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In many manufacturing enterprises, inventory is the largest income-producing asset on the balance sheet and plays an important role in the financial and operational behavior of the business. From an operational perspective, a missing raw material or spare part from inventory can bring a manufacturing process to a standstill. Perishable inventory that is not turning at an adequate rate may expire, representing not only lost inventory dollars, but also additional costs for disposal. From a financial perspective, too much inventory may tie up cash that can be used for other purposes and create additional costs associated with storage and handling. Improper financing arrangements can restrict the ability to invest in the necessary materials for a growing business.
Inventory is an important part of the efficient operation of most manufacturing and distribution businesses; consequently a critical evaluation of the operational risks and processes of inventory control is essential for maximizing profits. Inventory is money. Knowing how to control the risks and processes associated with your inventory gives you the power to control your money.
Inventory control risk is affected by the accuracy of both inventory accounting controls and physical safeguarding procedures. Theft, obsolescence, damage and otherwise lost inventory are some of the results of poor physical inventory controls. Incorrect pricing and cost structures, perpetually inaccurate inventory reporting and maintaining too much or too little inventory on hand can be the products of inadequate inventory accounting controls. It is essential for an inventory control system to report how much of a product is available for sale, how much it costs to produce and where it is located.
In general, to establish a system with effective controls over inventory, the system must include well-designed procedures in the following areas:
- Purchasing
- Receiving
- Warehousing and storage
- Shipment and delivery
- Invoicing
- Cost accounting
- Perpetual inventory record keeping
When these systems are properly designed and maintained they can be a valuable tool for improving efficiencies, cash flow and customer service.
A critical evaluation of controls over inventory begins with the simple question “how accurate are my reported inventory quantities?” The answer will reveal if the first area of need is the basic maintenance of accurate quantities. Accurate reporting of quantities on hand is the foundation of inventory controls. If the reported quantities are accurate, a further analysis of experienced problems can identify where there are control deficiencies and areas for building an improved inventory control system. The next step is a review of the types of inventory items and their uses. An inventory consisting of high value, readily salable small items will have a different risk profile than an inventory of large perishable items, and the controls should be designed around those different characteristics.
The answers to the following questions can indicate potential areas of risk and control improvement:
- Are operating margins consistent and in an expected range?
- Are there high amounts of obsolete, damaged or spoiled inventory?
- Are inventory quantities shrinking or growing unexpectedly?
- Do perpetual inventory reports agree to the general ledger?
- Are there chronic shortages of inventory items?
- Are amounts received and shipped the same as the amounts ordered?
- Are there unexpected variances between perpetual records and results of physical inventories?
These are just a few of the many questions and problems that can indicate there is a need for an evaluation of risk and improvement of controls. An important part of controls improvement is identifying problems, searching for their cause then changing processes to address the risks and deficiencies.
Each inventory system is unique and must meet the demands of the business model and operating style of the enterprise. Our professionals have a diverse knowledge of many different systems and the capability to evaluate the risks specific to unique needs and provide appropriate solutions. If cash flow and producing income is important to your business, then inventory risk analysis and tight controls are important.
Some of the services we can provide are:
- Evaluation of cost accounting system including a review of costing methodology and calculations
- Review of appropriate internal controls over inventory including segregation of duties and proper physical safeguards to deter misappropriation of assets
- Development of a periodic physical inventory counting process
- Calculation of meaningful inventory performance metrics and comparison to industry benchmarks.
When you need guidance on your company's inventory risk, contact Decosimo's manufacturing team.
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