Inventory Essentials is a two-part series. This article will focus on a basic understanding of inventory and counting systems, while the second article will focus on error resolution and prevention.
Inventory is a critical asset. It can help manufacturers fulfill demand, reduce costs through quantity discounts, or increase profitability by improving production efficiencies. However, holding too much inventory can harm a business by depleting cash, wasting labor resources, or reducing stated profit when write offs are needed. As a result, a manufacturer must manage its inventory levels.
Types of Inventory
For most manufacturers, inventory includes:
- Raw Materials: materials or parts used to manufacture a sellable product. You likely purchase raw materials from suppliers. Think of raw materials as the “ingredients” in the product you will sell to customers.
- Work in Process (or WIP): products that are partially made or “in process”. Some but not all production processes are complete. Some companies do not have WIP inventory.
- Finished Goods: products that are complete. All manufacturing processes are finished, and these products are ready to sell to customers.
Physical Inventory vs. Cycle Counts
Verifying inventory levels is a fundamental internal control practice. For financial statement or tax purposes, you may be required to take a physical inventory even if you maintain a perpetual counting system. It is recommended that all businesses, whether required or not, confirm their inventory counts regularly. Some manufacturers perform both physical and perpetual counts. Choosing the best inventory validation process is dependent on your business, your inventory, and the processes and controls you have in place.
Manufacturers may take physical inventory counts annually, semi-annually, quarterly, or even monthly. Operations are halted, and all items – raw materials, WIP, and finished goods - are counted. Counts are reconciled with the accounting system inventory. Physical inventory counts provide a “clean slate”, which can be beneficial as you enter a new year or fiscal period. Depending on your inventory size, physical inventories can be time-consuming and costly. However, physical inventory and planned operational shutdowns can be scheduled simultaneously to reduce the impact of downtime.
With cycle counting, a sample of inventory is counted at specific times and in specific frequencies. The sample may be random or determined by other methods, such as the ABC or 80/20 method. Manufacturers should consider their business, inventory, and the support their inventory management software offers when selecting a cycle count method. Cycle counts cause less disruption than a physical inventory because a complete operational shutdown is not required. They may also improve the accuracy of inventory during the year. This may help purchasing agents make better decisions since they can better predict replenishment needs.