Do Business Well

Income statement. You’ll want to produce one every month. Your business can be in big trouble for a long time and you won’t even know it without an income statement. We have fully detailed the income statement in section 2, part 6.

Inventory. This is the value of all merchandise that you carry for resale. It does not include office furniture, production equipment, or other items that aren’t being offered for sale. As mentioned above, there are some very sophisticated aspects to placing a value on that inventory.

In addition to the question of how much direct and indirect overhead to include in the value, there are other issues such as LIFO and FIFO. FIFO means first in, first out. If you use the FIFO method you make the assumption that the inventory of items you continuously purchase that are now in your warehouse are those you have most recently purchased. If you use LIFO (last in, first out), you assume that your current inventory is made up of items purchased earlier, and that the items you have recently purchased are sold.

In an inflationary environment the use of FIFO would result in a higher valuation for your inventory. Good for the balance sheet; bad for income tax. LIFO would have the opposite effect.

These and other questions have profit and tax ramifications, and should be discussed in detail with your accountant. All that aside, in evaluating your inventory for the purpose of determining whether you are profitable, you must be consistent. If you change the method of valuation from period to period, you will not have any idea what your profit is.

You may find it costly in terms of time and energy to take a physical inventory each month, but it’s usually worth it. You should almost certainly set up a perpetual inventory (in which each sale or receipt of product is recorded and changes your inventory balance immediately). You will achieve excellent advantages from doing one or the other. Your month-end inventory report might look likethis.

Item	On Hand	Value	Purchases	Sales	Average YTD
B52	522	570.55	80	120	110
XKE	6	9.00	30	50	30
711	140	280.00	65	70	60
R2D2	50	500.00	0	2	10

The last column, average YTD, means the average monthly sales you have experienced so far this year. There are many other meaningful averages you may like to look at such as average last twelve months or last four months. The first would give you long-term experience with the product. The other might show a trend.

As you look at the information above, the first thing that sticks out is that you are over inventoried in R2D2’s, especially considering how much they cost. The second thing is almost as obvious. You should probably be buying way more XKE’s. Your B52’s are a little heavy, maybe a sale is in order, but your sales of this item are good, so you don’t want to give them away. Product 711 shows an almost perfect example of purchases and inventory in relation to sales.

Gross-profit-margin method of determining profit and loss. You probably won’t want to take an inventory every month. You may not even find the time to take a proper inventory every quarter. However, you’ll still want to have a P & L prepared monthly. You can do this by establishing a normal gross margin for your business. It may take three or four actual inventories to begin to get a handle on this normal amount. Each time you take an inventory, you’ll arrive at a gross margin percentage. Soon you’ll be able to determine an average for your operation. If you show 45 percent for one period, 52 percent for another, and 46 percent for another, you can just add and divide by 3.

With this number you can now determine the dollar amount of your cost of sales and your gross profit without taking an inventory. However, it is easy to become deluded when using this method, especially if you don’t take an actual—the term is “physical“— inventory for a long time. Maybe you have had to discount more heavily during the period you are using the gross-margin method than you did when you took an actual inventory. Over time, youmay begin to add overhead, because, according to your P & L you _are quite profitable. Then you take an actual inventory only to find out you’ve been losing money all along.

Another way to avoid this problem is to maintain a perpetual inventory. This means that either by using a computer or a manual method you account for every item sold or bought during the period. In this case you would know the value of your “book” inventory without actually counting it. The reason we refer to this inventory as a book inventory is to differentiate it from a physical inventory. You see, you could still be way off base. Through bookkeeping errors, short shipments by your suppliers, invoicing errors, overshipments by your staff, or outright theft, your actual inventory may be substantially different from your book inventory.

In order of preference you will want to use physical inventory, perpetual inventory, and, only as a last resort, gross-profit method.

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