Inventory 101

When a company’s inventory count comes up short, the hunt for the missing inventory begins. Are employees are stealing from the warehouse in the middle of the night? Is a dishonest bookkeeper recording fictitious purchases and pocketing the difference? Possibly. But while employee theft may be the reason, less nefarious causes might be to blame.

Defining & Tracking Inventory

Inventory can be defined as the raw materials, work-in-process products and finished goods considered to be the portion of a business’s assets that are ready or will be ready for sale.

It can be tricky to get a handle on inventory. Production processes and the volume of products in a warehouse are complicating factors. That can result inventory shrinkage – when the actual number of items on the shelves is less than the number of recorded items. In the manufacturing world, shrinkage also refers to the loss of raw materials (ex. metal or food ingredients) during the production process.

Companies often take a complete physical inventory count of inventory or equipment on a periodical basis, such as once or twice a year. Or companies may take a partial physical inventory count of inventory or equipment on a more frequent basis, also known as cycle counts.

An inventory computation is a comparison of what is recorded in the accounting records to the actual count of items. The difference between the two amounts is the inventory variance.

For example:

Retail Cost
Book Value $50,000 $25,000
Physical Inventory
(Inventory Counted) 40,000 20,000
Difference – Variance $10,000 $5,000

An inventory computation is based on a comparison of:

  1. Quantity and/or,
  2. Quantum (quantity x value).

A quantum inventory computation variance has more variables or non-employee theft causes than a quantity inventory variance.

Reasons, Other than Theft, for Inventory Variances

Inventory variances may be due to physical, reconciliation, cost, quantity or other system errors. For example:

  1. Physical
    1. Inaccurate physical counts.
    2. Inaccurate receiving cutoffs.
    3. Inaccurate shipping cutoffs.
    4. Mis-keying.
    5. Mis-shipping.
    6. Mis-receiving.
  2. Reconciliation
    1. Are all items (different categories) included?
    2. Are all items carried forward accurately from the physical count?
    3. Are the quantity and price extensions and columnar additions accurate?
  3. Cost
    1. Different cost files are used for material purchase costing, bill-of-material costing and inventory valuation.
    2. Inventory repriced by parent company.
  4. Quantity
    1. Unit of measure errors, such as barrels vs. gallons.
    2. Quantity should agree to tags or count sheets.
    3. Misplaced decimal.
  5.  Consider scrap factors
    1. Test to ensure that factors have been property applied and recorded.
      1. Variations from expected scrap rates properly have been recognized.
      2. Scrap in excess of that costed but not recorded will create a book to physical count shortage.
    2. Concerns with unrecorded spoilage or lost yield.
      1. Examination of trash barrels may reveal parts that have been discarded without proper inventory relief.
      2. Assemblies damaged in production may have been reworked or scrapped without proper costing.
      3. Damaged assemblies may have been set aside, not counted and not properly relieved from inventory accounts.
      4. Look at all items for offsetting quantities because of substitutions.
  6. Other issues in the costing system
    1. New products.
    2. Redesigned products.
    3. Changed procedures for:
      1. Receiving
      2. Shipping
    4. New computer system.

Inventory Variances Due to Employee Theft

If employee theft is suspected, after examining inventory control procedures, owners should examine their policies to see if they contain language similar to the following policy language:

  1. Insuring Agreement A. 1. does not cover:
    1. Inventory Shortages
      Loss, or that part of any loss, the proof of which as to its existence or amount is dependent upon:

      1. An inventory computation; or
      2. A profit and loss computation.

However, where you establish wholly apart from such computations that you have sustained a loss, then you may offer your inventory records and actual physical count of inventory in support of the amount of loss claimed.

In the event of the policy containing such language, owners will need to examine not only the inventory computation and profit and loss calculation, but also work to obtain other evidence. Such other evidence may include third-party evidence, witness statements, surveillance records, police reports, confessions, etc.

Ensuring the accuracy of inventory counts, maintaining strong controls over inventory procedures and implementing security procedures can help to pinpoint the reasons for inventory variances. Such protocols can help determine whether inventory is missing due to employee theft or whether inventory is “missing” due to sloppy or inaccurate recordkeeping.