For many companies, especially public companies, an annual external audit (often performed at year-end) is required and must be completed by an external auditor. Private companies, on the other hand, often perform inventory audits to satisfy their bank or investors. But whether it is required for your company or not, completing regular inventory audits is a key component of an overall inventory management strategy. As we will see, the benefits of an inventory audit go far beyond knowing how much stock you have on hand or checking the box on regulatory compliance.
An effective inventory audit can answer many important questions, including:
- Is my inventory valuation accurate or are there discrepancies I need to address?
- What is my true rate of inventory turnover?
- Do I have an issue with inventory shrinkage?
- Do I need a more effective inventory management system or inventory management software?
- Am I maintaining optimal inventory levels?
Let’s take a look at how inventory audits are completed.
Why are inventory audits important?
The benefits of inventory audits can vary based on the dynamics of each business, but here are five common ways that these audits provide value.
1. Maintain compliance.
Especially for public companies, compliance is a huge issue and penalties are a real concern for those that are unable to maintain accurate inventory management. For private companies, inventory audits can help ensure ongoing compliance with Generally Accepted Accounting Procedures (GAAP).
2. Identify inefficiencies.
Audits may reveal many inefficiencies, from unexpected shrinkage to damage-prone items to how products are stored and picked. Resolving these issues can help companies improve their processes and, most importantly, the bottom line.
3. Eliminate phantom inventory.
Phantom inventory appears to be available in storage, but in reality is unavailable. This is a problem not just from an audit standpoint—remember, we’re trying to match physical inventory to financial records—but for your customers as well. No one likes to place an order for an item that appears to be available, only to be told it’s out of stock.
4. Reveal actual profit margins.
Maintaining a precise view of profit margins can be more elusive than it may seem. Without a clear picture of stock counts, cost of goods, overhead and indirect costs, shrinkage, and other factors, it’s virtually impossible to accurately determine profit margins, whether by SKU, category, or as an organization overall.
5. Optimize inventory.
At the end of the day, every organization is striving to stock the right items in the right amounts. Effective inventory audits can help guide the decision to phase out low-value items or increase stock of profitable, high-demand items. Maintaining optimal inventory is not just a good business practice—it makes your customers happier, too.
How to run a standard inventory audit
A standard inventory audit uses the complete physical inventory count method (more on this below) and can be accomplished using the following steps:
- Set a date and establish a cutoff analysis.
- Assign team members to perform the audit.
- Record pre-count inventory.
- Observe the physical inventory.
- Tag inventory (for example, with barcodes).
- Check inventory against pre-count inventory.
- Rectify discrepancies and repeat Steps 4 and 5 to ensure accuracy.
What are some common inventory audit procedures?
Most often, an inventory audit begins with counting physical inventory. Simple, right? Yes and no. Let’s discuss two different inventory methods.
A complete physical inventory count can be a highly disruptive procedure. This type of count must be processed by hand with barcode scanners—and requires that no inventory be moved in or out of your facility for the entire duration of the count.
To avoid discrepancies, auditors will often perform a process known as a cutoff analysis. Even though you may have made an honest effort to halt all flow of inventory, that’s sometimes a tricky process, so as part of the audit process, auditors will examine the last transactions before the physical count, along with those immediately following it, to help verify the accuracy of the count.
A cycle count, on the other hand, is a count procedure in which only a small portion of inventory SKUs are counted. Cycle counts are more common among large companies moving significant amounts of inventory, and while far less disruptive than physical inventory counts, they must be completed far more often. Cycle counts are a continuous process which may be completed weekly or even daily.
The benefits of cycle counts are numerous. Beyond being less disruptive than physical inventory counts, they can give organizations a much more up-to-date, if not real-time, view of their inventory status, therefore proving the ability for a nimble, proactive approach to inventory management.
