!

InventorY FOR

Handmade Success Why keeping on top of your materials, expenses and orders is essential to the success of your handmade

business.

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What is inventory? 3 .............................................................................Raw materials 3 ............................................................................................................Your inventory is your asset 3 ......................................................................................Tracking your inventory 3 ............................................................................................

Why do I need to track my inventory? 4 .............................................Stock level management 4 ............................................................................................Profitability 4 .................................................................................................................Anticipating Demand 5 .................................................................................................Shrinkage and loss control 5 .........................................................................................Insurance 5 ....................................................................................................................Financial and Tax calculations 5 ..................................................................................

Supplies and Materials 6 ......................................................................Supplies 6 .......................................................................................................................Materials 7 .....................................................................................................................

Direct and Indirect Expenses 8 ............................................................Direct Expenses 8 ..........................................................................................................Indirect Expenses 8 .......................................................................................................

Methods of Valuing Inventory 9 ..........................................................The FIFO Method 9 ........................................................................................................The LIFO Method 10 ......................................................................................................The Rolling Weighted Average Method 11 ...................................................................Which inventory method to choose? 11 .........................................................................

What is COGS? 12 .................................................................................Perpetual vs. Periodic Tracking 14 .......................................................Periodic Tracking 14 .....................................................................................................Perpetual Tracking 14 ...................................................................................................

Stocktaking 16 .......................................................................................End of Year (EOY) Stocktaking 16 ................................................................................The Cycle Count 16 ........................................................................................................What to do when you find a stock discrepancy 17 .......................................................Tips for getting into the cycle count groove 17 .............................................................

Summary 18..........................................................................................

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What is inventory? As a crafter, you are a manufacturer of products for sale. To do this, you purchase raw materials and combine or otherwise modify these into goods for sale. Although you may also consider your finished stock on hand to be your inventory, for the purposes of this book your inventory is defined as the raw materials your business currently holds in its possession.

Raw materials Raw materials are the things you purchase for the purpose of creating into your products for sale. Common examples are yarn, buttons, clasps, fabric, elastic, beads, scents, colouring, wood and paint. The key indicator of a raw material is that they get “used up” when used to produce the product - you don’t retain any part of the item after the manufacture.

Your inventory is your asset Most craft businesses have thousands of dollars of raw materials on hand at any point in time, thus your inventory one of the major assets of your business. It’s important to start seeing your materials as an asset, rather than a series of purchases that require expensing as this will make things clearer in the following chapters.

When you purchase raw materials, you will be adding value to your inventory asset and when you manufacture and sell goods you’ll be removing value from this asset.

Tracking your inventory As with any of your other assets, Inventory needs to be valued for financial and tax reporting. To do this, you’ll need to have a tracking system in place to calculate the amount and value of each material you have in stock. This could be a software system, a series of Excel spreadsheets or even a paper journal - the method you choose should fit with the size of your business and the way you work.

Your tracking system should also involve creating regular manual processes within your business like stocktaking and manufacture measuring to ensure that your system is accurately representing your inventory.

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Why do I need to track my inventory? Although some people only decide to start tracking their inventory due to immediate financial or tax obligations, there are a number of great reasons why tracking your inventory is a great practice for your business.

Stock level management Where once it may have been a case of taking a quick look at your inventory boxes to determine which materials were running low, as your business grows you'll probably be finding that it's not quite that easy anymore.

Making sure that you have not only enough materials to keep manufacturing to keep up with demand while being mindful about overstocking is truly a balancing act that can become quite stressful if not being managed properly. Essentially, ensuring you have the right amount of materials and manufactured stock on hand at all times is essential to ensuring you can manufacture and deliver in the timeframe you have promised your customers.

Knowing your stock levels and usage means that you can start purchasing your materials in advance in bulk. This can lead to significant reductions in your manufacture costs - which ultimately results to higher profits for you.

Profitability Knowing your exact costs of production is the key to pricing your products - without this knowledge, you are running blind and will need to rely on external factors such as looking at your competitors price points to set your own or asking friends and family to “value” your products.

