A well-executed inventory count can provide valuable insight into improving operational efficiency for your Maine-based company, even if they seem time consuming and disruptive. Unfortunately, inventory counts are among the most dreaded chores for business owners and managers. Here’s how to run your count to maximize the benefits and minimize the hassle.

Reviewing the Basics

Inventory includes finished goods, as well as raw materials, and work-in-progress. Your physical inventory count also may include parts and supplies inventory. Under U.S. Generally Accepted Accounting Principles (GAAP), inventory is recorded at the lower of cost or market value. Estimating the value of inventory may involve subjective judgment calls, especially if your company converts the goods from raw materials into finished goods available for sale. The value of work-in-progress inventory can be especially hard to objectively assess, because it includes overhead allocations and, in some cases, may require percentage of completion assessments.

A physical inventory count gives a snapshot of how much inventory your company has on hand at year end. For example, a manufacturing plant might need to count what’s on its warehouse shelves, on the shop floor and shipping dock, on consignment, at the repair shop, at remote or public warehouses, and in transit from suppliers and between company locations.

It’s essential that business operations “freeze” while the count takes place to obtain a static value at year end, because the value of inventory is always in flux, as work is performed and items are delivered or shipped. Usually, it makes sense to count inventory during off-hours to minimize the disruption to business operations. For larger organizations with multiple locations, it may not be possible to count everything at once, so larger companies often break down their counts by physical location.

In order to minimize disruptions, advance planning is key. Before the counting starts, management generally should:

Order (or create) prenumbered inventory tags. It’s best to use two-part tags to count inventory. One tag stays with the item on the shelf; the other is returned to the manager at the end of the count. Tags are numbered sequentially to ensure the manager can account for every tag issued. Using a tagging system prevents items from being counted twice or omitted. Each tag should identify the part number, location, quantity and person who performed the count.

Preview inventory. To make the count more efficient, many companies do a dry run a few days before the count to identify any potential roadblocks and determine how many workers to schedule. This also gives warehouse personnel the opportunity to correct any foreseeable problems, such as missing part numbers and unbagged supplies.

Write off any unsalable items. All defective or obsolete items should be thrown away or recycled before the inventory count begins. There’s no sense counting items that will be written off.

Assign workers to count inventory. Assemble two-person teams to prevent fraudulent counts, and assign each team a specific area to count. Avoid giving employees inventory listings to reference during the count, otherwise, they may be tempted to duplicate the amount from the listing, rather than bring attention to a possible discrepancy.

Precount and bag slow-moving items. To make the physical count faster, some items that aren’t expected to be used before year end can be counted a few days in advance. Precounted items should be tagged and placed in sealed containers. If a broken seal is noticed on the day of the actual physical count, the items in the container should be recounted.

If your company issues audited financial statements, one or more members of your external audit team will be present during your physical inventory count. They are there to observe the inventory procedures (including any statistical sampling methods), review written inventory processes, evaluate internal controls over inventory, and perform independent counts to compare to your inventory listing and counts made by your employees.

They’ll also look for obsolete, broken or slow-moving items that need to be written off the books. Be ready to provide them with invoices and shipping/receiving reports. Auditors review these documents to evaluate cutoff procedures for year-end deliveries and confirm the values reported on your inventory listing.

Understanding the Importance of Accuracy

There are many reasons to get the inventory count right. First, you want a reliable estimate of ending inventory so that the profits you record this year are accurate. Your cost of sales, a major expense on the income statement, is a function of the value of beginning and ending inventories.

At the most basic level, here’s how the accounting department estimates cost of sales:

Cost of sales = Beginning Inventory + Purchases – Ending Inventory

Management won’t know how profitable the company truly is if the inventory balance is incorrect at the beginning or end of the year.

In addition, inventory is a major line item on your company’s balance sheet. Lenders rely on inventory as a form of loan collateral. Stockholders look to inventory-based ratios (such as the current ratio or days-in-inventory ratio) to evaluate financial strength. And if disaster strikes, your insurance coverage (which is based on asset values on your balance sheet) should be adequate to cover any inventory losses.

Most companies track the value of inventory through a computerized perpetual inventory system; the value increases when purchases are made (or as raw materials are processed into finished goods) and decreases when goods are sold. But a count taken from a perpetual inventory system may not always be accurate.

Explaining Discrepancies

Be sure to note and explain any discrepancies found at the end of your physical inventory count. Possible reasons for differences between the perpetual inventory system and the physical count include:

• Data entry errors,
• Inaccurate bin or part numbers,
• Shipping errors,
• Inventory in the authorized possession of employees (such as owners or salespeople),
• Theft, and
• Intentional financial misstatement.

Companies that conduct a year-end physical inventory count send a message to would-be fraudsters: We’re watching our assets and taking steps to catch fraud.

Making Counts Count

Compliance and fraud prevention are not the only benefits of a well-executed physical inventory count. Opportunities also exist for management to evaluate how to stock items more efficiently, reduce carrying costs and identify actual fraud losses. And, more efficient inventory management can lead to improved customer satisfaction and higher sales.

For example, when conducting counts, management should evaluate how the warehouse is laid out. The most commonly used items should also be the most accessible. Employees should navigate the warehouse with familiarity and find items off the inventory listing with ease. Bin and aisle labels should be easy to read quickly. High value items should be locked away during off hours, and counted on a regular basis to reduce pilferage. And plant managers should know how to systematically compute the optimal reorder point and buffer stock levels for key inventory items (rather than just rely on gut instinct) to avoid manufacturing and shipping delays.

Seeking External Input

Accountants have seen the best, and worst, practices for managing physical inventory counts. If your Maine business is looking to perform an effective inventory count, contact Filler & Associates, or your financial advisor for year end, and get advice on best practices.