To count or not to count

Effects of Inventory Errors

Article written by EricBank

The difference between inventory selling price and acquisition cost is the basis for a merchandizing company's profits. The speed at which you restock inventory depends on your sales volume. To figure how quickly you are moving inventory, you can compute a measure called turnover. However, you have to avoid inventory inaccuracies lest you end up with misleading results.

Inventory Costs

As we've discussed in previous blogs, the cost of goods sold and gross profits are calculated thusly:

COGS = inventory purchases + beginning inventory - ending inventory

Gross profits = net sales - COGS = (sales - refunds -discounts) - COGS

To satisfy the IRS, you'll have to make a physical inventory count at reasonable intervals and apply adjustments to balance sheet inventory to realign it with the actual counts. You should look upon the requirement to take physical counts as a blessing, because you'll inevitably find discrepancies arising from shrinkage, damage, spoilage and other reasons.

Turnover Ratio

A successful merchandizer sells stock on hand and replenishes it with more inventory. Use the inventory turnover ratio to quantify this process:

Turnover ratio = COGS / average turnover

                      = COGS / ((beginning inventory + ending inventory) / 2)

Your goal is to increase your turnover ratio, because that indicates you are operating efficiently. A falling ratio is a red flag, since it means you have too much stock on hand. This is risky, because it increases storage costs and the chances that your older stock will become obsolete or spoiled. Ideally, you would never experience a stock-out and would only carry the amount of inventory you immediately need. Returning to reality, you have to settle for a respectable turnover ratio while keeping stock-outs and backorders to a minimum. Naturally, what constitutes a good turnover ratio depends on the industry you're in.

Effect of Errors

Let's examine sources of error in the turnover ratio's numerator, which is COGS, and in its denominator. COGS errors can occur for numerous reasons. For example, you are supposed to write down obsolete inventory, and failure to do so will understate your COGS, because it needs to absorb the loss in value of the obsolete stock. Your turnover ratio will be misleadingly low if you understate COGS. Denominator errors can crop up if you miscount or improperly record ending inventory. For example, you'll overstate turnover ratio and understate ending inventory if you fail to count everything you've stocked. Of course, errors in reporting your COGS or ending inventory will skew your tax bill, which is never a good thing.

Considerations

One excellent strategy to catch errors early on is through cycle counting. In case you're not familiar with the term, it refers to taking a partial count every day until you cycle through all your stock. Then you start all over again. Damaged and missing inventory will turn up during these spot checks. Keep in mind that, under generally accepted accounting principles, you have to restate your prior-period financial results arising from "material" errors, which are errors that result in incorrect actions. Sometimes, errors cancel over time. For example, overstating net income and ending inventory in one period will usually lead to understating these in the next period.