Inventory management can present a lot of challenges for even the smallest businesses, but things can become exponentially more difficult when dealing with large amounts of inventory. Especially when those inventory levels are constantly shifting as new product comes in and stock on hand is sold.
In most companies, inventory is a large part of your assets. In some companies, it represents your largest asset. If you’re not tracking and managing it effectively, it can cost you money.
Today, we’ll take a look at how to effectively manage large inventories using three different methods. By the end of this article, you should not only have an understanding of the pros and cons of each approach, but enough information to begin figuring out which approach would be most beneficial for you and your business.
Ready to get started? Let’s go.
The three different methods for managing large inventories
Before we get to the nuts and bolts of how each of the inventory management systems work, let’s first go over the three methods that can help you take control of your stock and product levels.
Each approach has benefits and drawbacks, so there’s no “one size fits all” solution. However, understanding how each approach works, and its strengths and limitations, can help you choose the method with the most upside for your business.
Understanding FIFO, LIFO, and Average Cost
Now that we know what the three methods are, let’s talk more about what each method means.
1. First In, First Out (FIFO)
We’ll start with First In, First Out method.
So, what is FIFO?
Basically, in the First In First Out approach, we move inventory like this: The first items into to stock are also the first items we sell.
The upsides of this approach are numerous.
First off, we’re constantly rotating our inventory – nothing is sitting in a warehouse or stockroom indefinitely. If you run a business with perishable items or things that have to be rotated for expiration dates and the like, this is a very sensible approach. The oldest stock is always the first stock sold.
When we start to look at things from an accounting perspective, this approach also offers some value.
As prices of your stock are likely to fluctuate over time (material costs, inflation, and so on), this can help us find an advantageous way to track the cost of goods sold (COGS).
For example, assume your company makes 200 donuts on Monday at a cost of $1 per donut. Then on Tuesday it makes another 200 donuts, but the cost has gone up to $1.50 per donut. If we sell 200 donuts on Wednesday, we track those donuts’ COGS at the $1 amount – because we sold the first inventory in.
This allows business owners to manipulate their profit margins a bit. The more expensive donuts would be tracked at $1.50 on your ending inventory balance sheet.
Honestly, this is probably way more technical than we need to get for this article, but if you’re interested in accounting all of these methods will help you manage your financials in different ways. Don’t worry about it now – but be aware that it’s an extra facet in your decision.
The real benefit of the FIFO system is that you’re continually rotating out old stock when new stock comes in – so you have a fairly accurate assessment when it comes to actual inventory value.
2. Last In, First Out (LIFO)
Next up is Last In, First Out (LIFO).
As the name suggests, this is basically the opposite of the First In, First Out approach. Here, the newest inventory received is the first inventory sold. This means your older inventory is left over at the end of the accounting period.
So, you may be wondering what the advantage of this approach is – after all, you’re sitting on old inventory.
As mentioned in the previous entry, one of the big benefits here is from a tax and accounting perspective. Last In, First Out produces a higher cost of goods sold, and a lower dollar amount when it comes to leftover inventory. This can be a boon on your taxes.
3. Average Cost
At first glance, Average Cost appears to be a best of both worlds approach from the name. And in some cases, it can be – but as with everything else in this article, it ultimately comes down to your business, your inventory, and your specific needs.
As the name implies, Average Cost inventory methods use a weighted average method to determine the taxable value of all inventory on-hand. This means everything is essentially valued in the same way regardless of what you paid in costs or when you sold it.
The upside of the Average Cost Method is that it’s easy to use and implement. For small and mid-sized enterprises, this can be a huge selling point. If you’re still tracking inventory manually, this approach provides reasonable numbers without all of the work and complications of FIFO or LIFO.
However, choosing something solely for the sake of simplicity can be a dangerous approach. With a multitude of inventory management software on the market, the higher degree of difficulty between FIFO, and LIFO has all but been eliminated thanks to the magic of technology.
FIFO vs. LIFO
At this point, everyone basically says, “Okay, I get how Average Cost works, but which is the better option between LIFO and FIFO?”
