Achieving Smoother Operations: The Key to Ecommerce Inventory Management

If you read The Power of Purchase Orders, you know the importance of operationalizing purchase orders in your business. If you manage purchase orders effectively, ecommerce inventory management gets much more straightforward, and inventory management is the next milestone for effective financial planning.

In this technical walkthrough, you’ll learn why and how to operationalize inventory adjustments from an accounting perspective and the level of effort it requires in terms of systems and people.

Use this article to run a realistic diagnostic of your current inventory management practices with your team. If you don’t like their answers, call us.

Table of Contents

• What is Ecommerce Inventory Management?
• The Value of Ecommerce Inventory Management
• Diagnose Your Current Inventory Management Process
• Choose the Strategy That’s Right For You
• Master Ecommerce Inventory Management

What is Ecommerce Inventory Management?

Ecommerce inventory management is simple to understand but can be complicated to implement.

As a simple definition, it tracks the location, quantities, pricing, and inventory mix available in your business. The ecommerce aspect considers the necessities of an online retailer that may need to track inventory for multiple online sales channels.

Source: Big Commerce

The Value of Ecommerce Inventory Management 

When you don’t accurately translate what’s happening in your business into your financial system, it could cost your business considerably. By implementing an ecommerce inventory management system, you’re more equipped to streamline your operations and make smarter decisions faster.

Here are some of the most significant changes you’ll see with a healthy ecommerce inventory management process:

• Avoid wild swings in your inventory and COGS values throughout the year
• Know how much inventory you have at any given time
• Understand your actual COGS 
• Accurately budget and forecast cash flow
• Pass an audit (yay!)

Follow our diagnostic below to evaluate your current inventory management practices so that you understand your supply chain and when to create inventory variances.

Diagnose Your Current Inventory Management Process

The first step is to ask yourself two questions to assess the level of complexity you need from your finance and accounting team and your tech stack:

1. Who needs to perform the task? 
2. How can you automate?

We’ll pretend you are our client and walk through the same questions we would ask during onboarding to tailor the right accounting strategy for inventory in your financials. 

Usually, these questions lead to you changing some of your processes for the better. We’re not operations consultants, but change is inevitable when you’re upgrading your financials.

Choose the Strategy That’s Right For You

Of course, responses to the above questions generate more questions, but these 13 are typically the most important at this stage.

With those in mind, we choose to deploy one of these three strategies depending on the answers to the diagnostic and materiality (we’ll get to that next):

• A2X Method
• Quickbooks Online (QBO) Inventory Method
• Custom Method

Materiality, or the 80/20 Principle 

Products get scraped, lost, damaged, and given away. Accounting for each minor instance doesn’t help you make better decisions and will drive you insane.

Enter materiality. Materiality is a fancy term for the 80/20 principle. The technical accounting as defined by FASB is:

“The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”

Materiality isn’t exclusive to inventory. We apply this concept in almost every part of the financials. But, it’s particularly important when accounting for inventory because the aforementioned minor instances DO matter at some point.

Practically, there is no set threshold, but standard “rule of thumb” materiality thresholds are 5% of net income,1% of total assets, and 1% of total revenue.

Here are some examples from the real world.

Another critical point about materiality is that it’s not “set it and forget it.”  As the business changes, so does the materiality threshold. And we’re constantly asking ourselves these questions each month to provide our clients with the appropriate level of granularity.

Okay, let’s get into the strategies you might deploy for your inventory management. 

A2X Method

A2X is an excellent piece of accounting software we use with many of our clients. There’s some configuration and setup, but the tool removes much of the old ways of manual reconciliation.

Who uses this method and why?

Profile of client:

• Less complex operations
• >100 SKUs or <10 SKUs
• Low volatility in supplier cost
• No operations team

Key Steps

1. Get an inventory count for each SKU from the client
2. Multiply the quantity of each SKU by the last cost in A2X
3. Compare the value in QuickBooks to the value extrapolated from the client’s inventory count
4. If our inventory value is higher, debit COGS and credit inventory
5. If the client’s inventory value is higher, debit inventory and credit COGS

Pros

• Easier overall process
• Doesn’t require an operations team in place
• Doesn’t require purchase order management

Cons

• Not GAAP compliant
• More challenging to investigate variances
• QBO cannot serve as a source of truth for on-hand quantities

Requirements

• Provide Ecom CFO team updates to COGS
• Provide Ecom CFO team with periodic inventory counts (ideally monthly)

The overview of the A2X COGS process is as follows:

1. Each SKU is assigned a unit cost. These costs are not tied directly to an invoice or PO. 
2. Instead, the costs are assigned manually by uploading a spreadsheet to A2X. 
3. The costs from this spreadsheet are then used to calculate the COGS for each settlement/payout. 

