Thu, Dec 1, 2022

Defining Inventory

When one thinks of inventory, the physical items in storage or warehouse facilities may come to mind. Yet the term is much broader. Inventory consists of owned items that are held for sale or consumption in the production of goods and services. These include items physically on hand at all locations other than items on consignment, items not on hand but those where the risk of loss rests with the company, in transit to the company with shipping terms of free on board (FOB) shipping point, items held by a vendor when the risk of loss has passed to the company, items held on consignment where the entity is the consignor, inventory in possession of bailers, and items in transit to a customer with shipping terms of FOB destination.

So, when addressing inventory management procedures, one needs to factor in the management of all the above, not just what’s stored in the company warehouse. What this means is that inventory management can, in some cases, be a highly complex function of a business's operations. Its complexity will depend on several factors, including the quantities and varieties of inventory and materials; the intricacies of the business operations, locations, supply chains and material shelf life/expiration; and the cyclicality of the business. Furthermore, such macro factors as interest rates, currency exchange rates, commodity prices, tax and legislation will influence inventory and, thus, the bottom line.

Inventory Policy

Any business with inventory should begin its inventory and materials management controls function by drafting, reviewing and updating an inventory policy. To facilitate the process, the business should begin with an outline that highlights key factors, such as the control of inventory (who and how it is managed and accounted for), its valuation (which is not static as prices change over time), and losses or shortages (where, when and how the loss came about and what risk management tools are in place to prevent or mitigate loss in the future). The policy should apply to all inventory items, including raw materials, work-in-progress, finished goods and consigned inventory.

Here's a short list of procedures to get started:

  • Inventory valuation
  • Slow-moving and excess inventory/reserves
  • Reconciliation of perpetual inventory
  • Physical inventory
  • Consigned inventory
  • Scrap/excess materials
  • Intercompany transfers
  • Capitalized costs

The valuation method for each item of inventory should remain consistent from one accounting period to the next accounting period unless regulatory requirements and/or tax laws change and, therefore, are noted accordingly.

The Inventory Valuation Policy

Valuation is at the top of the above list for a reason. It affects all businesses and will have meaningful and measurable effects on both the top and bottom lines of a business.

A valuation policy should outline a set of procedures to ensure that inventory will be properly controlled and prevent losses or shortages. Parts of a valuation policy can be considered standard across all industries. Yet, in its entirety, it is far from a cookie-cutter document; rather, it is unique to both the industry and the business, recognizing that they each have their own set of idiosyncratic risks as well as unique infrastructures and operations.

As an example, a valuation policy may state that all inventory should be properly controlled to ensure the accuracy of records for materials, work in process, and finished or partly finished new or used goods, and spares — only those supplies that have been acquired for sale or which will become a part of the merchandise intended for sale. This policy may discuss the "lower of cost or market" valuation method and state that it should be applied to actual inventory quantities when determining the value of each item of inventory.

Physical Inventory Policy

As there are physical and non-physical inventories, it’s advisable to separate physical inventories as they have their own set of characteristics and risks.

A physical inventory policy provides guidance for a company and its subsidiaries regarding the need to take regular physical inventories of the business’s raw material, work in process, finished goods and store inventories (if applicable).

A company may use various types of inventories in the course of business. Maintaining adequate controls over inventory is crucial to ensure proper balance sheet valuation and recognition of the cost of products/goods sold. Furthermore, a physical inventory provides an opportunity to maintain the accuracy of perpetual inventory records. Under this policy, procedures should ensure that all physical inventory results are summarized, discrepancies are investigated and necessary adjustments are recorded.

Inventory Process Flow

With the appropriate inventory policies in place, the next step is to develop an inventory process flow. This process flow focuses on the following subprocesses within manufacturing and inventory:

  • Bill of materials
  • Standard cost
  • Sales forecasting and purchasing
  • Receiving and inventory locations
  • Material transfer
  • Configure-to-order (CTO) orders
  • Physical inventory count
  • Inventory reserve calculation
  • Inventory in transit accrual
  • PPV amortization
  • Manufacturing overhead variance amortization

One should continuously monitor the process to ensure that the steps described are accurate.

The SIOP Process

SIOP is an acronym for sales, inventory and operations planning. A properly implemented SIOP process can deliver value that spans demand, supply and product management, while simultaneously driving financial discipline.

Many may be familiar with the traditional SIOP process. Yet there is a more advanced approach that integrates business planning to include inventory as a category, typically a missing key factor in the more traditional SIOP approach.

An SIOP process can provide a competitive advantage by allowing organizations to be more agile, reduce working capital costs and increase speed to market.