Performance: Spot Checking Inventory

It’s year end, do you know what your inventory number is?  It is not uncommon to finish the year end inventory count and find that the company needs to make a significant adjustment to their books.  While the year end inventory count is a valuable internal control, only checking inventory once a year can lead to wrong information accumulating over 12 months.  This makes it difficult to monitor the performance of your company.

The problem with keeping inventory accurate is that it can take a significant amount of time and resources to count it.  This is why many small businesses put it off until their tax accountant starts asking for it at year end.  Fortunately, there is an alternative to counting the entire inventory on a frequent basis.  Consider methods of spot checking inventory.

Inventory can go out of whack for a few different reasons.  Probably the two most common reasons are theft and issues with your Accounting Information System (AIS).  In the simple case of theft, it is difficult to identify and prevent it when inventory is counted only once a year.  Issues with your Accounting Information System can snowball over twelve months and take time and money to unravel and correct.  Typical AIS issues are caused by invoice items being tied to the wrong accounts or improper transaction recording procedures.  These problems can also be compounded if you mix softwares, e.g. using Quickbooks with an outside Point of Sale system.

The best way to spot check inventory is with a cycle counting system.  Instead of doing an entire physical count on a monthly or quarterly basis, consider spot checking different portions of the inventory at a time.  There are three major methods of cycle counting that I recommend.

Random Count – As it’s name suggests, a random count focuses on a random selection of inventory materials.  This method is probably one of the best ways to identify and prevent theft.  With no announced system for what inventory is going to be checked, a thief is taking their chances.

Block Count – This method divides inventory up into specific blocks which are then counted on a rotating basis.  This is more of a defined system that could be figured out, but creates a thorough way to discover problems with the AIS.  In other words, if your invoicing items are mostly correct but one is set up wrong, this method will help you find that mistake and correct it early on.  In Quickbooks, it is especially important to keep your modules clean so that they match the General Ledger and give you reliable numbers.

ABC Count – The theory behind an ABC count is that 20% of your inventory represents 80% of your inventory costs.  This can be especially true if you are manufacturing larger equipment items or specialize in sales of certain items.  The idea with the ABC count is to focus on higher priced inventory items and leave the smaller items for the year end count.  If your AIS is set up properly, there is definitely a cost benefit to focusing and simplifying your count throughout the year.

So why does this matter for performance?  Incorrect inventory creates problems with management’s decision making process.  In today’s technological world, management often relies on the count the computer is showing them for re-order points.  In more complex inventory systems, smaller parts are incorporated into various assemblies which are then sold.  Accurate inventory costs help management determine which product lines have better profit margins.

Beyond that, management should be looking at how quickly their inventory turns over, whether they face significant losses from spoiling or theft, and various cost metrics such as their Cost of Goods Sold as a percentage of total revenue.  If inventory is not being recorded properly, then revenue and/or COGS are usually misrepresented.  As a result, the company financials may look much better or worse than reality.

– This blog post is part of the 2014 Performance Series.  GunnChamberlain, PL offers outsourced CFO Performance services on a monthly and quarterly basis as well as outsourced accounting services.  Our goal is to ensure that you have accurate financial information and understand what that information is telling you.  We can also prepare a one time Business Performance Review for your company.   If you have any questions, please don’t hesitate to contact us.