total cost of goods available for sale / total units available for sale = average cost per unit
Example: A toy store has $20,000 in cost of goods available for sale and 5,000 units available for sale. The average cost per unit is $4 ($20,000 / 5,000 units).
6. Ending Inventory
Definition: The total value of inventory on hand at the end of a reporting period.
Importance in inventory-based businesses: Ending inventory is used to calculate the cost of goods sold and is a critical component of a company's financial statements.
Calculation: Beginning inventory + purchases - cost of goods sold = ending inventory
Example: A jewelry store has a beginning inventory of $10,000, $15,000 in purchases, and a cost of goods sold of $20,000. The ending inventory is $5,000 ($10,000 + $15,000 - $20,000).
7. Aging
Definition: A method of categorizing accounts receivable based on the length of time they have been outstanding. Typically, accounts receivable are categorized into 30-day, 60-day, and 90-day intervals.
Importance in inventory-based businesses: Aging helps businesses identify outstanding receivables that may be at risk of becoming bad debt. This information allows businesses to take action to collect these outstanding payments and avoid future losses.
Calculation: Create aging intervals and categorize accounts receivable accordingly.
Example: A supplier has $50,000 in accounts receivable, with $20,000 outstanding for 30 days, $15,000 outstanding for 60 days, and $15,000 outstanding for 90 days or more. By analyzing the aging of these receivables, the supplier can take action to collect these outstanding payments and avoid future losses.
8. Return On Investment (ROI)
Definition: A measure of the profitability of an investment relative to its cost.
Importance in inventory-based businesses: ROI is a key metric for determining the effectiveness of inventory investments and can help businesses make informed decisions about future investments.
Calculation: (Revenue - Cost of Investment) / Cost of Investment x 100%
Example: Let's say an ecommerce business spends $10,000 on a Facebook ad campaign to promote a new product line. The campaign results in $50,000 in sales directly attributed to the campaign. The ROI for this campaign can be calculated as follows:
ROI = (Revenue - Cost of Investment) / Cost of Investment x 100%
ROI = ($50,000 - $10,000) / $10,000 x 100%
ROI = 400%
This means that for every dollar invested in the campaign, the ecommerce business earned $4 in revenue. This is a very strong ROI and indicates that the campaign was highly effective in driving sales for the new product line.
9. Profit Per Unit
Definition: The amount of profit a company earns on each unit of a product sold.
Importance in inventory-based businesses: Profit per unit helps businesses determine the profitability of each product in their inventory and make informed decisions about pricing and inventory management.
Calculation: (Revenue per unit - cost per unit) = profit per unit
Example: A distributor sells a product for $50 with a cost of goods sold of $30. The profit per unit is $20 ($50 - $30).
10. Average Order Value
Definition: The average amount of money a customer spends per order.
Importance in inventory-based businesses: Average order value helps businesses determine the effectiveness of their sales strategy and can help identify opportunities for increasing revenue.
Calculation: Total revenue / number of orders = average order value
Example: An e-commerce retailer generates $100,000 in revenue from 1,000 orders. The average order value is $100 ($100,000 / 1,000).
11. Safety Stock
Definition: Extra inventory held to guard against unexpected demand or delays in supply.
Importance in inventory-based businesses: Safety stock helps businesses avoid stockouts and reduce the risk of lost sales.
Calculation: Determine the appropriate level of safety stock based on historical sales data and lead times.
Example: A hardware store has an average weekly sales volume of 100 units of a particular item with a lead time of two weeks. To guard against unexpected demand, the store holds two weeks' worth of safety stock, or 200 units.
12. Economic Order Quantity (EOQ)
Definition: The optimal order quantity that minimizes the total cost of ordering and holding inventory.
Importance in inventory-based businesses: EOQ helps businesses optimize their inventory ordering process and reduce costs.
Calculation: Sqrt(2AS / H) where A = annual usage, S = setup cost, and H = holding cost per unit.
