Let’s dive into one of the most complicated yet crucial aspects of ecommerce bookkeeping: inventory adjustments. As specialists in ecommerce accounting, we understand the intricacies involved and are here to guide you through this complex process.
What Is an Inventory Adjustment?
Inventory adjustments (sometimes referred to as inventory reconciliations or true-ups) are about ensuring that your ending balance sheet reflects the reality of your physical inventory. Your balance sheet reflects the facts of your business. You should be able to independently verify all figures on your balance sheet against some sort of truth, and that includes your inventory.
Why Are Inventory Adjustments So Hard?
The complexity of inventory adjustments stems from various factors. Ecommerce sellers often use different warehouses, like FBA and non-FBA, each with its unique reporting style and data inconsistencies. Or add to this the challenge of managing multiple sales channels with different costs of goods sold (COGS). It is also an easy place for miscommunication to happen between your operations team and accounting team. Clearly defining expenses and vendors related to landed COGS so everyone has an understanding of what expenses go directly on the P&L vs the balance sheet to be capitalized allows everyone to be talking “apples-to-apples.”
The Stakes of Getting Inventory Right (or Wrong)
Inventory adjustments are essential for validating your costing system. This is the only way to double-check that the assumptions you made in calculating sku-level landed cogs were accurate, or as close to accurate, as reasonably possible. Decisions made based on inaccurate inventory data can severely impact your cash flow, profitability, and even your business’ valuation. This is especially crucial for businesses preparing for market entry or in the midst of due diligence.
Failure to perform regular inventory adjustments can create a false financial narrative. You might appear profitable on paper while suffering from cash flow issues, causing you to wonder if you can trust your books and truly make business decisions based on the numbers. Or it could cause you to understate your profitability, causing unnecessary stress and anxiety, when you really could be using your books to help you decide to pay yourself a salary, distribute owner draws, hire a new teammate, or test a new product or sales channel. Tedious but necessary, inventory adjustments allow you to have confidence in your costing system, books, profitability, and margins, allowing you to make informed business decisions.
Tips for a Successful Inventory Adjustment
Be sure to conduct a physical inventory count on the last day of a month. Any counts done on a different day will be very difficult to sync with your ecommerce accountants and their data.
Understand your internal inventory management system and document it. Knowledge is power, and the more you comprehend your day-to-day operations, the better you can bridge the gap between your accounting system and operational realities. Be ready to speak to the process and help troubleshoot discrepancies.
Repeat this process quarterly, unless you are a large or complicated seller or if you are going to market in the next three months – in these instances, you will want to repeat the process monthly. And once you are in due diligence, be prepared to continue the monthly rhythm for potential investors.
Common Inventory Adjustment Challenges
While your adjustment will never be zero, you do want to aim for the adjustment to be within a certain margin of error. We recommend that all inventory adjustments over the course of a year be no more than 5% of your actual inventory balance. If it is more than 5%, here are some troubleshooting strategies, along with a free inventory troubleshooting guide:
Overstated Inventory on the Balance Sheet:
This happens when the physical count is lower than what’s recorded on the balance sheet. It could be due to:
Missing in-transit goods: Did you remember to include goods that are in-transit between warehouses or on the water from the supplier? Your accounting system might show that the cash has been paid for these goods, but if they aren’t included in the physical inventory count, there will be misalignment between these two figures.
Misclassification in the accounting system: Ensuring that only relevant expenses contribute to the inventory on the balance sheet is key.
Missing COGS: Does your P&L include all sales channels and their corresponding COGS?
Understated COGS: COGS could be understated due to estimation errors when calculating landed costs per unit.
Understated Inventory on the Balance Sheet:
When the balance sheet shows less inventory than what’s physically present, it may be due to:
Misclassification of expenses: For example, is an expense that is included in your landed cogs accidentally ending up directly expensed on the P&L? This results in double-counting an expense.
Accounts payable or complicated vendor terms: It is very common to have a portion of your inventory terms to include net-30 days, meaning you owe a remaining balance 30 days after receiving the inventory. If so, could be including physical inventory in your count that you have not completely paid for, which means your accounting team needs to capture the AP owed to the factory or supplier, thus increasing the inventory balance in the accounting system.
Double-counting COGS: Your books may have COGS double-counted, especially if you are not careful when integrating accounting software like A2X. Make sure your accountant has a clear understanding of how sales channels are fulfilled to ensure critical tools such as A2X are set up correctly. (PS – If you need help connecting A2X to your accounting software, let us know!)
Now What?
If you exhaust these troubleshooting techniques but still have a material difference between your accounting system and physical inventory account, go ahead and enter the adjustment in your books. Be sure to conduct another inventory count and reconciliation the following month. This will help you validate the first adjustment and check for trends. If the next adjustment swings in the opposite direction and effectively cancels out the first adjustment, you were probably just missing some data the first time around that is now captured. If you continue to see the same adjustment time over time, you probably have some noise in your landed cogs calculations.
Final Thoughts
Tackling inventory adjustments might seem daunting, but it’s essential for the financial health of your ecommerce business. Our firm offers free resources, like the troubleshooting tool above, and expert services to assist you in this intricate process. Our goal is to empower entrepreneurs like you with the right financial tools and knowledge to make a significant impact on your business and community. Remember, effective accounting can give you the insight you need to operate your business by the numbers.