A2X does this by seeing how many of each SKU is sold in each payout and then multiplying that number by the unit cost that has been uploaded. Although this is a simple and partially automated way to account for COGS, there are some drawbacks to using this method.

First, the cost for a unit is not tied to an invoice or purchase order because it’s assigned manually once a month, which is not as accurate. With the A2X process, it’s typical to update the unit costs monthly, which means all units of a given SKU for that month will have the exact cost. 

The A2X method also ignores that units sold in a month may have different costs. The greater the fluctuation of costs during a month and through the year, the greater this problem will be. The other issue with this method is that it does not conform to the three GAAP-approved costing methods:

• First in First Out (FIFO)
• Last in First Out (LIFO)
• Weighted Average Cost (WAC). 

Although A2X does not conform to these methods, a periodic inventory count – ideally monthly – can mitigate the difference between the A2X calculation and using a GAAP-approved method.

QBO Inventory Method

The QBO Inventory Method is a comprehensive, GAAP-compliant method for managing inventory and COGS. Although more labor intensive, it provides better visibility and granularity than the A2X method.

Who uses this method and why?

Profile of client:

• More complex operations
• <100 SKUs
• Operations team in place managing key processes

Key Steps

1. Get an inventory count for each SKU from the client
2. Compare the numbers on hand in QBO with the clients’ inventory on hand
3. Make an inventory quantity adjustment to match the clients’ quantity on hand

Pros

• GAAP compliant
• More accurate than A2X method
• Allows QBO to serve as a source of truth for monthly on-hand quantities
• Easier to investigate variances

Cons

• High level of effort

Requirements

• Operations team in place managing key processes
• The operations and accounting teams must be in sync
• Accounting must have a deep understanding of the client’s operations
• Must be managing purchase orders in QBO

The overview of the QBO Inventory Method is as follows: 

1. Start by creating a purchase order
2. On the purchase order, enter the quantity and price for each SKU being purchased
3. When the items on the purchase order are received and invoiced, the invoice will be taken against the purchase order
4. The units will be added to inventory at the unit cost shown on the invoice. 

With the QBO method, there will be different batches of units with different costs assigned to them, assuming that costs fluctuate over time.

The purchase order and invoice process is how costs are assigned to units using the QBO method. The way these inventory costs are then translated into COGS is through inventory quantity adjustments or sales orders. 

Each month, the number of units of each SKU sold will be entered using an inventory quantity adjustment or sales order in QBO. Once the units sold are entered, QBO will remove these units from inventory and calculate COGS on a FIFO basis.

In addition to being a more accurate method for calculating COGS, this method helps reduce variables in the COGS calculation. The unit costs come directly from POs and invoices, so the only variable to solve for is the number of units sold each month.

A Custom Method

In some client situations, we use a fully custom method to maintain inventory and COGS while still in compliance with GAAP. If the client has a robust inventory and/or warehouse management system, we may rely on those systems and create a simple journal entry to Quickbooks. We don’t want to reinvent the wheel. 

Who uses this method and why?

Profile of client:

• More complex operations
• Usually involves a third-party inventory and/or warehouse management system
• >100 SKUs
• Operations team in place managing key processes

Key Steps

1. Understand the client’s operations
2. Co-develop a COGS methodology
3. Execute monthly

Pros

• GAAP compliant (presumably)
• Custom-tailored to client’s business

Cons

• Highest level of effort

Requirements

• Operations team in place managing key processes
• The operations and accounting teams must be in sync
• Accounting must have a deep understanding of the client’s operations

Master Ecommerce Inventory Management

By embracing an ecommerce inventory management system, you’re streamlining your operations and empowering yourself to make informed decisions swiftly.

The benefits of robust ecommerce inventory management are substantial. It shields your business from erratic inventory fluctuations. It ensures you understand your inventory levels and actual cost of goods sold (COGS). This knowledge becomes the cornerstone of sound financial planning, enabling you to budget effectively and accurately forecast cash flow. It also positions you well for audits, a cause for celebration.

Here’s what you need to do:

1. Take 5-10 minutes and answer the questions in the diagnostics
2. Ask your current accounting team how they are handling inventory management
3. If you’re not satisfied with their answers, call us

In the world of ecommerce, precision and agility are critical, and mastering inventory management can be the game-changer your business needs.