The Value of Inventory Management

By Edward L. Fixen

For all too many small businesses, one of the most commonly overlooked management tool that can truly improve cash flow, profitability and the value of a company is inventory management.  Small reductions in cost of goods sold and reduced levels of inventory can really produce some very significant and measurable returns in income and business value.  However, there needs to be effective inventory management practices and processes in place to realize these improvements and benefits.

Many small businesses do not accurately track inventory or have an inventory management process to keep a reliable accounting of inventory and miss the opportunity to improve profitability and the value of the company.  Some companies have the information in their accounting software or point-of-sale system but do not effectively utilize the information to analyze their cost of goods sold to help drive costs down and profitability up.

For manufacturing, wholesale and retail businesses, the cost of goods sold (COGS) is typically one of the largest, if not the largest expense at 50% to 80% of revenue with materials and product inventory being a significant component of this expense.  For wholesale and retail businesses, the cost of goods sold can be almost entirely driven by purchasing practices and inventory management.  However, the cost of goods sold reported on many small business financials or tax returns is just a plug-in number intended to reduce tax liability or only reflects the cost of inventory purchased during the year.  The actual beginning and ending inventory is unknown and not included in the calculated cost of goods sold.  In either case, opportunities to truly understand the actual cost of goods sold to be able to improve cash flow and profitability through effective inventory management are missed.

One of the valuable uses of inventory management is to be able to monitor purchasing trends up or down so that an owner can be aware and respond to negative trends pro-actively.  I recently sold an otherwise very nice retail business whose selling price was reduced almost 20% by the time it sold because management was not aware their cost of goods sold had increased by 5% over the past year until their end of year financials were prepared by their accountant.  They had a point-of-sale system with cost of goods sold information but did not use or monitor the information.  Unfortunately, every dollar of lost income cost them a little over two dollars in the final sale price.

Additionally, when it comes time to sell the business, the lack of good records for cost of goods sold will create uncertainty with respect to the real expenses and earnings of the business and likely reduce the price a buyer would be willing to pay due to uncertainty of earnings.  In many cases, buyers will not pursue an acquisition with inaccurate or misleading record keeping of cost of goods sold.  In my personal experience as a business broker, poor record keeping, particularly with regard to cost of goods sold will cost a selling owner 10% or more of the sale price.

I recently prepared a business valuation for a wholesale company with annuals sales of approximately $3.5 million and a reported inventory value of roughly $3 million.  It carried a high level of inventory because it sold very unique and hard to find products.  A valuation of the company showed the owner that both cash flow and the value of the company could be significantly improved by implementing some new inventory management practices and work towards reducing the inventory.  This would free up cash that was tied up in inventory and sitting in the warehouse and by improving cash flow, increase the value of the business when he was ready to sell.  By finding ways to decrease inventory by 10% or roughly $300,000 in the next year alone, the owner increased liquid working capital, improved profitability and the value of the business increased nearly $500,000.

Clearly, the effects of good inventory management have numerous positive effects that make it worth the effort and investment.  An effective inventory management plan and process will increase profitability, increase income and ultimately make your business more valuable.

Author: Mr. Fixen is a Certified Business Appraiser (CBA) and Certified Business Broker (CBB).  Mr. Fixen is the President of BusinessQuest, a business valuation and M&A brokerage firm serving small & mid size, privately-held businesses throughout California and can be found at BusinessQuestInc.com.