While these activities can be helpful in understanding what the market is likely to pay for your products, it’s not going to show you how much money you will make. You can end up quite quickly in the situation of creating and selling a popular product that makes you no profit margin at all, or worse still actually loses you money. Without tracking costs though the year, what was thought of as a successfully growing business with an enthusiastic customer base is deemed a failure when the figures are done at the end of the year - and all that work you put in to creating those products is effectively for naught.

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Anticipating Demand Without knowing your previous sales and manufacturing history, it’s impossible to predict different sales patterns to account for seasonality, holidays and weather. Keeping track of your manufacturing can lead to insight as to when your busiest periods are so that you can better prepare for them.

Shrinkage and loss control By tracking where your stock is being used, you can then start to see opportunities for improvement - you might find that you have a certain product which you can now see produces a large amount of unusable scrap. This can lead you to relook at your entire manufacture process to see if any changes can be made.

Insurance Think about what sort of information and records your insurance company will want to know if disaster strikes. Given that your inventory is one of your biggest assets, you’ll be wanting to provide detailed records to prove what you had on hand.

Financial and Tax calculations One of the most important reasons to track your inventory is so that you can calculate the numbers you need to fulfil your financial obligations. To often, this task this left to the last minute and as a consequence what should be a straightforward process becomes a rushed scramble to file. Dedicating time now to plan how you are going to track your inventory, along with learning about the concepts involved means you will be much more in control and will be able to prepare for your filings without stress.

There will be some that will tell you that if you have a small turnover, track using the cash basis or have a "hobby" business that inventory for tax isn't required. This isn't true - it is an essential obligation for your business. If you are based in the US, manufacture your products and your gross (before expenses) revenue is at least $400 a year, you need to file a Schedule C before April each year and to do this you will need to know your inventory values. To do this, it's vital that you accurately record the costs of your material purchases and manufactured products.

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Supplies and Materials As a crafter, you’ll need to know how to categorise the materials you use to produce your products. For COGS in particular, certain materials need to be excluded from your asset total and included instead as a direct expense in the year it was purchased (we’ll cover direct and indirect expenses in more detail in the next chapter). It can understandably be confusing as it often involves a fair bit of “rule of thumb” thinking and knowledge of how the material is used and counted: many tax professionals also struggle with classifying the materials their clients use so you are in good company!

Supplies Supplies are defined as:

a) Materials not used directly in the manufacture of your products or

b) Materials used in the production of your products that are not able to be inventoried due to an inability to accurately measure the material.

Examples:

If you think your material is a supply, it should generally be tracked as an indirect expense rather than a material. This is because supplies are typically claimable only within the year that they were purchased (materials used to produce your products are on the other hand treated as an "asset until sold" - we'll cover that in the section below).

If you are using Craftybase, you have two options for tracking your supplies: you can either enter it just as an expense or create a "non-inventoriable" material and link it to your expense. In this case, Craftybase will recognise that the material is non-inventoriable and will assign the expense cost directly to your expenses tally to ensure it does not get included in COGS. This is good for situations where you'd like to keep a photo or a description of the supply item purchased for insurance reasons.

Envelopes Shipping Labels Thread

Packaging Tape Thread Dye

Glue Stabilizer Bubble Wrap

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Materials Materials on the other hand are defined as things you consume directly in the manufacture of your products. For a handmade business, this will mostly be what you are dealing with on a day-to-day basis.

Examples:

Materials are always added to your inventory instantly when purchased, which is treated as an "asset until sold". So what does this mean exactly? It means that you don't claim the purchase of the materials up-front, rather you claim it in small amounts slowly over time as you sell the products containing the materials (this tally is known as your COGS - "cost of goods sold").

This is a tricky thing to track, so you'll most definitely need specialised inventory software or a pretty amazing spreadsheet to do the crazy calculations that COGS require. Otherwise, you'll be needing to maintain a rolling average of your material costs and manufacture costs over time yourself to ensure you are attributing the correct costs to each item you sell.

If you are already using Craftybase to track your COGS, you'll simply be adding in your material and then linking an expense whenever you purchase more stock - this will trigger the rolling average calculations you need. From here, including the material in each manufacture will ensure that your material usage tally will be correct on your Schedule C Guidance report.

