Annual Physical Inventory is a Waste of Time & Money

Eliminating Annual Physical Inventory Counts

Cycle counting is not a new phenomenon. However, there are many common misconceptions regarding how such a process is managed and what benefits may and may not result. Not only can cycle counting provide greater inventory control, but larger systemic issues also that resulted in discrepancies can be addressed immediately.  Therefore, having a demonstrated sustainable cycle counting program has emerged as a generally acceptable practice for the elimination of year-end physical inventories

Traditionally, full wall to wall physical counts have been the inventory control of choice. Understandably, shutting down operations at the end of each year and counting inventory can be a great way to start the new year with a clean slate.

However, there are several problems with a full annual physical count approach:

• Completely shutting down and subsequently restarting operations is costly
• Counting inventory during the holiday season is no fun This may seem trivial, but employee morale is a worthy consideration
• Discrepancies in perpetual versus physical numbers can be very difficult to reconcile. Reviewing and reconciling transactions that occurred during the current cycle is easier than reviewing transactions that occurred over the course of an entire year
• Discrepancies between perpetual and physical inventory numbers are usually the symptom of a single mistake, or worse, a broken procedure or process
• If a system “breaks” in any way after an annual count, it may continue to create unnoticed problems in your inventory all year
• It may not be until next year’s count that you discover the issue. Not only is this problem costly in terms of misrepresentation of inventory figures, but it may also be a symptom of a larger issue

• Such events may ruin customer satisfaction levels and increase customer service and accounts receivable costs. Had the problem been uncovered earlier, fewer customers would have been affected.

To mitigate the shortcomings of annual counts, cycle counts can be performed at the beginning or end of each day on a regular basis as part of normal operations. No shutdown in operation is required. Each day (or other regularly prescribed basis), a small number of items are counted in stock locations. When a discrepancy is found, the key is to research the root cause and discover the underlying problem that led to the discrepancy. Allowing reconciliation of issuing the part out to a work order and capturing the true cost of repair.

Note: Simply adjusting the perpetual value in the accounting or warehouse management system without performing in-depth research is not an acceptable practice.  Documentation and reconciliation are reviewable by auditors or finance and if financial adjustments are regularly made at the end of the month, then you will get someone’s attention.

When performed correctly, the primary benefits of cycle counting are realized in two key functions:

• Perpetual inventory is consistently matched to physical inventory on an ongoing basis. As a result, your accounting records have a greater probability of being accurate.
• With cycle counts, the odds of proactively uncovering and fixing a problem are much higher. In the example given above, you will likely discover the problem in your system or process before it impacts the organization.

As a result of these factors, cycle counts typically add substantial benefit to the bottom line.

There are three common approaches to cycle counting:

• Pareto method – Derived from the Pareto Principle (or 80/20 rule), the goal of this method is to set cycle count priorities based on percentages of inventory value. In short, expensive items are counted most frequently and inexpensive items are counted least frequently.

• The Pareto method generally appeals to accountants because it minimizes variances in inventory value. Lower write downs result in higher net income and a healthier balance sheet.
• However, the Pareto method can be inefficient in terms of effectively managing the supply chain. Shortages of inexpensive items can bring the assembly line and/or fulfillment operation to a standstill.
• Usage method – The usage method requires that items issued more frequently should be counted more often, regardless of the item’s value. This method purports that the risk of variance is higher every time an employee adds or removes an item from the shelf.
• Hybrid method – In an attempt to combine the benefits of both the Pareto and usage methods, most companies “score” each inventoried item based on value and frequency of use. The goal is to derive a count schedule based on the relative “importance” of each item. As such, items that are deemed both high value and high frequency are counted more often while items deemed low value and low frequency are counted less often.

A scorecard method can be useful regardless of which of these three methods is implemented. Categorizing each product / item in inventory according to an “ABC” method is often useful. In such an approach, “A” items are counted most often (quarterly), “B” items bi-annually, while “C” items are counted once a year.

Keep in mind that there are only two reasons the perpetual and actual inventory is off.  Either the process failed, or someone failed to follow the process!