Inventory Accounting and Management: How to Reduce Losses and Increase Profitability
Imagine that your business is profitable on paper and sales are stable, yet there is consistently not enough available cash in your bank account. Where is the money going? Often, the answer is sitting in your warehouse — tied up in inventory that locks away financial resources for long periods of time.
Effective inventory management is about finding the optimal balance that helps a business reduce unnecessary costs, prevent losses, and improve cash flow management. In this blog, we explain how to cut costs, release cash tied up in inventory, and manage financial resources more efficiently.
What Is Inventory and How Is Its Cost Determined?
Inventory is an asset that has been purchased or produced for sale, for use in providing services, or for direct consumption in business operations.
According to the financial reporting standard IAS 2, the cost of inventory consists of three main components:
Purchase costs: The purchase price, including import duties and non-refundable taxes, less discounts and rebates;
Conversion costs: Direct labor costs and production overheads;
Other relevant costs: Only those costs incurred in bringing inventory to its current location and condition.
It is important to understand that inventory cost does not automatically include abnormal waste, storage costs (unless they are necessary as part of the production process), administrative expenses, or selling costs.
Inventory must also be measured at the lower of cost and net realizable value (NRV). If market prices decline or inventory becomes obsolete or damaged, its value should be written down to NRV.
Inventory as “Frozen Cash” and Five Types of Problem Inventory
An increase in inventory means an increase in assets, but it also means that more of the company’s cash is tied up. The key question is: How long is your money locked in inventory?
To protect your cash flow, businesses should avoid five types of problematic inventory:
Excess inventory;
Stockouts: A lack of inventory can lead to lost sales, dissatisfied customers, reputational damage, and the risk of customers switching to competitors;
Slow-moving inventory;
Obsolete inventory;
Inventory that exists but cannot be located.
Remember: buying in large quantities at a significant discount is not always a good deal.
For example, suppose you purchase a product for GEL 8 instead of GEL 10 and save GEL 20,000. However, if you are left with 4,000 unsold units, GEL 32,000 remains tied up in your warehouse.
Analytics: Tools and Formulas for Effective Inventory Management
Accounting tells us “how much inventory we have,” while analytics tells us “how efficiently we are managing it.”
Several key indicators and formulas can help businesses manage inventory more effectively.
1. Inventory Turnover and Days Inventory Outstanding (DIO)
Inventory Turnover: Shows how many times a company sells and replaces its inventory during a year. The formula is:
Inventory Turnover = Cost of Goods Sold (COGS) ÷ Average Inventory
DIO (Days Inventory Outstanding): Shows the average number of days inventory remains in stock.
DIO = 360 ÷ Inventory Turnover
Generally, the lower the DIO, the more efficiently inventory is being managed.
2. EOQ (Economic Order Quantity)
EOQ answers the question:
How much should we order at one time to minimize ordering and holding costs?
Formula: EOQ = √(2DS/H)
Where:
D = annual demand
S = cost per order
H = annual holding cost per unit
Example: If you need 10,000 units per year (D = 10,000), the cost of placing one order is 450 (S = 450), and the annual holding cost per unit is 2 (H = 2), the formula suggests ordering approximately 2,121 units at a time to minimize costs.
3. ROP (Reorder Point)
While EOQ tells us “how much to order,” ROP answers another important question:
When should we place the next order?
Formula: ROP = (Daily Demand × Lead Time) + Safety Stock
Example: If you sell an average of 20 units per day, delivery takes 10 days, and you maintain a minimum safety stock of 50 units, the calculation is: 20 × 10 + 50 = 250 units
Once the inventory level reaches 250 units, a new order should be placed.
How ABC Control Helps
The quantities recorded in an accounting or inventory management system often do not match the actual physical inventory.
This may happen because incoming or outgoing inventory was not recorded, an incorrect weight or quantity was entered, or an internal inventory transfer was not properly reflected in the system.
One effective way to address this issue is the ABC approach:
A - High-priority products: Require frequent monitoring and control;
B - Medium-priority products: Require periodic monitoring;
C - Low-priority products: Less frequent monitoring is usually sufficient.
When discrepancies are identified, simply correcting the quantity is not enough. The most important question is: Why did the discrepancy occur?
If the root cause is not addressed, the same problem is likely to happen again.
A 30-Day Action Plan
To improve inventory management, businesses can start with a simple 30-day plan:
Week 1: Count actual inventory and identify problematic SKUs;
Week 2: Categorize products into A, B, and C groups based on their importance;
Week 3: Define target inventory levels and determine when each product should be reordered;
Week 4: Create a simple dashboard and assign clear responsibilities to relevant team members.
Conclusion
Inventory management becomes truly effective when three areas work together: accounting shows the result, analytics explains the reason, and management makes the decision.
The key takeaway is that good inventory management does not mean having an empty warehouse.
Your warehouse should not simply be full - it should be intelligently stocked.
And that comes down to three simple principles:
The right product • The right quantity • The right time
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