What happened to my cash?
This is a common question that business owners ask themselves all the time. Say, for example, that you invest $30,000 in cash into your business. Three months later, your cash balance is down to $10,000.
If you’ve been generating a profit, the lower cash position may not make sense to you. After all, making a profit should increase your cash balance, right?
Well, not necessarily.
Two accounts that tie up cash
There are two accounts in your balance sheet that tie up your cash: accounts receivable and inventory. If your receivable balance is high, you need to collect money owed by customers faster. On the other hand, if you carry a large inventory balance, you may need to reduce the amount of inventory you carry.
This post discusses factors that impact the amount of inventory you carry, and the value of that inventory.
The matching principle requires a business to match revenue earned with expenses incurred to generate the revenue. Now, the matching principle also requires you to post inventory-related costs to inventory (an asset account), rather than simply expense them as incurred. Inventory-related costs are also called inventoriable costs.
Let’s assume that you own Lakeside Custom Furniture, and you manufacture wooden desks, chairs and tables. You receive shipments of wood from Canada each week, and the freight costs (called freight-in by accountants) can be expensive.
Those freight costs should be added to the cost of inventory, rather than immediately expensed. Think of putting those freight costs in the warehouse with the wood shipment. The costs remain with the wood, until the wood is used to produce furniture and sold to a customer. At that point, both the wood and the freight costs are reclassified to cost of goods sold.
Carefully review your spending, so that inventoriable costs are posted to the inventory account.
Another area of confusion is inventory valuations, or the method you use to attach a cost to a unit of inventory when it’s sold. I’ll explain the methods in a minute, but keep these three points in mind:
- Total units purchase and sold are the same, regardless of the valuation method
- Total inventory cost is the same, regardless of the valuation method
- Total cost of sales is the same, and the only difference is in the timing of the expense as inventory items are sold
If you remember these three points, you’ll be able to understand the differences between the inventory valuations methods.
Assume that you start with zero inventory, then purchase inventory on three different dates at these prices:
1st 5 units at $10/ unit = $50 cost
15th 10 units at $14/ unit = $140 cost
28th 6 units at $18/ unit = $108 cost
You purchased 21 units and spent $298. Eventually, you’ll sell all 21 units, and the entire $298 will be reclassified to cost of goods sold. To keep the example simple, assume no other purchases of inventory during the month.
Inventory value: first sale
Next, assume that you sell 8 units on the 30th. FIFO and LIFO will produce a different dollar amount of cost of sales for those 8 units:
- FIFO: FIFO assume that the oldest units are sold first. You sell 5 units at $10 ($50) and 3 units at $14 ($42). Total cost of sales is ($50 + $42 = $92).
- LIFO: LIFO assume that the newest units are sold first. You sell 6 units at $18 ($108) and 2 units at $14 ($28). Total cost of sales is ($108 + $28 = $136).
LIFO’s cost of sales ($136) is higher than FIFO ($92), because LIFO sells the newest (more expensive) units first. As more sales occur, however, LIFO will start to sell the older (less expensive) units.
In the end, once all of the units are sold, total cost of goods sold will be the same for both FIFO and LIFO.
Inventory may require a large cash investment, so it’s important to understand these concepts. Use these tips to properly handle your inventory accounting. If you understand these topics, you can move on to analyzing just how much inventory you need to meet customer needs.