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Inventory Management A Financial Perspective


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An article on inventory management, inclulding variance analysis, valuation, financial implications, internal control and accuracy.

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Inventory Management A Financial Perspective

  1. 1. Inventory Management – A Financial Perspective by Lynn Sears, CMA For many companies, inventory is the most complex and difficult item to value. It may be the largest current asset if not the largest item on the balance sheet. As such, its accuracy is of great concern to a company’s stakeholders, internal or external auditors, and creditors such as banks and vendors. Many privately held firms, and all publicly trades ones, have their financial records audited each year by a public accounting (CPA) firm. This type of audit provides reasonable assurance that the company’s financial statements are free of material misstatements. Auditors test three major aspects of inventory to determine its fair representation on the balance sheet - existence, rights of ownership and proper valuation. Inventory was not always so extensively audited, in fact, it used to be limited to the examination of inventory records. The McKesson & Roberts Fraud Case of 1939 expanded the scope of auditors’ responsibilities. McKesson & Roberts, a pharmaceutical company listed on the NYSE, was trying to boost its stock price. Customary audit practices of the time didn’t include verification of existence or observation of the physical inventory process since auditors claimed they didn’t know enough about the products. McKesson & Roberts’ inventory was overstated by $19 million – containing fictitious items that amounted to one fourth of the total assets on their balance sheet. Generally Accepted Auditing Standards were subsequently revised to require that auditors observe the taking of physical inventory. The annual audit is a long and involved process and very likely the busiest time of year for your company’s accounting department. If you are involved with inventory management, just when you’re knee deep in the annual physical count you are visited by an auditor along with one or more of your colleagues from Accounting. Armed with clipboards and calculators, they question you regarding counting methods, recordkeeping transactions, movement of stock within the facility and how duties are divided between your staff. Depending on the relative dollar value of inventory and the amount of cycle count adjustments done throughout the year, their efforts spent on this could be extensive. The procedural questions help them understand your company’s internal control system. Internal control is a set of system attributes and procedures designed to prevent inaccuracies and losses. Assessing internal control is an early step in the audit process and helps the CPA firm plan the extent of their testing of transactions and other components of their field work. Strong internal control lends greater credibility to the financial records, results in substantially less work for everyone involved, and reduces the overall cost of the audit. How do you strengthen internal control over inventory? The easiest way, and a given for large companies, is division of duties. In short, no one person Inventory Management/Lynn Sears, CMA Page 1
  2. 2. should handle a transaction from beginning to end. Purchasing, receiving, storing, processing and shipping duties should be performed independently of each other. A good perpetual inventory system providing real time information is essential for effective production planning, purchasing and sales. It also promotes accountability and reduces the chance of theft. Serial numbers, lot tracking, pre-numbered documents, timely processing, and safe keeping of valuables further enhance accuracy and control. Computer security, access control, and limited numbers of users performing certain transactions, especially inventory adjustments, are also important. The cost benefit criterion should be considered when choosing a system or evaluating procedures. The most compelling indicator of internal control over inventory is the amount and nature of inventory variances. When the system quantity on hand exceeds the physical quantity on the floor, this is a negative or unfavorable variance. If the quantity on the floor is greater than the system quantity, this is a positive or favorable variance. There are many reasons for variances but errors can be minimal with modern inventory control techniques such as RFID and bar code scanning. However, many companies still experience variances and we’ll take a look at some of the major causes. It’s essential to troubleshoot variances so they can be prevented in the future. It is good for multiple departments to collaborate on this effort. The value of interdepartmental variance analysis lies in its opportunity for learning experiences, leading to greater understanding, more sound processes, less errors and solid internal control. Consistently recurring negative variances are the most disconcerting, because they could represent waste, unbilled sales, duplicate vendor invoices, higher than expected product costs, or chronic errors in the way transactions are executed. The first question is whether there exists a positive variance that could be related. If so, then there is probably a training issue or system problem with how transactions are recorded. For example, a negative work in process inventory variance offsetting a related positive finished goods variance may mean production is not being recorded in a consist manner. Similarly, a positive work in process variance offset by a related negative raw materials variance means the raw materials are not properly being issued or allocated to production. Manufacturing firms using a back-flush costing environment, where inventory is relieved using theoretical consumption, persistent negative variances signal inconsistencies between the production models and the actual production process. This is assuming there is nothing wrong with how the system is posting transactions. If variances have grown but no changes have been made to the system, then a cross functional team of representatives from production, and those departments responsible for designing and Inventory Management/Lynn Sears, CMA Page 2