Fabric Oil Clasps

Ribbon Fragrance Jump Rings

Elastic Butter Earring Bases

Buttons Bases Cord

Snaps Wood Chain

Tags Metal Paint

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Direct and Indirect Expenses It is important to know the difference between Direct and Indirect Expenses as they can have a big impact on your calculations at the end of your financial year.

Direct Expenses As a manufacturing business, your direct expenses are the costs associated with the materials directly used in the production of your goods for sale.

For most handmade businesses, direct expenses will be the bulk of your overall expenses during the year. As mentioned in the previous Materials and Supplies chapter, direct expenses result in an increase to your inventory asset that decreases only when goods sold using the materials are sold (COGS).

Indirect Expenses All other expenses are considered indirect expenses. These are things like depreciation, repairs and electricity - costs that are indirectly related to the production of your goods for sale. As these costs cannot be directly factored into your COGS, they are claimable within the financial period they are incurred. Shipping materials also tend to be included here - although they could be argued as materials that are used to sell your goods, they are not immediately used to create the product you have sold.

Examples:

Envelopes Shipping Labels SVG Digital Files

Packaging Tape Thread Dye

Printer Ink Needles Paper

Patterns Pens Backdrops

Scissors Stabilizer Needles

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Methods of Valuing Inventory There are three ways recognised by the IRS for valuing the cost of your inventory: FIFO, LIFO and Weighted Average Cost. We'll go through each, along with the pros and cons of each approach.

The FIFO Method FIFO stands for "First In, First Out". This means that you always use and sell the oldest stock in your inventory first. This is commonly used with stock that has limited shelf life, as it allows you to sell the stock nearing expiry first and represents the inventory flow of many businesses in general.

If you are having trouble picturing this scenario, imagine a supermarket shelf: the employee will always add new products to the back and the customer will always take the ones from the front of the shelf. Stock continuously moves toward the front of the shelf as new stock is added / removed until it is at the front.

One disadvantage of this method is if you have a long elapsed time between the purchase of your materials and their use, costs will be calculated from old stock values which may not represent the current cost of production - this can cause a mismatch between revenue and costs and thus margin calculations can be misrepresented.

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The LIFO Method LIFO means "Last In, First Out". This means you are always using the stock most recently purchased and working back from there: your most recent material purchased is the one you will use in your most recent manufacture.

In the "supermarket shelf" example again, the employee instead adds the newest items to the front of the shelf and the customer also always takes from the front. Old stock will thus never be taken from the shelf if new stock is always added to replace the removed ones.

This method, although seeming counter-intuitive in practice (as you would always retain your old stock in inventory) it is still in use in the US, particularly for businesses in which the perceived value of the product decreases rapidly with time - an example being fashion: last seasons styles are not as covetable as this season, demand then drops along with the potential sale value.

The other rationale for this approach is that it allows you to factor in price inflation for your sales: presuming that costs always increase over time, it means that your costs of goods sold will always reflect the greatest cost paid for your materials. This can be useful when offsetting your revenue, but doesn't give a true reflection of your actual production costs. For this reason, this method is banned under international financial reporting standards, however is currently still allowable under IRS regulations for certain situations.

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The Rolling Weighted Average Method This method assumes that all inventories are being sold simultaneously from a single "pool". This method is most commonly used in manufacturing situations where materials

are piled or mixed together once purchased and thus can no longer be differentiated by their exact unit costs. From 2008, the IRS declared that using rolling average costs was an allowable method for calculating inventory.

In the supermarket scenario, the shelf is now a box, whereby stock is removed by customers and added by employees randomly. Each time an item is removed or added, the combined cost is re-evaluated and a new calculated unit price is set for all items contained in the box.

If you use a periodic inventory system (i.e. a paper-based one in which you do end of year

physical count) then this method will not work for your business as you require the individual changes to inventory levels in order to make these calculations.

This method is supported by perpetual inventory tracking systems like Craftybase, where all adjustments and costs are tracked during the year as they occur.

Which inventory method to choose? To determine which inventory method to use, take a look around at your current inventory: if your materials are mainly stored together with limited ability to distinguish the exact amount paid for each one then the Rolling Average Cost method is the best one to use for your business.

If you label and track each unit cost and then cost out each of your products separately using this information then you may be better using the FIFO method and maintain a spreadsheet to indicate your exact costs for each order sold.

