Inventory management is a key balance sheet item for many companies. Depending on the nature of your operations, inventory may include raw materials, work-in-progress (WIP) inventory, and finished goods. While you need to have enough inventory on hand to meet your customers’ needs, carrying excessive amounts can be costly. Here are some smart ways to manage inventory more efficiently — without compromising revenue and customer service.

Reliable counts

Effective inventory management starts with a physical inventory count. This exercise provides a snapshot of how much inventory your company has on hand at that point in time. For example, a manufacturing plant might need to count what’s on its warehouse shelves, on the shop floor and shipping dock, on consignment, at the repair shop, at remote or public warehouses, and in transit from suppliers and between company locations.

The value of inventory is always in flux, as work is performed and items are delivered or shipped. To capture a static value as of the reporting day, companies may “freeze” business operations while counting inventory. Usually, it makes sense to conduct counts during off-hours to minimize the disruption to business operations. For larger organizations with multiple locations, it may not be possible to count everything at once. So, larger companies often break down their counts by physical location.

Accuracy is essential to knowing your cost of goods sold, as well as to identifying and remedying discrepancies between your physical count and perpetual inventory records. Possible reasons for discrepancies include:

• Data entry errors,
• Inaccurate bin or part numbers,
• Shipping errors,
• Inventory in the authorized possession of employees (such as owners or salespeople),
• Theft, and
• Intentional financial misstatement.

It’s important to identify what’s happening and resolve any problems or errors.

Benchmarking studies

The next step is to compare your inventory costs to those of other companies in your industry. Trade associations often publish benchmarks for:

• Gross margin [(revenue – cost of goods sold) / revenue],
• Net profit margin (net income/revenue), and
• Days in inventory (annual revenue / average inventory × 365 days).

Your company should strive to meet — or beat — industry standards. For a retailer or wholesaler, inventory is simply purchased from manufacturers. However, inventory is more complicated for manufacturers and construction firms. These entities must allocate costs to projects that are in progress.

Efficiency measures

What can you do to improve your inventory metrics? The composition of your company’s cost of goods will guide you on where to cut. In today’s tight labor market, it may be difficult to reduce labor costs. But it may be possible to renegotiate prices with suppliers.

And don’t forget the carrying costs of inventory, such as storage, insurance, obsolescence, and pilferage. You can also improve margins by negotiating a net lease for your warehouse, installing antitheft devices, or opting for less expensive insurance coverage.

To cut your days-in-inventory ratio, compute product-by-product margins. You might stock more products with high margins and high demand — and less of everything else. Consider returning excessive supplies of slow-moving materials or products to your suppliers, whenever possible.

Product mix can be a delicate balance, however. It should be sufficiently broad and in tune with consumer needs. Before cutting back on inventory, you might need to negotiate speedier delivery from suppliers or give suppliers access to your perpetual inventory system. These precautionary measures can help prevent lost sales due to lean inventory.

Inventorying your inventory

Management often focuses on growth and puts inventory management on the back burner. This can be a costly mistake. Contact us for help researching industry benchmarks and calculating inventory ratios to help minimize the guesswork in managing your inventory.

External auditors spend a lot of time during fieldwork evaluating how businesses report work-in-progress (WIP) inventory. Here’s why this warrants special attention and how auditors evaluate whether WIP estimates seem reasonable.

Valuing WIP

Companies may report various categories of inventory on their balance sheets, depending on the nature of their operations. For companies that convert raw materials into finished goods, a key element is WIP inventory. This refers to partially finished products at various stages of completion. Management uses estimates to determine the value of WIP. In general, the more materials, labor, and overhead invested in WIP, the higher its value.

Most experienced managers use realistic estimates, but inexperienced or dishonest managers may inflate WIP values. This can make a company appear healthier than it really is by overstating the value of inventory at the end of the period and understating cost of goods sold during the current accounting period.

Accounting for costs

Companies assign costs to WIP depending on the type of products they produce. When a company produces large volumes of the same product, they allocate costs as they complete each phase of the production process. This is known as standard costing. For example, if a production process involves six steps, at the completion of step two the company might allocate one-third of their costs to the product.

On the other hand, when a company produces unique products — such as the construction of an office building or made-to-order parts — it typically uses a job costing system to allocate materials, labor, and overhead costs as incurred.

Auditing WIP

Financial statement auditors closely analyze how companies quantify and allocate their costs. Under standard costing, the WIP balance grows based on the number of steps completed in the production process. Therefore, auditors analyze the methods used to quantify a product’s standard costs, as well as how the company allocates the costs corresponding to each phase of the process.

With job costing, auditors analyze the process to allocate materials, labor and overhead to each job. In particular, auditors test to ensure that costs assigned to a particular product or projects correspond to that job.

Recognizing revenue

Auditors perform additional audit procedures to ensure that a company’s recognition of revenue complies with its accounting policies. Under standard costing, companies typically record inventory (including WIP) at cost, and then recognize revenue once they sell the products. For job costing, revenue recognition typically happens based on the percentage-of-completion or completed-contract method.

Get it right

Under both the standard and job costing methods, accounting for WIP affects the balance sheet and the income statement. Contact us if you need help reporting WIP. We can help you make reliable estimates based on your company’s specific production process.