Inventory out of control? Featured

8:00pm EDT June 25, 2008

If your inventory seems out of hand, you’re not alone. Even the most profitable manufacturers will struggle at times with inventory controls.

“There is a tremendous opportunity for fraud if your inventory controls are weak,” says John O. Heck, director, Accounting & Auditing Group at Kreischer Miller. “Employees can set up fictitious vendors and ‘pay themselves’ for goods never received. People have been known to take and sell truckloads of inventory to noncustomers. Without controls, no one at the company may recognize the stealing.”

Equally damaging is if your manufacturing facility builds up too much inventory, and you do not know exactly how much product is stored in the warehouse. Inventory takes up space and incurs the cost associated with that space.

Heck explained to Smart Business how to manage each of the ‘four categories of inventory control.’

What are the basic principles of maintaining control of inventory?

To manage inventory costs, you must address these four areas of inventory control:

  • Does the inventory you think you have actually exist?

  • Is inventory in the condition you believe it is in? Are you housing normal, slow-moving or obsolete inventory?

  • Is inventory being carried on the books at the appropriate value?

  • Will the level of inventory on hand accommodate expected activity (i.e. sales)?

What implications do manufacturers confront when determining what inventory is there and what is paid for?

You need inventory controls that sufficiently show that the inventory you paid for is in your warehouse, which isn’t as easy as it sounds. This requires establishing controls in the receiving location and physical controls where the inventory is maintained. This system should accompany accounting controls to ensure you pay only for items received, which then requires matching receiving documents and invoices. Formulate regular procedures to verify that inventory is recorded on the books. That includes making cycle counts to compare physical inventory to what your records say. This is best accomplished with an effective perpetual inventory system by which you keep continual track of inventory balances, incoming and outgoing shipments and cost of goods sold on a day-today basis. The more up-to-date and ‘real time’ your records, the better you can rely on cycle counts as a true check on whether the inventory you think you have is actually there.

How can the condition of inventory sabotage efficiency?

Without physical observation by someone who knows the quality standards for your inventory, you could be storing items that are damaged or even obsolete. Then you may confront a situation where you think you have plenty of inventory, but, in fact, you do not have the items necessary to fill orders. Systems to ensure proper condition of inventory can range from assigning ‘inspectors’ that evaluate manufactured products and confirm their quality standards to conducting regular inventory checks where knowledgeable employees review all items and segregate those that are no longer relevant.

What are various ways that manufacturers carry the value of inventory on their books?

Traditionally, manufacturers used a standard cost approach to determine the value of inventory. This means including labor, materials and overhead for each item. Each widget is responsible for covering a proportion of each fixed cost, and the goal is to produce inventory for the lowest standard cost possible. This results in producing long runs of inventory, and generally making more than needed at one time at what appears to be a lower cost. But, in reality, the cost of that inventory is increasing between 20 to 35 percent annually because of the carrying costs.

An alternative to this is a direct costing approach, common in the Lean and theory of constraints (TOC) environments. Inventory is viewed as a variable cost encompassing materials. Labor and overhead are considered period costs and are expensed each month. The key is getting materials out the door as quickly and efficiently as possible because only then, when goods are shipped, does the company make money. Operations are tweaked and refined so that items can be produced ‘just in time’ to ship to customers.

With Lean, a large inventory is viewed as a sickness. No inventory sits for too long. A primary focus is on reducing ‘changeover,’ which is the time between a machine producing one product and changing over to a different product. Nimble operations that can produce a diverse inventory with just minutes of changeover are the most profitable.

Where should companies start if they want to make tweaks in their processes?

First, for any system to be effective, the initiative must come from the top. Executing inventory controls requires buy-in from every employee, from the shop floor to the back office. There are plenty of books and consultants who can guide your company as you adopt Lean practices or modify your inventory systems. Discuss your goals with a trusted adviser, who can suggest a specialist. Most of all, communicate your goals with the entire organization.

JOHN O. HECK is director, Accounting & Auditing Group, Kreischer Miller, Horsham, Pa. Reach him at (215) 441-4600 or jheck@kmco.com.