This is part of a series of reflections inspired by my courses at HBX, an online business school cohort powered by Harvard Business School. With Business Analytics, Economics for Managers, and Financial Accounting, I'm learning the fundamentals of business. Find the whole series here.
It's 3AM. Do you know where your inventory is?
When you're dealing with any business, you have to know what's going in and what's going out. Its success depends on making sure the value coming in is greater than the cost of selling the goods going out. For most things, that's easy to determine. Cash changes hands, you get a bill in the mail, or receive a receipt of payment. These are called explicit transactions in accounting.
Life isn't so easy. Enter implicit transactions. They're fuzzy. (You're saying: Accounting!? Fuzzy? Since when!?) Judgement is key. Implicit transactions involve longer periods of time with no set "trigger," or transaction, that determines whether or not you should put something in the books.
Inventory deals with implicit transactions in the way companies organize their business. Without core knowledge of how that business is run, an accountant might not choose the method that makes sense for recording what goes on in the warehouse.
Periodic vs. Perpetual
Companies have two options to record inventory: periodic or perpetual. If you've ever worked in retail hell, you know the perils of periodic inventory. The story shuts down for two days after the Christmas rush to figure out how much of everything is left in the store. It's best for small businesses and is pretty old school.
Perpetual, on the other hand, records inventory stocks in real time. Think about the giant robotic machinery behind your magical Amazon purchase. Could you imagine Amazon shutting down for several days to count everything in every warehouse around the globe? Exactly. They always know where everything is at all times. Because technology.
In and Out
On top of that, there's two ways companies can organize their inventory: through FIFO (first-in-first-out) or LIFO (last-in-first-out). This is especially relevant with real time markets. The oranges you're buying for your grocery store change price based on the season, environmental conditions, and shipping costs.
Imagine one month you receive 2,000 lbs of oranges at $1.00/lb, but the next month you receive 3,000 lbs of oranges at $2.00/lb. When you sell 1,000 lbs of oranges at the end of the second month, FIFO or LIFO determines how much cash you have:
- If you're following FIFO, you would record that 1,000 lbs sold using the original price ($1.00/lb.) That puts you at $1,000 for the month.
- If you're following LIFO, you would record that 1,000 lbs sold using the new price ($2.00/lb), which puts you at $2,000 for the month. Big difference.
To be clear, as you recorded pounds of oranges, you would record this way until you tapped out one price, and would then record at the other. To finish our example, for FIFO, that means you would record up to 2,000 lbs first at the first price, and then finish your inventory sales with the second price. The opposite goes for LIFO. The final balance is still the same, but the short term financial statement looks very different.
All this changes the data you're dealing with: how fast you're transferring inventory, at what cost, and what your cash flows look like. Once you know what's important, you have to know how you're classifying it, analyzing it, and making sure it ends up in the right place: the hands of the customer.