inventory

Lean manufacturers: Reap the benefits of lean accounting

Standard cost accounting doesn’t necessarily work for lean operations. Instead, lean accounting offers a simplified reporting alternative that generates more timely, relevant financial data. But it’s not right for every situation.

What’s lean manufacturing?

Lean manufacturers strive for continuous improvement and elimination of non-value-added activities. Rather than scheduling workflow from one functional department to another, these manufacturers organize their facilities into cross-functional work groups or cells.

Lean manufacturing is a “pull-demand” system, where customer orders jumpstart the production process. Lean companies view inventory not as an asset but as a waste of cash flow and storage space.

Why won’t traditional accounting methods work?

From a benchmarking standpoint, liquidity and profitability ratios tend to decline when traditional cost accounting methods are applied to newly improved operations. For example, to minimize inventory, companies transitioning from mass production to lean production must initially deplete in-stock inventories before producing more units. They also must write off obsolete items. As they implement lean principles, many companies learn that their inventories were overvalued due to obsolete items and inaccurate overhead allocation rates (traditionally based on direct labor hours).

During the transition phase, several costs — such as deferred compensation and overhead expense — transition from the balance sheet to the income statement. Accordingly, lean manufacturers may initially report higher costs and, therefore, reduced profits on their income statements. In addition, their balance sheets initially show lower inventory.

Alone, these financial statement trends will likely raise a red flag among investors and lenders — and possibly lead to erroneous business decisions.

How does lean accounting work?

Standard cost accounting is time consuming and transaction-driven. To estimate cost of goods sold, standard cost accounting uses complex variance accounts, such as purchase price variances, labor efficiency variances and overhead spending variances.

In contrast, lean accounting is relatively simple and flexible. Rather than lumping costs into overhead, lean accounting methods trace costs directly to the manufacturer’s cost of goods sold, typically dividing them into four value stream categories:

  1. Materials costs,
  2. Procurement costs,
  3. Conversion costs, such as factory wages and benefits, equipment depreciation and repairs, supplies, and scrap, and
  4. Occupancy costs.

These are easier to understand and evaluate than the variances used in standard cost accounting. In addition, box score reports are often used in lean accounting to supplement profit and loss statements. These reports list performance measures that traditional financial statements neglect, such as scrap rates, inventory turns, on-time delivery rates, customer satisfaction scores and sales per employee.

Should your company abandon standard cost accounting?

Most companies are required to use standard cost accounting methods for formal reporting purposes to comply with U.S. Generally Accepted Accounting Principles (GAAP). But lean manufacturers may benefit from comparing traditional and lean financial statements. Such comparisons may even highlight areas to target with future lean improvement initiatives. Contact us for more information.

© 2019

How to prepare for year-end physical inventory counts

As year end approaches, it’s time for calendar-year entities to perform physical inventory counts. This activity is more than a compliance chore. Proactive companies see it as an opportunity to improve operational efficiency.

Inventory basics

Under U.S. Generally Accepted Accounting Principles (GAAP), inventory is recorded at the lower of cost or market value. There are three types of inventory:

  1. Raw materials,
  2. Work-in-progress, and
  3. Finished goods.

Estimating the value of inventory may involve subjective judgment calls, especially if your company converts raw materials into finished goods available for sale. The value of work-in-progress inventory can be especially hard to assess, because it includes overhead allocations and, in some cases, may require percentage-of-completion assessments.

Physical counts

A physical inventory count gives a snapshot of how much inventory your company has on hand at year end. 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.

Before counting starts, you should consider:

  • Ordering or creating prenumbered tags that identify the part number and location and leave space to add the quantity and person who performed the count,
  • Conducting a dry run a few days before the count to identify any potential roadblocks and determine how many workers to schedule,
  • Assigning two-person teams to count inventory to minimize errors and fraud,
  • Carving the location into “count zones” to ensure full coverage and avoid duplication of efforts,
  • Writing off any unsalable or obsolete items, and
  • Precounting and bagging slow-moving items.

It’s essential that business operations “freeze” while the count takes place. Usually, inventory is counted during off-hours to minimize the disruption to business operations.

Auditor’s role

If your company issues audited financial statements, one or more members of your external audit team will be present during your physical inventory count. They aren’t there to help you count inventory. Instead, they’ll observe the procedures, review written inventory processes, evaluate internal controls over inventory, and perform independent counts to compare to your inventory listing and counts made by your employees.

Be ready to provide auditors with invoices and shipping/receiving reports. They review these documents to evaluate cutoff procedures for year-end deliveries and confirm the values reported on your inventory listing.

Making counts count

When it comes to physical inventory counts, our auditors have seen the best (and worst) practices over the years. For more information on how to perform an effective inventory count, contact us before year end.

© 2018

Signs of inventory fraud

Is your inventory being stolen by dishonest employees or customers? Inventory is a prime target for fraud schemes, second only to cash. And it doesn’t always involve the physical theft of items. Here are some early warning signs that your inventory has been targeted.

Know your risk profile

Some companies are more at risk for inventory fraud than others. Obviously, service companies with minimal inventory on hand bear little risk of inventory embezzlement; instead, it’s more common among retailers, manufacturers and contractors. In general, higher-value inventory items, such as electronics or jewelry, tend to be more attractive to thieves.

