Time to Act
Charlie Goodrich 


Proper accounting and controls for inventory is, at best, mind numbing. But it's also important. So much so, that its absence is a constant, hidden referral source for much of my distressed client work.

It's a big topic - too much for one newsletter. And so today, we address why it matters as well as identify some of the common inventory red flags. Future editions will consider remedies.
Your comments are always welcome. Just click "reply" to send them to me.
Charlie Goodrich 

Founder and Principal

Goodrich & Associates
August 2013 Vol. 2 No. 8
In this issue...
Inventory Can Hide the Unknown Unknowns - The Importance of Proper Accounting and Controls
Heard on the Street
About Us
Goodrich & Associates
[email protected]
Inventory Can Hide the Unknown Unknowns - The Importance of Proper Accounting and Controls
Several years ago, I found myself in the Rent-A-Car business, with a fleet of 18,000 cars. Said differently, I was responsible for $300MM in inventory that was on wheels. A scary thought, made worse by the fact that most of it was rented to anyone with a credit card and driver's license (fake or not).

My first order of business, therefore, was to build a staff for tracking vehicles, to make sure they were not on permanent rent. Fortunately, and thanks to the extra attention paid, we had "negative-shrinkage" - our inventory of cars grew modestly, as we found and recovered vehicles that had already been written off.

Why is proper accounting and control over inventory important? Many reasons.
  • For retailers and wholesalers, you can't sell what you don't have and you don't want to reorder what you do have. In the manufacturing world, running out of inventory means a costly production disruption, whereas more inventory than you think you have results in space problems and increased material handling costs.
  • Inventory can hide P&L problems. If inventory costs are wrong, then usually expenses on the P&L are wrong. One distressed client of mine, for example, botched an ERP installation in a way that botched inventory cost. The net result was that inventory was grossly overstated, leading to a surprise loss when the standard costing was eventually corrected.

    In another instance, when I was CFO of the S. S. Pierce Company that Kraft Foods had just acquired, I was sent in to bring the Company's finances up to speed. It was a mess. Vendors were shutting the company off for non-payment and Kraft's problem was what to do with all the cash it generated. As we began to clean things up, we learned that many invoices had been double-paid, something the Company's computer system had no safeguards against. The clerks had been cutting checks for whatever invoice they saw, to keep product flowing. Where did those payments go in the accounting system? Inventory!
  • Inventory valuation, for many companies, directly effects how much the bank will lend them. When inventory is overstated, companies can borrow more money than they should. When the bank finds the problem (they usually do), the company has to pay the excess amount back to the bank immediately and often find a new, higher cost lender. Back to the botched ERP example - their lenders forced the company into bankruptcy because they had lent too much money based on the overstated value of the inventory.
As you can see, poor inventory controls and accounting leads to bad things all around. So what are the red flags? There are many, but here are four of the most common:
  1. The CFO thinks inventory is the responsibility of operations (or is otherwise not keeping a close watch on the inventory ball). One of my clients was forced into bankruptcy because the surveyors found the company's inventory to be worth much less than what had been reported to the bank.* When I finally got a copy of the inventory records from the COO, they were in an archaic Microsoft format, one that not only predated Excel, but Lotus 123!.

    [*This company was in the scrap metal business. To take a physical inventory, a surveyor would come in, measure the size of the scrap piles, take samples for weight and metal type, and then comes up with a value.]
  1. Lots of "out of stocks" or negative item counts. Both are a sign of poor controls over the physical inventory records (negative item counts means the product was physically there and sold, but not on the inventory records.)

    Often, this is as much a problem with operations ignoring or being ignorant of proper controls and procedures. For example, operations may ship a substitute product because the ordered product is out of stock. Instead of invoicing the product shipped, the product ordered is invoiced. As a consequence, there is negative inventory in the out of stock product and too much inventory in the in stock product.

    A client of mine that was in the materials distribution business struggled to get operations to properly receive inventory and accurately record what was shipped. Items were over ordered because they appeared out of stock. More expensive near substitutes were sold in lieu of the out of stock item, but the item ordered was relieved from inventory instead of the more expensive substitute that was shipped. Margins shrank and inventory was a mess. Such a mess, a lender declined to make a loan.
  1. Infrequent physical inventories. Mistakes do happen, even in well run companies. Or, perhaps, the inventory is literally walking out the back door, with employee help of course. Either way, and unless you physically count inventory from time to time, you never know.
  1. Perpetual inventory is not reconciled to general ledger inventory. This is the biggest red flag of all. Most businesses with large inventories, particularly distributors, have a computer system that tracks when an item is received, where it is stored in a warehouse, and lowers the inventory count when the item is shipped or used in a manufacturing process. That system, the perpetual system, uses the cost of the item to determine the inventory value.

    The general ledger system, on the other hand, adds dollars to inventory when goods are received and takes the dollars out of inventory and charges them to cost of goods sold when the goods are shipped or used. The general ledger inventory value and the perpetual inventory value should equal. Often they don't (or if they do, it is because an accountant arbitrarily adjusted the general ledger inventory to the perpetual).
As you can see, improper accounting and control of inventory can lead to all kinds of (often devastating) problems. Future issues of this newsletter will examine how to do this properly!

Heard on the Street
An economic outlook for the USA, shared by many these days, is for slow, steady growth.

Van Hoisington and Lacy Hunt of Hoisington Investment Management, however, have a decidedly more pessimistic view and a belief that long-term interest rates will come back down.

Click here for their somewhat contrarian perspective.

About Us
Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent financial problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years experience in this area.

To ensure that you continue to receive emails from us, please add
[email protected] to your address book today.

Goodrich & Associates respects your privacy.
We do not sell, rent, or share your information with anybody.

Copyright © 2013 Goodrich & Associates LLC. All rights reserved.

For more on Goodrich & Associates and the services we offer, click here.

Newsletter developed by Blue Penguin Development