Inventory Accounting Does Not Have to Be Hard

Poll any seasoned accounting manager in retail and distribution, and you’ll get varying degrees of frustration even with a better-than-average operations team in place.

Inventory is nuanced. Counts can become inaccurate quickly and many times too easily. Product valuation is normally automated when an inventory management system is in place. If not, valuation is a nightmare.

Cutoff procedures may be hit-or-miss, especially if the finance team lacks an accounting background. The timing of ownership becomes an issue if the inventory management system does not sync with the terms of vendor purchase orders (hit me with a question if this does not make sense).

Cash is easy to manage, monitor, and reconcile. Why not inventory? When I walk inventory aisles in the warehouse, I don’t see product; I see cash (deferred cash is more accurate). If cash is supposed to be 100% accurate, why not raise expectations for inventory management, too?

Let’s address some of the ugly culprits that lead to the frustration that “Accounting for inventory is hard.”

Inventory Accounting Painpoint 1: No Inventory Management Software

Mike Kearns is one of my all-time favorite CTOs. He’s one of the co-founders of Pro Athlete, and then he left to build another dream business, where I got a front-row seat.

Within Mike’s first two weeks of setting up his wine subscription business, he had already chosen his accounting and inventory management systems, nearly a year before he received his first customer cash receipt.

Mike understood the value of clean and accurate inventory management. Doing so in Shopify (the ecommerce system he chose) was out of the question because Shopify’s inventory management is a myth.

Show me a company without an inventory management system, and I’ll show you a CEO with no operations experience, or a company without a technology and operations manager with 5-10 years of related experience.

The operational risks of not having an inventory management system seem self-evident:

• Buying too much inventory.
• Not having enough inventory (stockouts).
• Having too much crusty inventory (obsolescence and slow-moving product).
• Team member chaos, looking for a product that does not exist or is misplaced.

I could keep adding bullet points, but a trainwreck comes to mind when I see businesses without an inventory management system. The underlying problem isn’t the lack of a system; it’s leadership. “It costs too much.” Or, “I don’t understand it,” so let’s keep doing it the manual way.

In addition to the operational risks of not having an inventory management system, the biggest financial risk is that the numbers on the balance sheet and COGs on the P&L will typically be wrong (always). That’s because there are far too many moving parts to getting the numbers right using manual conventions.

Before we move on, I can promise all accountants that the month-end closing process for inventory with an inventory management system will take less than 30 minutes, even with inventory values nearing $10 million. Inventory managers will also be less frustrated with you.

Inventory Accounting Painpoint 2: The Missing TOM

TOM is a person, but the three letters stand for technology and operations manager.

We live in the business era of title inflation. Ops managers are now COOs. And, like CFOs, I fear we are losing the meaning of what a COO is and what they do. That’s why I prefer using words like ‘technology and operations expert’ and someone with plenty of experience.

I don’t have the budget for a Jim Collins-like research team. But I can assure you that when there is a missing inventory management system, or it is drastically misused, there is no TOM in the organization. And that needs to change fast.

Not only can any TOM expert create new systems and processes in their sleep, but they also fully understand GAAP reporting requirements, especially since their job requires certain turnover and ROI thresholds.

The biggest mistake I’ve observed CEOs make in COO selection is going too fast and being sold by the candidate by inflating their skills. Slow down, and do the following:

1. Focus first on the outcomes you need in this role.
2. Revisit the words behind TOM. What skills do they need to bring to the table? Experience is also vital. This is not a learn-on-the-job position. Would you want a person with no financial expertise managing your $10 million equity portfolio? The more money (inventory) you have a risk, the stronger the candidate you need.
3. Make sure you speak with the candidate referrals. When I do this, I require the candidate to set up those meetings (The A Players are great at this).

Inventory Accounting Painpoint 3: The Poor Accounting Team

In most of my client work, I’m introduced to a so-called outsourced accountant. They are so-called because they are not accountants and know just a little bit about QuickBooks. Perhaps your situation has been far different.

Some of these resources might have three to four accounting credits at a community college, but they generally have zero auditing experience and have never worked under a seasoned controller for at least five years.

In these cases, inventory reporting will be nearly always inaccurate and incomplete, and it will reveal gross margins ranging from negative percentages to impossible big numbers. For instance, the gross margin reported one month might be -59% in June, but 79% two months later, when the norm should consistently be 35% to 39%.

The good news is that this issue is fixable. As an Executive Financial Advisor, I’ve hired many accounting managers with the proper qualifications, and then our next roles are AP and AR clerks who can do other work.

With the accounting manager in place, the “inventory is hard” mentality tends to go away. When it does not, it’s either because of the missing TOM and/or the missing inventory management system.

Even with a strong TOM and an effective inventory management system, if you are missing a qualified, competent accounting manager, your inventory and gross margin reporting will be useless.

I’ve lost count of how many inventory management workshops I’ve conducted in-house for accountants. If you have the system, the highly skilled TOM, and the ideal accounting manager, and still struggle with inventory management, then go with the workshop route. Want to pull a page from my playbook? Start with three simple questions:

1. What is inventory management excellence?
2. How do we achieve it?
3. When will we know we’ve achieved it?

A Refresher In Key Inventory Terms

Since accounting is in the title of this article, I’m sticking to financial reporting concepts in this section. I’m also loosely following a term I learned during my early years at KPMG called CEAVOP. I’ll approach this one letter at a time.

C for Completeness: At the end of every month, the accounting manager (AM) and the TOM need to ask, “Is the overall extended total complete?” Or, “Are we missing any inventory?” Typically, the answer is ‘yes’ if there is product in transit that is not being counted and we own it under the terms of the purchase order. For the AM, ensure you have procedures in place to address inventory completeness.

E is for Existence: Think like a third-party auditor. Does every SKU exist in the tabulated data from the perpetual reporting? How do you know? What steps are you using to ensure existence?

A is for Accuracy: Inventory accuracy is not a significant risk when an inventory management system is used. That applies whether you are using the FIFO, LIFO, or weighted average methods for valuing the basis. Do freight and taxes apply? No problem, the system takes care of that math too. In these cases, consider recalculating a few skus to ensure the system is following the set of rules you applied for cost basis when you set up the system.

V is for Valuation: There is overlap with the A above and V in this section. I’m a big believer in using the weighted-average inventory method, even in times of sharp inflation or when costs are dropping. I think the weighted-average is fairer for staff if you have a profit-sharing plan. I believe there is more fairness when reporting financial results to banks.

O is for Obligations and Rights: I prefer using the term ownership as in, “Do we own this inventory?” I still encounter owners and operating managers who think they own the inventory after payment. Ownership is always defined by the purchase order. If the PO reveals FOP Shipping Point, you own the inventory when the product is on their dock, not when you’ve paid for it.

P is for Presentation: This one is easy. Owners with an inventory management system, a great TOM, and a solid accounting manager are typically flush with inventory analytics (both at the macro and micro levels), so I do not need to comment further on the presentation.

As an operations person myself, I will do everything I can to mitigate excess inventory and stockouts, but CEAVOP mastery will still hone my operational mindset.

Next Steps

Now what? Is inventory management and/or accounting hard? Why? And what will you do about it?

Hopefully, I’ve slowed the game down a bit by focusing on the system and the people (the TOM and the AM). Start there and create an action plan to reach your definition of inventory excellence.