One of the most bewildering aspects to managing a business that stocks and sells physical goods (as opposed to selling only electronic downloads, or items drop-shipped directly from manufacturers to customers) is understanding the huge importance of inventory that you keep on hand to sell.

It’s entirely possible that at some point your accounting software will tell you that your business is making a healthy profit, yet there’s no cash on hand to pay your bills. How is this possible?

It can happen because the finished products you buy and stock to resell (or the components that you assemble) are likely to tie up more and more of your profits, and perhaps personal savings, as your business grows.

This could put you in a position where you don’t have the cash you need to pay suppliers or even the IRS – because so much money is tied up in physical inventory on your shelves. And the concerns don’t end there.

• As your business grows you’ll likely need to keep an ever greater value of inventory to maintain a constant number of days’ supply, since running out of products will lose customers and waste advertising dollars.
• Many local property tax districts require you to file a report – separate from your home appraisal – showing the value of your business inventory at the end of each year so that they can collect additional property tax.
• Once the inventory you keep on hand grows to a value that you can’t easily replace, you should seriously consider buying business insurance so that fire, theft, and accidents won’t shut you down.

Avoiding the Trap

Many online stores limit their inventory costs by drop shipping products directly from manufacturers to their customers, without ever handling the products themselves. While drop shipping can eliminate inventory costs, there are several disadvantages.

• You’ll likely pay more for products that manufacturers drop ship to your customers, compared to items that you buy for stock.
• You’ll lose control over the quality and promptness of the shipments that manufacturers send directly to customers.
• Your website could have too little differentiation with other retailers who likely publish similar descriptions, and offer the same stock status and delivery times, provided by manufacturers who drop ship.

In the case of our business, we chose to ship our own manufactured goods and stock items, and to make it a priority to proactively manage inventory.

Next we’ll discuss some of those strategies to control inventory costs.

Next: Control Your Inventory

Today there seem to be almost limitless ways for criminals to steal money from an online business. Your bank accounts, online merchant account, credit card accounts, website, and the computers you use for work will be under constant attack.

You’re never 100% safe, but I can suggest some basic guidelines that should greatly reduce the odds of losing your hard-earned income to thieves.

Here are some general recommendations to stay safer online.

• As soon as you can afford to, get a separate PC just for business. Keep its operating system and antivirus up-to-date, install and test a system to backup files, and avoid visiting unfamiliar websites with this machine.
• Be sure that two-factor authentication is in place for every account that handles your money. At a minimum you should be required to reply to an automated email any time you login from a browser that isn’t recognized.
• Use different passwords for all online accounts that handle money or confidential information.

Email has become an big source of risk, and so requires extra precautions.

• Treat everything in your inbox with suspicion, especially if it has a link or attachment that you did not request from the sender. Potentially harmful phishing emails can appear to be from people and services you know, with believable text, and dangerous links or attachments.
• Never email sensitive information – including passwords, payment card numbers, or Social Security numbers – since your messages are easily shared and create permanent copies on many computers.
• Be on guard against 419 scams and other email fraud designed to steal your funds. An especially annoying scam, disguised as a customer service request, is explained in our story about why email is dangerous.

Stay Involved with Bookkeeping

Early-on, one of our biggest challenges was finding an accountant with enough skill to help us set up our accounting software and manage our financial records efficiently.

It wasn’t until we’d paid three other accountants – who all were of little help – that we finally found the right Certified Public Accountant (CPA). In the end, it was a recommendation from a really smart Chief Financial Officer (CFO), who I knew from a past job, that led us to the right CPA.

It’s essential that you’re able to trust anyone who can access your financial records and accounts, and that you stay actively involved in the bookkeeping process. One colleague learned this when he hired a bookkeeper who eventually fled after embezzling a great deal of money.

If your business sells physical goods, a big financial concern is likely to be something I call the inventory trap. We’ll discuss that next.

Next: The Inventory Trap

After the first full year of running a moonlight business, I found that we’d earned a nice profit. The money wasn’t yet as much as I earned from my day job, but it represented more spare funds than our family had seen in a long time.

Unfortunately, anyone who knows US tax law* will tell you that the extra income you earn as a sole proprietor is taxed at your highest marginal rate, and is subject to additional self-employment taxes.

