In January 2020, Mark Belle knew he was going to have a challenging conversation with his boss. Mark was the general manager at one of the three locations of a food service provider that I had just begun to provide virtual CFO services. The company sold several retail products but also produced fresh, ready to eat food.
When I had initially met with ownership, their biggest challenge was calculating accurate margins. The owners explained they had never completed a inventory count because their POS system tracked inventory.
I have worked with many companies where completing a regular count of inventory is not reasonable. I tell all of my clients that there are alternative methods to help make sure inventory is accurate. However, even using these methods, I believe that an inventory count should be done at least yearly.
Back to Mark…. he had just completed his inventory count, and the result was not good. At his location, he had been given instructions to keep inventory levels around $35,000. Based on what his system was telling him, he had been doing good. Mark always kept a little more than needed on hand but had kept levels mostly steady.
When Mark started his count, his system showed a total balance of just over $37,000. However, after completing the count, the POS system showed only $27,500. He called and asked how the results would impact his store’s reports. I explained that from an accounting perspective, the results would decrease the gross margin by $9,500. Since Mark’s bonus was, in part, determined by gross margin, this was not welcome news.
Mark was bewildered. How could this happen? His store had only been open for ten months. He asked what the possible reasons for this difference were.
I assured him that this was somewhat expected (this doesn’t mean that it is OK). Whenever I start providing virtual CFO or bookkeeping services, there is generally some cleanup. Inventory is typically one of the accounts that get hit the hardest. The average US retail operation has an inventory accurate of only 63%.
I told him I would schedule a video call the following week to discuss why his inventory was off and a plan to make sure it didn’t happen again.
Why Actual Inventory can Differ from Reported Inventory
There is no shortage of reasons that actual and reported inventory differ. However, there are a few main culprits.
Theft – No one likes to think their employees are stealing from them. I am here to tell you that it is probably happening. In fact, 3 out of 4 employees admit to stealing from their employer at least once. Many times, theft is pretty innocent. It might be a candy bar here, a free ham sandwich there. But these add up. And over a long period, the theft amount can be substantial.
Waste – Another reason for the inventory differences is waste. While many businesses with inventory think that waste only applies to manufacturers, they are wrong. Every business has waste. In one study in Australia, they estimated there was $1.1 trillion in inventory waste annually. When Mark’s employees were making sandwiches, occasionally they would grab the wrong type of bun or use the wrong dressing. When that was thrown in the trash, it became waste.
Spoilage – Spoilage can be a big issue for many companies. Years ago, I ran an indoor kids play business. Occasionally we would need to throw out expired soda or syrups. Spoilage doesn’t just apply to food. It can also deal with obsolete inventory so as wiring that might not meet code anymore, and therefore needs to be thrown away.
Inventory Receipt Process – You might not realize this, but when vendors deliver inventory, they make mistakes too. Too many businesses take for granted that when a vendor says there are 10 items there, there are actually 10. Vendors most likely don’t mean to short you, but they make mistakes too.
OK, I get it….my inventory balances might be off, but why does it matter?
Having inaccurate inventory means that margins are not being reported correctly and cash flow is less than expected. In other words, if you don’t track inventory correctly, you are not as profitable as you could be.
Most businesses owners I provide virtual CFO services to benchmark their margins. For example, I work with several food manufacturers who sell multiple products and have an ideal gross margin for each.
Without tracking inventory accurately, there is no chance that gross margins will be correct. In these cases, 99% of the time, the actual margin is lower than the reported.
So far you might be thinking, “this is just a financial statement problem”. However, if a business owner believes they are meeting a target margin when they really aren’t, they will have profitability issues. How many owners would like to make an extra 3-5% each year?
Sooner or later, this will impact cash flow. It is nearly impossible to accurately project cash flow if there is constant pressure on margins due to inaccuracies. When you can’t project cash flow, it is hard to grow profitability.
In short, if your inventory balance is off, you are not making as much money as you could be.
How Can I Account for my Inventory More Accurately?
I mentioned earlier there a few methods to improve the accuracy of your inventory.
First, get the right system in place. Forty-three percent of small businesses in the United States don’t track inventory, or do so using a manual system. There are thousands of software systems out there to track inventory. These systems differ by complexity, industry, and process. Finding the right system for your business can be time consuming but worth it. The ideal system fits your business processes and isn’t overly complicated.
Even with the right system in place, it will require proper upkeep and procedures.
Inventory counts at some level are a must. There are typically two types of inventory counts. The first is a full inventory. This is what it sounds like; you count all inventory. This process can be time consuming and disruptive. However, for some businesses where is is practical, it might be the best method.
Another method of inventory counting is doing cycle counts. With cycle counts, you are completing an entire inventory count over a period. For instance, a business might count all inventory over 3 months. In this example, you would count just a few items each day. This is more realistic for some businesses because you typically don’t need to stop your manufacturing process or close your store.
The last tip to account for inventory more accurately is to use a purchase order process. Using a purchase order process allows you to make sure that you are accurately receiving all inventory that you order. It also ensures that you are not missing any invoices in the system for orders received.
Why does this all matter?
There are a laundry list of reasons for having accurate inventory matters. However, the most important one is that you can’t calculate your gross margin accurately if you don’t have an accurate inventory.
While some might look at gross margin as merely a number on a report, they are wrong. Most investors looking at businesses will look at gross margin first, not any other number. Even if you are looking for investment, tracking margin accurately is a must when making pricing and vendor purchase decisisons.
About Krieger Analytics
My name is Matt Krieger, and I am the founder of Krieger Analytics. We are a virtual CFO and bookkeeping services partner for small businesses and franchisors. Our goal is to completely outsource your accounting department from bookkeeping to victual CFO services. I am also the owner and franchisor of a concept called Monkey Bizness, in Denver, Colorado. I know what running a business entails.
As a small business owner with a background in finance and strategy, I realized the benefits that a virtual CFO could bring to smaller organizations. Most franchisors and small business owners don’t have a need (or budget) for a full-time CFO or bookkeeper. To better fit my clients, Krieger Analytics is a part-time resource. While most think of CFO’s being involved in finance and accounting (we are), we are also involved in much more. We partner with clients by coaching, giving them clarity into their business, and creating growth strategies. Conversations are free, so don’t hesitate to reach out to me at [email protected].