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Inventory Internal Controls

Published on June 30, 2016

A company's investment in inventory is usually a large one, and it may be comprised of a large number of merchandise items that can be readily stolen and resold. If the inventory contains mostly raw materials, keeping track of it is essential for ensuring that the production processes using it will not run short of materials.

This means that you need to implement an array of controls, either to prevent theft or to ensure that the manufacturing operation does not run short of inputs. We will describe below a number of the key controls you should consider for your inventory investment.

 Key internal controls for your inventory are:

  • Fence and lock the warehouse. The single most important inventory control is simply locking down the warehouse. This means that you construct a fence around the inventory, lock the gate, and only allow authorized personnel into the warehouse.
  • Organize the inventory. It may not seem like a control to simply organize the inventory in the warehouse, but if you cannot find it, you cannot control it. Thus, a fundamental basis for inventory internal control is to number all locations, identify each inventory item, and track these items by location.

  • Count all incoming inventory. Do not just take the word of the supplier that the quantity stated on the delivery is the correct one. Count the inventory before recording it "as received". This keeps errors from being introduced into the inventory records.

  • Inspect incoming inventory. Verify that all incoming inventory is of the correct type and is not damaged. All items that fail inspection should be returned at once, and the accounts payable staff notified that the returned items should not be paid for.

  • Tag all inventory. Every scrap of inventory in the warehouse should be identified with a tag or the inventory location tagged, which states the part number, description, unit of measure, and quantity. Otherwise, inventory items are bound to be misidentified.

  • Segregate customer-owned inventory. If there is inventory on-site that customers own, the warehouse staff will likely count it as though it is owned by the company, so have a procedure in place for labeling these items as customer-owned when they arrive, and segregate them in a separate part of the warehouse.

  • Standardize record keeping for inventory picking. When an item is picked from the shelf in the warehouse, for use either in the production area or for sale to customers, have a standard procedure for developing the pick list by customer or work order, identification of the employee doing the picking, and for recording the picks in the inventory and billing system as soon as they leave the warehouse (which is easier if there is a warehouse fence, and inventory can only pass through a single controlled gate).

  • Sign for all inventory removed from the warehouse. If inventory items are being removed from the warehouse for reasons outside of the normal picking process, have the person removing the inventory sign for the removal, so that there is a record of who is responsible.

  • Audit the bill of materials. The bill of materials is a record of the parts used to construct a product. The bill of materials is used to pick items from stock, so if the bill is incorrect, pickers will pull incorrect amounts from the warehouse. This calls for a periodic audit of every bill, as well as password-only access to the bill of material records in the computer system.

  • Trace extra requisitions and returns. If the production staff asks for extra issuances of parts, or returns excess amounts to the warehouse, then there is an error in the picking records (possibly in the bill of materials, as just noted).

  • Conduct a periodic obsolete inventory review. The warehouse can eventually become choked with obsolete inventory that cannot be used, which requires high storage costs and also interferes with the components that are needed in production. Form a materials review board that periodically combs through the inventory records to determine which items should be sold off or otherwise eliminated.

  • Conduct cycle counts. Have the warehouse staff conduct small, frequent counts of a small portion of the inventory, and investigate and correct any errors they find. This gradually improves the inventory record accuracy.

  • Investigate negative-balance inventory records. If the accounting records show that there is negative inventory on hand, then there is obviously a transactional flaw that caused the negative balance. This is a prime target for a detailed investigation.

  • Record scrap transactions. Do not just throw scrap in a scrap bin when it occurs. If you do, the accounting system still thinks the scrapped item is in stock, and so will overstate the amount of inventory. Instead, create a procedure to track scrap on a regular basis.

  • Focus on Demand Forecasting.  Using information available from the sales system, market demand reports, and general economic conditions, the amount of inventory needed and the timing of the need can be forecasted to insure adequate inventory for sales or operations.

  • Order points and order quantities.  Consider implementing a system that has preset order points where the system notifies you to replenish inventory stock when inventory reaches those order points.  Also, consider identifying pre-set order quantities based on manufacturing usage or sales.

A number of problems may still arise with inventory record accuracy despite these controls, so be prepared to add more controls if the problems are persistent.