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What is COGS? COGS is short for "Cost Of Goods Sold" and is the material cost of making all the products you have sold within the financial year.

The IRS requires you to calculate this number as part of your Schedule C filing, which all US businesses need to submit in April if their gross revenue (this is your total before expenses) is more than $400 annually. If you make products and your bookkeeper insists you don't need to track inventory, then it's really time to find another one!

It's important to know that your COGS total cannot be estimated and needs to be calculated directly from the true value of your inventory - this is because if you are ever audited, you'll need to show the IRS how you arrived at the totals you submitted.

The calculation can be summarised as:

Beginning Inventory Value + Purchases - Ending Inventory Value = COGS

For Schedule C, you’ll also be factoring in external labor and supplies, which we will cover in upcoming chapter.

For an example of this in practice:

Calculating this correctly is important as it reduces your business income and therefore your tax liabilities. It allows you to spread the costs of your material expenses over a number of years so that sales and expenses align.

If you claim your material expenses directly as a "supply" rather than as part of COGS, this can cause big problems down the track if you still have inventory stock on hand at the end

of the year. Why? While it might feel great to have a huge expense total to offset your revenue in year 1, this is only a good thing if you have a high turnover. Now, think about what happens in year 2 and 3 when your sales increase but your expenses decrease due to the greater leftover inventory stock on hand (i.e. you are

Beginning Inventory US$14,000

Material Purchases US$8,000

Ending Inventory US$10,000

Cost of Goods Sold US$12,000

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using materials from the excess stock you purchased last year). You'll effectively lose the ability to claim the expenses you are using to produce your products: your expenses to offset your revenue have already been claimed in a prior year leaving you with a high business income. This is a very tax inefficient situation.

Claiming your material expenditure as one-off costs is not the approach that the IRS requires for an inventory based business, so doing this may cause the IRS to scrutinise

your returns and you may need to recalculate past returns and amend.

Tracking your material expenditure as COGS means that you always have a direct relationship between your revenue and your expenses - as your revenue increases, the cost of manufacture increases (you make and sell more products).

This means that you are always claiming a constant amount of expenses against your revenue: this is something that the IRS expects to see if you are filing as a manufacturer. Most importantly for a small business, it means that there are zero surprises come tax time as you can estimate your liabilities will a high degree of confidence.

Craftybase features automatic order level COGS tracking and a Schedule C Guidance report that conveniently brings together most of the numbers you need for this filing.

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Perpetual vs. Periodic Tracking As we have learnt so far, tracking inventory is essential to provide the numbers you as a handmade business need come tax time. You can however choose one of two approaches for this: continuous real-time tracking using software, or once-a-year manual stocktaking using paper journaling or excel.

Periodic Tracking For small businesses with minimal inventory, manual once a year stocktaking (otherwise known as a periodic inventory system) is a popular choice for crafters making the first step from hobby to business. You can find lots of different excel sheets for sale that can help with this task, with varying levels of accuracy depending on their complexity.

This system involves undertaking a complete count of your inventory at least once a year. You can do this via any method you use: some people like using a paper-based system, while others feel more comfortable with a spreadsheet approach. Once you have a complete count of all materials at your end of year, you'll then also need to calculate their average unit cost based on the purchase history. This means also keeping corresponding records of your material expenses - again this can be done either with a paper system, spreadsheet or a basic expense tracking system.

Finding an excel spreadsheet powerful enough to calculate price fluctuations of materials and finished products during the year can be difficult: remember that any system you choose to use needs to be using a IRS / GAAP approved method (i.e. LIFO, FIFO, Rolling Average) for calculating stock increases and decreases so if you are looking into this option make sure you do your research first.

Perpetual Tracking Software that provides automatic real-time inventory calculations are called perpetual inventory systems. This effectively means that you'll be updating your stock levels as you change them throughout the year by logging expenses, orders and manufactures, not by solely undertaking huge stocktakes at the end of the year.

Craftybase, Quickbooks Premier and Unleashed Software are all examples of software you can use to manage your inventory using the perpetual tracking method.

