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The Basics of Inventory Control and Why You Should Care

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Clients often tell us that they want the inventory on their balance sheet to match the reality of their business. This question came up recently during a tax planning session and it quickly turned into a discussion on how to get started managing inventory. The client found the discussion to be very valuable so I thought I would make that the topic of this month’s article.

Accurate inventory control can be labor intensive and therefore expensive. Inventory control is not technically difficult but it requires written procedures, consistency, and discipline.

Inventory control is a worthy pursuit though. If you sell parts, materials, and equipment, and you don’t have accurate inventory control, you don’t have accurate job costing. You also don’t have accurate financial statements. Here’s why. If your balance sheet indicates that the value of your inventory is $250,000, but an actual count indicates that it is only worth $150,000, then your job costing and financial reports are incorrect by the $100,000 difference. You have understated your income by $150,000. The difference doesn’t usually show up all at once; it happens over time.

The first step to inventory tracking is to limit who has access to your inventory. You may need to build a locked parts room. If you have the space, this is ideal. Employees would have to receive the items across a counter like they would from one of your suppliers. When people can take whatever they want, when they want it, inventory counts will quickly be wrong.

You will need to decide what inventory items will be tracked. Generally speaking, if it has a serial number and/or is worth more than $10, you should classify it as an inventory item and track it. Anything that is important for the completion of a job, even if not very valuable, should probably be tracked as well.

Create truck stock lists for each vehicle. When doing so, consider the size of vehicle, the skill set of the technician, and the type of work they do. Your goal is to stock a truck adequately enough that your techs will not have to make special trips to restock. You should mark items as winter, summer, and year-round. Change out items when the seasons change.

Each truck should be assigned an individualized truck stock list. Empty each truck and replenish it with just the items on that list.

Run an item sales report by vehicle each day or two and pull those items for restock. When your technician comes to the office for regularly scheduled reasons, such as a service meeting, they will leave with their restock items. One important key to this is keeping your technicians out of supply houses. That improves productivity.

Service technicians and installers should be required to write down everything that they used for each job. Mobile software with bar code scanning makes this process easier. If you are not there yet, try using removable item number stickers. Peal the sticker and place it on the back of the invoice or work order. Reapply this same sticker to a reorder sheet. Finally, use the same sticker yet again. Stick it to the items that you have reordered. That will help crosscheck that everything has been reordered and received.

For installers, consider creating item kits. You might have a furnace kit, heat pump kit, air handler kit, RTU kit, and others. You will place commonly used items in containers. Those containers will be given to the installer(s) and returned once the work is complete. The person who restocks the kits will be able to easily determine what items were used. That information will flow into your job costing system.

Another highly effective inventory management technique is the use of trailers for new construction and other installations. Trailers can be stocked on a job-by-job basis with equipment, materials, duct, and parts. When installers arrive, they will be told what trailer to hitch up. When the job is complete, the trailer is returned, cleaned out, and refitted for the next job.

One last important inventory process needed is to install and maintain a very strong purchase order system. Nothing should be ordered without a purchase order. There is too much on that topic to cover here. In a future article, we will explore that topic in detail.

Finally, we are often asked if contractors need to track inventory and maintain an inventory balance on their balance sheet. The answer depends on if you file your federal (and state) taxes on the “Accrual” or “Cash” basis. So, the question is really which method are you required to use? We recommend that you speak to your tax advisor. The answer is not always clear-cut and can have a significant impact on your tax burden. Here is the most important point, even if you file your taxes under the Cash method, you can and should maintain your books and manage your business under the Accrual method. Do not print your financial reports, under the Cash method, for management purposes. Do not use Cash method information to analyze and plan your business. Your tax expert can easily file under the Cash basis using accrual reports.

Under Accrual, you recognize revenue and expenses when you incur them. Under Cash, you only recognize revenue when you actually receive the money, not when you do the work. Under Cash, you only recognize expenses when the money clears your bank account, not when you actually incurred the expense. For these reasons, Cash basis accounting is a horrible and dangerous way to manage your business.