Inventory is often only seen as the products and supplies on warehouse shelves, but it’s also generally one of the largest assets on a manufacturer’s balance sheet. When managed well, inventory supports steady production, healthy cash flow, and profitable growth. When it’s not, cash can become tied up in excess stock, storage costs can climb, and shortages can lead to delayed orders and lost sales. That is why manufacturing inventory management decisions can have a ripple effect across profitability, cash flow, financial reporting, lending relationships, and the company’s ability to grow.
Why Inventory Matters Financially
Inventory encompasses raw materials, work in progress (WIP), and finished goods. It’s viewed as a current asset on the balance sheet because it’s expected to be sold or used within a short period to free up cash. It’s also a major component of working capital, or current assets minus current liabilities. Positive working capital shows a business can comfortably cover its short-term obligations.
Inventory can also provide insight into future revenue because it represents products that are available to sell. Meanwhile, inaccurate inventory negatively affects financial statements as errors will trickle down to other areas. It plays a direct role in a company's profitability because it affects the Cost of Goods Sold (COGS) metric, which in turn affects gross profit and profit margins. When inventory is recorded correctly, the business gets a more accurate picture of how much it costs to produce or purchase the goods it sells.
Even small inventory errors can distort gross margins and profitability trends. A company may appear to be trending more or less profitable when, in reality, the change is the result of inaccurate inventory records rather than actual business performance.
That's why buyers, lenders, investors, and other stakeholders pay close attention to inventory and margin trends. Consistent and accurate inventory reporting helps them evaluate a company's financial health, profitability, and ability to generate future cash flow with greater confidence.
Inventory Costing Methods
There are several inventory costing methods manufacturers use. It’s essential to consistently use one of these methods. If you need to change the method, you need to do so with full disclosure and a clear business reason. Three commonly used methods are:
First In, First Out (FIFO)
This method assumes that the first goods purchased, or the oldest inventory, are the first to be sold. FIFO is common when the goods are perishable because it cuts down on spoilage. This method results in higher taxes because the cost of goods is lower. With this method, COGS is calculated by taking the cost of the first goods and multiplying by the number of goods sold.
Last In, First Out (LIFO)
LIFO assumes that the last goods purchased, or newest inventory, are the first to be sold. This method leads to lower taxes because the cost of goods is generally higher. COGS is calculated by taking the cost of the last goods in and multiplying by the number of goods sold. If your costs increase over time, this method gives you a tax advantage. By listing your most recent and higher costs first, you maximize your cost of goods sold, which in turn lowers your taxable income.
Weighted Average Cost (WAC)
The WAC method averages the cost of units for each inventory item, giving each item its own blended average cost per unit. For example, Item A and Item B would each have a different weighted average cost based on their respective costs and quantities. The average cost for each item is calculated by dividing the total cost of that item available for sale by the total units available for sale. That average cost is then used to calculate COGS for the units sold.
How Inventory Impacts Cash Flow
Having excess inventory ties up cash. By having products sitting on shelves, you incur higher storage and carrying costs such as rent and insurance.
Also, depending on your industry, there’s a risk that products could become obsolete. Examples include perishable items, technology, and some clothing products. Having excessive inventory that has no chance of selling ties up capital that you could be using to buy in-demand goods or investing in your growth. Dealing with obsolete inventory also ties up your team’s time by having to manage it, leading to decreased efficiency.
On the other hand, insufficient inventory can create lost revenue. Stockouts, or out-of-stock items, also can be harmful to your cash flow by affecting sales and potentially adding costs. They can also drive customers to purchase a product elsewhere. When materials are unavailable, production may slow down or stop entirely, which can delay orders, increase costs, and make it harder to meet customer expectations.
Inventory Turnover as a Key Performance Indicator (KPI)
The inventory turnover ratio measures how many times you sell and replace your inventory in a period, showing how efficiently you manage your inventory. It’s calculated by taking the COGS and dividing by the average inventory. The average inventory is your beginning inventory plus the ending inventory and then divided by two.
A higher ratio generally signals that you are selling the inventory quickly and it isn’t sitting for long periods on your shelves. You don’t want it to be too high, though, because that means you could constantly face stockouts. A lower ratio may show that you are overstocking or selling items more slowly.