This means that while the IRS might take, say, 20% of the of the earnings from a typical day job, you’re likely to pay closer to 40% of your additional business earnings in federal tax. Once your business starts to earn a real profit, you could be shocked by your federal tax bill.

Your Secret Weapon

Fortunately, if you can do without spending some of those extra earnings right away, the US tax code currently offers a powerful way to postpone – and almost certainly diminish – the taxes on much of your moonlight earnings. Your secret weapon is the Solo 401(k) .

Similar to the 401(k) savings plans offered by larger employers, a Solo 401(k) allows sole proprietors and their spouses put money from pre-tax earnings into a savings plan. That money and any dividends aren’t taxed until you withdraw the funds at a later date.

This helps you avoid paying federal tax on those earnings right away, and since you’ll likely be in a lower tax bracket when you retire, could help you avoid paying much of the total tax in the long run.

The amount of income that you can shield from immediate federal taxes with a Solo 401(k) changes each year, and depends on your age and net business profit. In general, your maximum contribution can range from $20,000 to over $50,000, plus more for a spouse.

I’d urge you to set up a Solo 401(k) as soon as your business shows a profit. It’s great to know you’re avoiding taxes and contributing to your security. You can search online for Solo 401(k) Providers to help create your account.

More Money Tips

The following suggestions are covered in depth in other articles.

1. You can avoid bad investments by heeding Steve’s First Rule of Money.
2. Read our story about how to keep your money safe.
3. If you sell physical goods, be careful to avoid the inventory trap.
4. To stay out of QuickBooks Hell, use your accounting software only for the things it does well.

Next, we’ll cover those important guidelines to help keep your money safe.

Next: Keep Your Money Safe

* I am not a CPA. This information changes with different circumstances, so please find a good accountant or tax professional to help you.

As discussed in our story about the inventory trap, if you sell physical products (as opposed to electronic downloads or items drop shipped directly from outside manufacturers to your customers) your ability to manage your inventory could be critical to the survival of your business.

Minimizing excess inventory is essential to ensure you’ll have enough cash on hand to pay bills. It’s equally important to avoid running out of items that customers want to buy so you’ll never lose sales or squander your advertising investments.

In our business, we find that inventory control amounts to three main tasks.

1. Keeping an accurate count of all stock quantities – with the ability to feed that information into our bookkeeping software
2. Creating a process to warn us in advance of items we need to buy to avoid running out
3. Taking frequent enough physical counts of our inventory to assure that our reports are correct

We first tried managing inventory using an expensive version QuickBooks, but found this to be hugely frustrating.

After struggling with the problem for a few years, I found our only solution was to track inventory with a spreadsheet. This required me to get a deeper knowledge of Microsoft Excel, a skill became useful for many other tasks.

Managing Inventory with Excel

Today we manage inventory using a single Excel workbook with different sheets where we record the data that determines our inventory.

• On one sheet we append newly completed (shipped) transactions reported by our shopping cart onto a long list. Each row shows an individual product ID purchased, order number, date of the sale, product cost, sales tax and shipping fees.
• On a second sheet we enter product refunds, mainly to keep track of refunded sales tax.
• On a third sheet we list the date, quantity and part number of items we receive from suppliers and any adjustments, say, for free replacements we send, changes in physical inventory counts, and so on.

With these three basic inputs, plus pages that use the Excel SUMIFS and SUMPRODUCT functions to calculate component parts consumed, we’re able to report the quantities of all items in stock on any prior day and time, and for any period the inventory used and the sales taxes collected and refunded. The workbook uses only conventional formulas, and no macros or add-ins.

We’re also able to see historical averages of components used, and alerts so that we know to order more stock when levels fall below thresholds we’ve set in days’ supply, accounting for each supplier’s normal lead times.

For our business, we’ve found that it’s critical to take physical inventory every few months, and to enter any adjustments into our spreadsheet so that we avoid any surprises.

We’ve also learned that it’s a good idea to keep plenty of critical, low-cost items (like labels, packaging materials and fasteners) in stock, while carefully monitoring our inventories of more expensive items.

Next, we’ll talk about bookkeeping processes we’ve found that work – and those that don’t – for running an online business.

Next: QuickBooks Hell