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Is performing a year-end inventory worth it?

Oct 28, 2020

I’m sure performing a full year-end physical inventory count is not on your list of favorite things to do.

And let’s face it, counting your inventory can be a tedious job, and oftentimes it even means shutting down your operations for a period of time to manage the process and ensure all items are counted properly. Couple that with the current COVID-19 global pandemic and challenges your company may be facing right now, and this laborious task could be more challenging or even seemingly impossible this year.

This may be the perfect time to reassess your current inventory procedures and determine whether a full year-end physical count is right for you. Below we discuss why accurate inventory balances are important, tips for an effective physical count and alternatives to a full year-end inventory count.

1. Advantages of having accurate inventory quantities

First and foremost, remember that GAAP and tax rules require that inventory quantities are accurately stated in year-end financial statements and tax returns. Adjustments are then made after the counts to record inventory quantities to what is actually on hand, leading to more accurate financial statement numbers — which will help management make better-informed decisions.

Physical inventory counts can also identify shrinkage issues that management may not have been aware of if the physical inventory was not performed. Even the best inventory systems can make mistakes, whether it’s due to the system itself or user error. Ultimately, a full physical count is the last way to identify errors and ensure that inventory is accurately stated. The last thing you want to assume is that you have sufficient inventory levels on hand to fulfill an important sales order, only to find out that the inventory shown in the system is nowhere to be found.

This is probably more crucial than ever, as your company may be experiencing decreased labor and sales levels during this unknown time of COVID-19.

2. Tips to an effective and efficient physical inventory count

If you decide a full physical inventory count at year-end is right for you, here are some tips and things you may want to consider:

  • Proper planning and preparation: Be sure to have a game plan in place and communicate the importance of the process to all individuals who will be involved. Tidy up your facilities and organize all inventory items beforehand to avoid hiccups on the big day.
  • Timing is everything: Make sure the timeframe you allow for counting is conducive to a good count.
  • Technology: Investing in some sort of scanning technology can be expensive up front but can significantly save time and money in the long run.
  • Map it out: Having a map of your warehouse or storage facility can be a great tool to ensure that all areas are being accounted for, as well as help your count team navigate effectively.
  • Choose wisely: Choosing your count team is also an important thing to take into consideration. A mix of employees who are familiar with the warehouse coupled with those that might provide a fresh perspective could be beneficial.
  • Hurry up and take your time: Take the time up front to adopt a durable labeling process to differentiate all boxes, crates, racks, etc. This will help not only for this year but also for adjusting counts throughout the following years as you rely on your perpetual inventory system as well as potential cycle counting procedures.

3. Is it really worth it? What are the alternatives?

Is a full physical count at year-end the only option? No. If you are simply conducting a full physical inventory because you think that is what your auditor or the IRS requires, you may be making an incorrect assumption. While it is true that auditors and the IRS do like the fact that a full physical inventory is performed each year, ultimately the only requirement is that your inventory values are adjusted to actual. This can be accomplished with an effectively managed perpetual inventory system.

The decision whether or not to perform a full physical inventory should be no different from any other business decision that you make and should be based on a cost/benefit analysis.

Let’s take a look at a real-life example. If a manufacturer produces $25 million in sales annually and we assume there are 250 production days in a year, then theoretically they are producing $100,000 of revenue each working day. Based on these facts, is it really worth it to shut down operations for a full day or more to count inventory? This question must be analyzed on a case-by-case basis, and the answer very well may be yes for some and no for others. In the end, one has to look at what “good” inventory accounting looks like and if that is really achieved by an annual shutdown. So what is the alternative?

One of the most common alternatives that companies have adopted is cycle counting. This method relies on periodic (e.g., weekly, bi-weekly, monthly) inventory counts of a smaller subset of inventory to reduce the need for a full inventory at year-end. All inventory units are counted on a rotational basis continuously throughout the year. Therefore, if you are comfortable with your perpetual inventory records, and your cycle counting process yields accurate results, you can likely use that process to completely eliminate the need for a full shutdown of your facility at year-end to count 100% of your inventory.

Let’s discuss some of the advantages of cycle counting compared to a full physical. Since you will be counting fewer items at a time periodically throughout the year, there will be less disruption within your facility, and you can likely do the counts without stopping production. Your inventory balances will also be more accurate throughout the entire year, rather than just at year-end. Since you will be truing up inventory balances continuously, the potential financial impact at year-end will be minimized. Even with performing cycle counts, some physical counting at year-end may be still be warranted or even required. For example, maybe your cycle-counting procedures during the year focus strictly on raw materials and finished goods and then at year-end you may still justify counting work-in-process. Just like with anything else, it is important to be flexible and evaluate what works best for you and your organization.

Looking to change your physical inventory count process?

Let’s be completely honest, a full physical inventory count is beginning to become an archaic and somewhat “old-school” process. With the wide array of technologies and inventory tracking systems available today, most companies can achieve accurate inventory counts without completing a full physical at year-end.

With that being said, you cannot completely ignore the process of tracking inventory and will still have to come up with a viable plan to ensure accurate inventory reporting for the many reasons noted above. If you have any questions about what your options are or how to implement a new plan, contact Wipfli.

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Author(s)

Kyle Wierzba, CPA
Manager
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