The goal is to regularly monitor this KPI and find the right balance in your inventory turnover rate. Knowing this helps you order the right amount of inventory for your business, cut your storage costs, and boost your profits. The ideal amount will depend on your product type, industry, and business model.
Common Inventory Accounting Challenges
Manufacturers often struggle with inventory and stock management challenges that affect their bottom line. Four common problems are:
- Inaccurate counts: Inventory accuracy is crucial for financial reporting. It compares the actual inventory with the recorded level of inventory. Correct counts lead to better decision making and make your financial data more trustworthy. Inaccuracy leads to higher storage and warehousing costs and inefficiencies in ordering inventory.
- Poor system reconciliation: Your financial reporting may be off if your inventory and accounting systems are disconnected. Information may not transfer accurately or on time, creating differences between inventory records and the general ledger that require manual reconciliation. This can lead to incorrect inventory values, COGS, and profit.
- Obsolete inventory: Inventory that can no longer be sold or used may need to be written down or written off. If it remains recorded at its original value, inventory and profit may be overstated, making the financial statements less accurate.
- WIP tracking issues: Inaccurate work-in-progress tracking can misstate current assets on the balance sheet. Because completion percentages can be difficult to estimate, companies may also underreport unfinished work.
Strong internal controls can help address these challenges. Regular physical counts, including cycle counts, improve inventory accuracy and financial reporting. An integrated financial technology stack reduces reconciliation issues, while documented processes support consistent tracking and help prevent errors.
Inventory's Effect on Business Valuation and Lending
Inventory management for manufacturing becomes especially important when you apply for financing, bring in investors, or prepare to sell the business. Lenders and buyers look at the inventory balance on your financial statements, but they also want to understand whether the inventory is accurately counted, properly valued, in demand, and likely to be converted into cash.
Banks may consider inventory as collateral when issuing a line of credit, but not every item carries the same value. Slow-moving, obsolete, highly specialized, or perishable inventory may be harder to sell, so a lender may discount its value or exclude it from the borrowing base. Accurate counts, detailed inventory-aging reports, reliable financial statements, and consistent controls can give lenders greater confidence in the collateral and the business’s ability to repay its debt obligations.
Buyers and investors, including private equity firms, will also review your inventory costing method, inventory age, turnover, gross margin trends, and the controls used to track quantities and costs.
During negotiations, the parties may adjust the purchase price or working capital target for excess, obsolete, damaged, or incorrectly valued inventory. Significant differences can delay due diligence, reduce buyer confidence, or even put the transaction at risk.
How Technology Supports Better Manufacturing Inventory Management
When your inventory and financial systems work together, it is easier to see what you have on-hand, what it costs, and how inventory decisions affect the business. Reliable, connected data can reduce manual work, support faster decisions, and help prevent inventory issues from creating surprises in your financial results.
An enterprise resource planning (ERP) system can connect inventory, production, purchasing, accounting, and other parts of your operation in one place. This gives your team a more up-to-date view of inventory levels and costs while automating reports that may otherwise require time-consuming manual updates.
It is also important to regularly review your finance technology and confirm that information flows accurately between systems. With clearer data, you can forecast demand more effectively, time purchases more strategically, identify slow-moving inventory sooner, and produce more reliable financial reports.
Best Practices for Inventory Management
Inventory management for manufacturers directly affects profitability, cash flow, financial reporting accuracy, borrowing capacity, and company value. While the specific requirements for inventory management vary, putting the following best practices in place can produce better results:
- Establish inventory controls
- Reconcile inventory regularly
- Monitor inventory turnover
- Track inventory aging
- Review costing methods periodically
- Align inventory management with financial reporting
Manufacturers that actively monitor and manage inventory are better positioned to improve performance, make informed choices, and support long-term growth. Work with our advisors to evaluate your existing inventory management processes, find ways to improve your outcomes, and determine your best path forward.
This content is for general informational purposes only and does not constitute tax, legal, or professional advice. Readers should consult their tax advisor regarding their specific situation before making any tax-related decisions.