So, cycle counts are the obvious choice, right? Again, it’s not quite that simple. Because cycle counts are performed on a perpetual basis, they may require dedicated staff and tools that come at a cost to the bottom line. And, for many companies, even if they are performing daily, weekly, or monthly cycle counts, that doesn’t eliminate the need for an annual physical inventory count.
ABC analysis. Thisis a process for prioritizing inventory according to its value. The number of inventory groups can vary, but it’s common for businesses to create three groups. A inventory is often comprised of high-value items or items that tend to move quickly. B inventory is mid-tier items that still have value for your business. Finally, C inventory, which some are surprised to find makes up the majority of inventory, is low-value items that tend to have long cycle times and low sales volume. An ABC analysis can offer value in several ways, from creating discounting strategies to deciding which SKUs to eliminate, moving forward.
Overhead analysis. Reflecting the reality that labor and materials are only part of the cost of inventory, an overhead analysis looks at ways that the cost of running a business—rent on a warehouse, for example—impacts overall inventory cost. When a business considers overhead costs in the calculation of its overall inventory valuation, auditors will take a close look at the way those costs are tracked. Are you using the same general ledger accounts as the source for your overhead costs? Did you incorrectly categorize an abnormal cost—unexpected equipment repairs, for example—as overhead? These are just a couple of the things auditors will examine.
Finished goods cost analysis. If finished goods represent a large percentage of the inventory valuation, auditors may want to “work backwards” to ensure that any given bill of materials for finished goods accurately reflects the components needed to create those goods—and their costs.
General ledger reconciliation compares the inventory count to what is shown in the general ledger. By confirming that the balance counted is accurately reflected in a company’s accounting records, auditors can identify discrepancies so that they can be resolved.
Freight cost analysis determines how much it costs to get products from one place to another. These shipping costs are typically calculated as part of the overall value of inventory, but may also be charged as an expense. Whichever you choose, it’s important to be consistent so that auditors can get a clear picture of these costs.
Analytical procedures. As discussed, an inventory audit goes far beyond matching inventory to financial records. Analytical procedures look for patterns in metrics like margins, costs, and turnover—all valuable metrics as you plan for the future.
Example of an inventory audit
Company A has just received 10,000 units of raw materials (polycarbonate plastic) from a new supplier that it will use to convert into high-end plastic bottles for the medical industry. Prior to production, the owner wishes to ensure accuracy of the order and issues a work order to the operations manager to complete an inventory audit.
To mitigate the risk of human error, the operations manager tasks two members of the operations team who are unaware of the pre-count inventory estimate to perform a manual audit while new shipments are placed on hold. The team members perform the audit, tagging and scanning each unit of raw materials during the process.
The team members then return to the operations manager to record and reconcile the manual audit figure against the pre-count inventory estimate of 10,000 units.
Most common inventory audit risks
While performing an inventory audit is designed to identify and mitigate business risks such as fraud and inefficient practices, the act of performing an inventory audit itself comes along with several risks which should be considered. These include:
- Risk of damaged goods as inventory is handled or moved during the audit process.
- Risk of human error resulting in bookkeeping inaccuracies and fulfillment issues.
- Risk of business disruption during the inventory audit process.
Can technology help with audit procedures?
Smart businesses are using an array of technology to increase the speed and accuracy of inventory audits. For physical counts, devices such as smart glasses, body cameras, and even drones are being used to execute and document the counting process. In light of pandemic concerns, these technologies can also reduce the need for auditors to be on site, instead observing remotely via live video feed. It’s even common to see robots on warehouse floors during audits!
Beyond the collection of raw data, AI-powered technology can scan and identify millions of images quickly and count the items captured in the images, greatly reducing the need for manual counting.
A final word
It’s time for businesses to change the way they view inventory audits. Long thought of as an operational necessity, they have rapidly become a way to create a strategic advantage. Smarter processes, lower overhead, higher profit margins, and more satisfied customers can all be achieved through effective inventory audits. Learn more about how to manage your inventory from start to finish with QuickBooks Enterprise.