Sometimes, however, the inventory account is just a convenient place to hide financial misstatement ploys, such as skimming or bogus sales. Thousands of journal entries are typically made to the inventory account, and it’s closed out to cost of sales each year. So, thieves with access to the accounting systems may bury their scams in the inventory account. Then, victim-organizations may write off discrepancies between the computerized perpetual inventory records and physical inventory counts as external pilferage, obsolescence or errors — when, in fact, it’s due to intentional manipulation of the accounting systems.

Monitor inventory metrics

If your year-end inventory counts aren’t adding up, don’t just write off the discrepancy as a cost of doing business; investigate why. You can shed light on the situation by computing various inventory ratios, including:

  • Days in inventory (average inventory divided by annual cost of sales times 365 days),
  • Gross margin (sales minus cost of sales) as a percentage of sales,
  • Inventory as a percentage of total assets,
  • Returns as a percentage of annual sales, and
  • Shipping costs as a percentage of sales.

These metrics should be consistent over time and comparable to industry benchmarks. Sudden changes require immediate action.

Catch fraud early

The median duration — from inception to detection of a fraud scam — is 18 months, according to the 2016 Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners. Many victims are unaware that inventory balances are inaccurate until they’ve accrued substantial losses. Diligent managers know the signs of inventory fraud and can identify anomalies early. Contact us for help investigating a suspected inventory scam.

© 2016

Tips for efficient year-end physical inventory counts

The basics

Inventory includes raw materials, work-in-progress and finished goods. Your physical inventory count also may include parts and supplies inventory. Under U.S. Generally Accepted Accounting Principles (GAAP), inventory is recorded at the lower of cost or market value.

Estimating the value of inventory may involve subjective judgment calls, especially if your company converts raw materials into finished goods available for sale. For example, the value of work-in-progress inventory includes overhead allocations and, in some cases, may require percentage-of-completion assessments.

A moving target

The inventory count gives a snapshot of how much inventory is on hand at year end. The value of inventory is always in flux, as work is performed and items are delivered or shipped. To capture a static value, it’s essential that business operations “freeze” while the count takes place.

Usually, it makes sense to count inventory during off-hours to minimize the disruption to business operations. Larger organizations with multiple locations may be unable to count everything at once. So, larger companies often break down their counts by physical location.

Proactive planning

Planning is the key to minimizing disruptions. Before counting starts, management can:.

  • Order (or create) prenumbered inventory tags,
  • Conduct a dry run to identify roadblocks and schedule workers,
  • Assign workers to count inventory using two-person teams to prevent fraud,
  • Write off any unsalable items, and
  • Precount and bag slow-moving items.

If your company issues audited financial statements, your audit team will be present during the physical inventory count. They aren’t there to help count inventory. Instead, they’ll observe the procedures, review written inventory processes and cutoffs, evaluate internal controls over inventory, and perform independent counts to compare to your inventory listing and counts made by your employees.

Beyond the count

When the inventory count is complete, it’s critical to investigate discrepancies between your computerized accounting records and physical inventory counts. We can use this information to help you evaluate how to stock items more efficiently and safeguard against future write-offs due to fraud, damage or obsolescence.

© 2016

Overview of inventory reporting methods

It’s critical to report inventory using the optimal method. There are several legitimate options for reporting inventory — but take heed: The method you choose ultimately affects how much inventory and profit you’ll show and how much tax you’ll owe.

The basics

Inventory is generally recorded when it’s received and title transfers to the company. Then, it moves to cost of goods sold when the product ships and title transfers to the customer. But you can apply different inventory methods that will affect the value of inventory on your company’s balance sheet.

FIFO vs. LIFO

Under the first-in, first-out (FIFO) method, the first units entered into inventory are the first ones presumed sold. Conversely, under the last-in, first-out (LIFO) method, the last units entered are the first presumed sold.

In an inflationary environment, companies that report inventory using FIFO report higher inventory values, lower cost of sales and higher pretax earnings than otherwise identical companies that use LIFO. So, in an increasing-cost market, companies that use FIFO appear stronger — on the surface.

But LIFO can be an effective way to defer taxes and, therefore, improve cash flow. Using LIFO causes the low-cost items to remain in inventory. Higher cost of sales generates lower pretax earnings as long as inventory keeps growing. To keep inventory growing and avoid expensing old cost layers, however, some companies may feel compelled to produce or purchase excessive amounts of inventory. This can be an inefficient use of resources.

Specific identification

When a company’s inventory is one of a kind, such as artwork or custom jewelry, it may be appropriate to use the specific-identification method. Here, each item is reported at historic cost and that amount is generally carried on the books until the specific item is sold. But a write-off may be required if an item’s market value falls below its carrying value.

Weighing your options

Each inventory reporting method has pros and cons — and what worked when you started your business may not be the right choice today. As you prepare for year end, consider whether your method is still optimal, given your current size and business operations, expected market conditions, and today’s tax laws and accounting rules. Not sure what’s right? We can help you evaluate the options.

© 2016