As perpetual systems allow you to update your stock levels in real time, you'll be a building a picture of your inventory throughout the year - this means that you can make better decisions for your business as you'll have the information you need at your fingertips:

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sales and expense figures, low stock alerts, profit margin changes, pricing guidance and estimated tax liabilities are features available in this type of software that are difficult or impossible to achieve in periodic systems.

Perpetual tracking can also remove the necessity for an End Of Year (EOY) stocktake as you have been logging your stock all year which can result in time savings for your business.

If you are going to try and drop the EOY count, it is essential to ensure and validate that your tracking is very accurate throughout the year, as small errors can add up if not watched closely - this is particularly true when accounting for material usage and wastage. With this in mind, dropping your EOY count may only be realistically achievable in your second or third year of using a perpetual tracker, as it can take a little while to achieve the accuracy levels required.

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Stocktaking Regardless of the method you choose to track your inventory, you’ll at some point need to physically count your stock on hand to ensure you are tracking accurately.

End of Year (EOY) Stocktaking For Periodic systems, you’ll be needing to ensure that you set aside a significant period of time at the end of year to do annual count: this will involve counting each and every material you have and logging the quantity remaining, then using your expenses to come up with the current correct value using either the LIFO or FIFO rules (explained in the previous chapter on methods of valuing inventory). Material value of unsold finished products needs to also be included in your counts, so ensure that you are logging the costs of production as you make to ensure you can prove these figures to the taxman if you have this situation at the end of year.

The Cycle Count Perpetual material inventory systems are instead designed to track the changes in your stock levels constantly through the year using constant updates of stock levels. Due to this, if you are tracking accurately it's technically not required to do an annual stocktake of your entire material inventory. The keyword here is “accurately” - if you don’t yet have a reliable degree of accuracy in your manufacture and wastage measurements by end of year then it is a good idea to schedule in a count regardless to ensure that your records are correct.

The best way to improve your accuracy going forward is to use an approach called the "cycle (or perpetual) count". This method involves regularly counting a small sample of your stock and comparing it to your current records. Any discrepancies can then be instantly adjusted or investigated to find out the cause.

How often you choose to cycle count is completely up to you: in large scale manufacturing it is typical to do daily counts, however for smaller craft operations it may be a case of bi-weekly or monthly.

The sample you select could be a completely random set of materials, or you might like to prioritise materials with high usage / cost. Alternatively, physical locations may work best if you have your stock arranged in an orderly way - you could work from top to bottom of your storage cabinet, for example.

Whichever selection method you choose, the goal is to work regularly through small groupings of your entire stock during the year and comparing accuracy so that you can justify that a big one-off count is not necessary at end of year. Keeping additional records

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of your cycle counts is a good idea if you use a bookkeeper or accountant, as it will give them confidence in your tracking accuracy - it’s also very useful to have on hand if you are the subject of an audit.

What to do when you find a stock discrepancy If you do find a large discrepancy between your actual count and your recorded stock on hand, it's wise to investigate the cause of this rather than just make a manual adjustment to your records: is it due to your manufacture usage records being over or under estimated, or are you not measuring wastage correctly? Once you have identified the issue, you can then amend the original manufacture records and recipes so that working forward your counts will be more accurate.

Once you are at a stage where your cycle counts are returning accurate and predictable numbers, you can then decide to decrease the number of counts you do during the year if you feel that the system is now handling your stock usage for you. If you find the opposite, doing more frequent counts until the cause of the issue is found is often a good strategy.

Tips for getting into the cycle count groove ‣ Set a calendar alert or reminder at a specific time each week or month and make sure

this time is reserved.

‣ Start your cycle counts by choosing small samples, if you feel you can handle more build up from there so it doesn't feel daunting.

‣ Choose a typically quiet time where distraction is at a minimum - e.g. the end or start of the day can work well.

‣ Find another friendly crafter to use as a "stocktake buddy" - set up a regular Skype call and do the mini-count at the same time to both keep you in the habit.

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Summary As you have learned, inventory tracking is a really important part of running a handmade business. We hope this book has been a useful introduction to the basic concepts around inventory tracking - if you have any further questions, please do get in touch:

Craftybase Support help@craftybase.com

Craftybase Facebook Community https://www.facebook.com/groups/craftybase/

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