Example: A distributor has annual usage of 10,000 units, a setup cost of $50 per order, and a holding cost of $1 per unit. The EOQ is 200 units (Sqrt(2 x 10,000 x $50 / $1)).
13. Reorder Point
Definition: The point at which inventory levels are low enough to trigger a reorder of stock.
Importance in inventory-based businesses: Reorder point helps businesses avoid stockouts and reduce the risk of lost sales.
Calculation: (Average daily usage x lead time) + safety stock = reorder point
Example: A restaurant uses 100 cans of tomato sauce per week with a lead time of 2 weeks. The safety stock is 50 cans. The reorder point is 250 cans ((100 cans/day x 14 days) + 50 cans).
14. Lead Time
Definition: The time it takes for an order to be fulfilled, from the point of ordering to the point of delivery.
Importance in inventory-based businesses: Lead time is a critical factor in determining reorder points and safety stock levels.
Calculation: Determine the average lead time based on historical data.
Example: A clothing store typically receives inventory shipments 7 days after placing an order. The lead time for inventory is 7 days.
15. Carrying Cost
Definition: The cost of holding inventory, including storage, insurance, and depreciation.
Importance in inventory-based businesses: Carrying cost is a critical factor in determining the optimal level of inventory to hold and helps businesses optimize their inventory management process.
Calculation: (Inventory value x carrying cost percentage) / 365 = daily carrying cost
Example: A distributor has $100,000 in inventory value and a carrying cost percentage of 20%. The daily carrying cost is $54.79 (($100,000 x 0.20) / 365).
Track Metrics With Inventory Management Software
One of the most critical aspects of running an inventory-based business is tracking metrics. Without accurate metrics, it is challenging to make informed decisions about inventory management, pricing, and other critical business operations. This is where an inventory management system like Inventoryy can be extremely helpful.
Inventoryy is a cloud-based inventory management software that helps businesses track their inventory in real-time, automate their inventory workflows, and generate valuable metrics and reports. With Inventoryy, businesses can gain valuable insights into their inventory operations, make informed decisions about inventory management, and optimize their supply chain processes. Here are some key metrics that can be tracked with Inventoryy:
Inventory turnover: Inventory turnover is a critical metric that measures how efficiently a business is managing its inventory. With Inventoryy, businesses can easily track inventory turnover and identify areas where they can improve.
Days sales of inventory (DSI): DSI is another key metric that measures how many days it takes for a business to sell its entire inventory. With Inventoryy, businesses can track DSI and take action to reduce the amount of time it takes to sell their inventory.
Cost of goods sold (COGS): COGS is the direct cost of producing the goods that a business sells. With Inventoryy, businesses can easily calculate COGS and gain insight into their gross profit margin.
Reorder point: Reorder point is the point at which inventory levels are low enough to trigger a reorder of stock. With Inventoryy, businesses can track their reorder point and avoid stockouts and lost sales.
Safety stock: Safety stock is extra inventory held to guard against unexpected demand or delays in supply. With Inventoryy, businesses can track their safety stock levels and ensure they have enough inventory to meet demand.
By tracking these metrics with Inventoryy, businesses can gain valuable insights into their inventory operations and make informed decisions about inventory management. With real-time inventory tracking, automated workflows, and advanced reporting and analytics, Inventoryy is an essential tool for any inventory-based business looking to improve their inventory management process.
Conclusion
From cost of goods sold to carrying costs, understanding these terms is critical for making informed decisions about inventory management, pricing, and other critical business operations. By tracking these metrics and using inventory management software like Inventoryy, businesses can optimize their inventory management process, reduce costs, and increase profitability.
It's important to recognize that accounting principles are not just theoretical concepts but practical tools that can help businesses make informed decisions. By taking the time to learn and apply these principles in your day-to-day operations, you can gain a competitive edge and position your business for long-term success.
We encourage you to continue learning and applying accounting principles in your business operations. By doing so, you'll be able to make better decisions, manage your inventory more effectively, and ultimately achieve your business goals. Remember, accounting terms are the language of business, and mastering them is essential for success.