  3. 3. maintaining the models, and perhaps information technology staff, should evaluate standard quantities for scrap, rework, production, and materials usage to make sure they are accurate, and most importantly, to look for opportunities for avoiding waste in the form of excessive scrap and rework. In a job order environment, persistent negative variances are likely to signify materials not allocated to the job perhaps due to parts pulled off the shelf without being scanned or billed to the job. This will result in understated job costs and possibly unbilled items. This is likely a procedural error that can be easily corrected with proper training. A recurring negative variance in purchased goods (raw materials or finished goods for resale) warrants a review of the receiving and vendor invoice process. Is every vendor invoice accompanied by a unique purchase order receipt? Is the system receipt based on a unique source document, such as a vendor packing list? Are there an especially high amount of open receipts for which there are no vendor invoices? A good accounts payable and receiving system usually prevents such errors, but if there is a variance, these are all worth looking at. Similarly, negative recurring variances in finished goods should call for evaluation of the sales and customer invoicing process. Is there a consistent procedure for scanning outbound shipments, and is there a method for following up on all open sales orders to make sure they are invoiced? How are samples, disposals and no charge replacements handled? A cycle count is an opportunity to assess accuracy and should not be grounds for making adjustments without finding the root cause. Timing of transactions or not observing a clean month-end cutoff can lead to problems that will reverse in the following month. To reduce errors, the entire SKU should be counted as opposed to just one location. If variances are substantial, pallet patterns and units of measurement should be checked. Test counts are required in order for auditors to verify the existence of the inventory. Typically they are given an inventory schedule, the sum total cost of which ties to the dollar value of inventory in the financial records. Working from a list of randomly selected samples, they trace each SKU back to the inventory schedule and make sure the quantities agree. The second generally accepted audit standard as it applies to inventory is to confirm ownership of the asset. They trace a sample of SKU’s back to suppliers’ invoices to make sure they were paid for, and to verify that the goods are not on consignment or owned by another company. Auditors will want to know if any of the goods are pledged as collateral for a loan; if so, the arrangement must be disclosed in the notes to the financials and with a corresponding liability account showing the debt. Inventory Management/Lynn Sears, CMA Page 3
  4. 4. Lastly, the auditors must determine that the inventory is appropriately valued. This entails evaluation of the appropriateness and consistent application of costing methods, the choice of which can greatly impact cost of goods sold, profitability and tax liability. The valuation method does not necessarily mirror what is happening on the floor, i.e., you may be using LIFO for valuation but you are still rotating stock and selling the oldest goods first. Manufacturers using a standard costing system present their inventory at standard cost. This is the expected current cost to produce the product or to buy the raw materials. Standards are generally re-calculated every year, and variances in purchase prices and other costs are expensed through cost of goods sold as they are incurred. Last in First Out, (LIFO), is probably the most widely used. The older inventory assumed to remain on the shelf is always at a lower cost because of inflation. Products sold in the current year wash through cost of goods sold at higher rates since these were assumed to be bought most recently. The result is lower gross profit and happily, less tax exposure. Inventories have a lower value on the balance sheet, which satisfies an important accounting convention known as conservatism. First in, First out, (FIFO) can be used for product with a limited shelf life, such as food. Since financial implications of FIFO are directly opposite to those of LIFO, it is not very popular due the likelihood of higher tax bill. Specific identification can be used when items are unique. But in the absence of lot or serial numbers, this method allows for manipulation of costs since a company can choose to assume the most expensive pieces were sold if the company desires to show less profit. Lower of Cost or Market is used for vehicles and other products whose market value may decline over time. Its cost must never exceed net realizable (wholesale) value (NRV). The difference between NRV and original cost is expensed when the inventory value is recorded. Market costing is used for commodities, such as gemstones, agricultural products, precious metals, oil, etc. They are presented at ending market value. A weighted average or moving average method can be used. The costs are re-calculated each time a purchase is made. This mitigates the volatility that comes from fluctuating costs and therefore lessens the resulting impact on gross profit. Work in Process (WIP) is the most difficult aspect of inventory to value. The allocation of raw materials is easy enough, but overhead and labor allocations can be problematic and vary greatly depending on the costing system being used. At any point in time the amount of WIP is usually Inventory Management/Lynn Sears, CMA Page 4
  5. 5. substantial, and care should be taken to make sure all costs are captured completely and on a timely basis lest variances arise in related areas. Other considerations for proper inventory valuation are obsolescence, spoilage, replacement cost and quality. Reserves for obsolete/aged and damaged inventory are either based on historical experience or specific identification & segregation of doubtful inventory. If the stock is vulnerable to these conditions it should be adjusted accordingly by a reduction in value and/or quantity and a corresponding expense. Obsolescence, shrinkage and damages are key indicators of inventory management effectiveness and should be tracked as a percentage of purchases, production or sales. Taking corrective action when these amounts exceed acceptable levels can reduce costs. Inventory turnover is a useful benchmark, particularly when a company monitors trends in its own ratio. A higher turnover ratio implies that inventory is well managed, marketable and that the company is not holding excessive stock. But in times of inflation, especially if using LIFO or standard cost, this ratio can be misleading. Therefore, it should always be reviewed in tandem with gross profit since higher product costs artificially increase this ratio. Many companies monitor the age of their inventory, most importantly in dealing with perishable goods, but also any time inventory value may erode with age. An aging report can also highlight the faster or slower SKU’s and serve to facilitate corrective merchandising or marketing strategies. Today more than ever we strike a fine balance between ordering costs and carrying costs while avoiding stock-outs, raw materials shortages and heroic recoveries that chip away at competitive advantage. We are fortunate in the availability and cost efficiency of sophisticated systems and new technology to effectively manage inventory, enhance productivity and control costs. Nothing in business is ever static, and we constantly improve our processes and acquire new understanding to adapt to ever changing environments. And from an accountant’s perspective, this ultimately adds the most value to a company, ensuring a healthy bottom line and a solid balance sheet for the long term. Inventory Management/Lynn Sears, CMA Page 5
  6. 6. Inventory Management/Lynn Sears, CMA Page 6