Control Inventory before It Controls You

By Mary Ellen Biery, Research Specialist, Sageworks Inc.

Today's uncertain economic environment means business owners and CFOs want to have as much cash on hand as possible for "unknowns," and that means making sure your money isn't tied up in inventory too long.
 
Recent data shows that privately held companies in the United States, on average, have seen their inventory-days ratio increase 16 percent since 2009. That means the number of days from when raw materials are purchased to when finished goods are sold is up to nearly 24 days from about 20.5 days three years ago. 
 
Of course, some inventory growth is necessary when sales are rising, and sales have been on the increase for private companies. 
 
"I've always been an advocate of the less inventory the better, but you have to be able to meet demand," said Michael W. McNeilly, director of advisory services for Sageworks Inc.
 
But he and other experts say that cash is the lifeblood of a business, so it's a good idea to manage inventory closely. Coupled with later customer payments, which many U.S. businesses are experiencing, a longer inventory turnover cycle means less money that's available to buy new equipment, hire, or otherwise grow your business.
 
McNeilly has worked with a lot of businesses operating with the traditional belief that keeping a lot of inventory helps create a better presentation of merchandise for customers. 
 
"Some business owners may also believe more inventory allows them to obtain bulk-purchase discounts from suppliers," he said. "That may sound good, but bulk purchases in a lot of situations only take up space and tie up cash. It's always a balancing act, but today's marketplace will often allow for a smaller inventory on hand with same-day or next-day delivery on additional inventory."
 
"Having good control of your inventory allows you to not only offer a wider selection of products but also can free up significant levels of cash flow while still providing the service your customers demand," he said.
 

Balancing Risk and Audit Standards for Inventories

Specific Auditing Standards for inventory are published in the AICPA Professional Standards, AU Section 331. Some of the key issues include:

  • Inventory observation is a generally accepted auditing procedure (before the McKesson Robbins case inventories could be confirmed by owners).
  • For physical counts of inventory, the auditor must usually be present at the time of the count to observe count procedures, make test counts and inquire about potential risks of material misstatement.
  • For accurate perpetual inventory records, the auditor's observation procedures may be performed at periods during or after the year being audited.
  • For statistical methods of sampling inventory, the auditor must be satisfied that the client's methods produce reliable results that are substantially the same as a count of all items. 
  • For inventories held in public warehouses, quantities may be confirmed but additional procedures are usually necessary. 
– By Larry Perry, CPA
Consultant Bob Phibbs, who has worked with Lumber Liquidators, Hunter Douglass, and others through his firm, The Retail Doctor, says a good place to start with managing your inventory is performing a physical count. This is a good idea for insurance purposes. "It's also a major determiner of your store's health," he said. 
 
Once you have an inventory count, you can figure your "open-to-buy" (how much you can purchase based on what you already have in your store). You should also get a better picture of your "shrink," which is the difference between what you thought you had and what you actually have - usually caused by not checking invoices, incorrectly keying items, and theft. And you can plan changes. "Without a physical inventory you do not have accurate information," Phibbs said.
 
Here are some other tips for improving inventory management:
  • Oversee ordering. Carefully manage the order points for inventory - the "who-orders-what-when" side of the business. Utilize a system that allows the business to order quickly when needed so your cash isn't tied up in merchandise.
  • Study sales. Watch the sales patterns of goods to learn what's sitting for too long or not moving at all. If sales of certain items are low, discounts may be necessary to get them out and replaced with something that will move.
  • Examine inventory. Continuously look at your inventory on a product basis to see what's moving. As with your study of sales, doing this may lead you to offer discounts to get overstocked or undesirable merchandise off the shelves so that fast-selling inventory can replace it. Discounts may also attract more customers to the store.
  • Fine-tune forecasting. Make sure your business is using a good system to forecast inventory needs. You want inventory/supply levels to be as low as possible without adversely affecting the business. Here's where your accountant may be able to provide valuable experience-based advice on how to use your bookkeeping system more effectively, how to improve internal controls, or how to otherwise view and manage inventory.
  • Study suppliers. Identify not only your current suppliers, but also some options. Those alternative suppliers may be eager to earn your business. "Pressing suppliers to deliver inventory quickly to you allows you to utilize the supplier for warehousing," McNeilly said. "Having a better understanding of available suppliers and their pricing and delivery capabilities, along with a better understanding of your inventory needs, will allow for quick improvement on cash flow."
 
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About the author:
Mary Ellen Biery is a research specialist at Sageworks, a financial information company that provides financial analysis and benchmarking applications to accounting firms and private companies. She is a veteran financial reporter whose works have appeared in The Wall Street Journal and on Dow Jones Newswires, CNN.com, MarketWatch.com, CNBC.com, and other sites.

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