And like so many things in life, the answer is….it depends.
The method used to assess inventory costs will affect profits, and as we’ve hinted at earlier, FIFO and LIFO affect profits and your taxes in different ways.
That being said, First In, First Out is generally viewed as the more trusted method for calculating the value of inventory and goods sold.
The reason for this is simplicity.
Simply put, FIFO follows the natural order of inventory many companies already use. The vast majority of businesses out there rotate inventory – old stock is sold before new stock, because to do otherwise increases the risk that the business will eventually get “stuck” with that old stock and never be able to sell it.
This approach means there are a lot less opportunities for errors in terms of bookkeeping and tracking.
Last In, First Out, on the other hand, is much easier to manipulate in somewhat nefarious ways if you were so inclined.
With LIFO, the cost to produce or obtain your newest inventory is generally going to be higher than the old inventory you may have been sitting on for quarters (or years). This makes profits look lower, which leads to less taxes, but it doesn’t provide a particularly accurate picture of the real value of your inventory. The value derived from FIFO is going to be much more accurate overall.
This is why most companies tend to go with First In, First Out when it comes to inventory management for accounting purposes.
When should you use weighted average cost?
While FIFO is basically an industry standard approach to tracking large quantities of inventory, there are times when Weighted Average Cost inventory can be the best solution.
For example, if you run a business where inventory is cycled in and out continuously, with a quick turnaround from adding inventory to sale, then this approach can actually be useful.
If you run a business where your inventory is commonly blended or very similar (think something like food service as an example), the Weighted Average Cost approach can eliminate the headache of trying to continually assign value to different units that are largely indistinguishable from one another.
Industries where weighted average cost is beneficial
As mentioned previously, choosing the right inventory system is largely dependent on the industry. Some industries are well-suited to using the Weighted Average Cost method. Here are some examples:
- Chemical Manufacturing
If you got the gist of the previous section, these industries should seem like pretty obvious choices to use the Weighted Average Cost approach. There’s a great deal of inventory turnover and sales, the inventory is largely indistinguishable from other things already in inventory, and so on.
In these circumstances, Weighted Average Cost is the best approach.
Industries where weighted average cost is not beneficial
On the flipside of that coin, there are also industries and businesses where Weighted Average Cost isn’t the best approach.
If your business is in the retail sector or even in manufacturing where you have long lapses between orders, then this method is less effective. If your stock batches are highly individualized, or there’s a big difference in cost between them, this can also present issues.
In these situations, you’re better off utilizing the First In, First Out or Last In, First Out methods to get more accurate results.
Managing large quantities of inventory can be challenging, particularly when it comes to taxes and financials.
However, the three options outlined in this article can help you not only manage your inventory, but make it easier to understand the value of all the products you’re carrying.
All three methods outlined in this article have pros and cons, which is why there’s no one clear-cut answer when it comes to choosing between them.
First In, First Out is arguably the best option for most businesses because it mimics how the majority of companies already handle their inventory and it provides an accurate valuation of said products.
Last In, First Out can provide financial benefits too, although there’s more room for errors and the potential to wind up sitting on inventory for years.
Weighted Average Cost is arguably the simplest method to use – and can be valuable if you work in certain industries – but it’s not quite as precise as FIFO in the long run.
As you can see, there isn’t a one-size fits all answer here. Each approach has its uses, but at the end of the day you have to make a judgment call based on your industry, your specific needs, and your goals.
The good news is that no matter which path you choose, there are software solutions available that will make managing large quantities of inventory much simpler.
Even better, there is an option available for businesses in any industry, of any size, and with any budget, so be sure to investigate those options before making a final decision. The right software can make managing your inventory a much less painful proposition – and companies will be happy to schedule demos to show you how they can help make your life easier.
No matter what path you take, utilizing the right inventory management approach can help you take your business to the next level.
Want to learn more about inventory management? Then be sure to subscribe to our blog so you don’t miss any of our posts.