Why your inventory count never matches your books (and how to fix it)

For a manufacturer, inventory is often the largest number on the balance sheet. It's the raw materials on the racks, the work in progress on the floor and the finished goods waiting to ship. When the count and the books disagree, your profit for the year is wrong by the same amount.

This article is part of our guide to the financial side of running a manufacturing business.

Why the count and the books drift apart

• Timing. Steel received on the 31st but entered in the books on the 4th. Units shipped before the count but not yet invoiced. Each one puts inventory in the wrong period. Our month-end close covers cut-off in detail.
• Unrecorded scrap and rework. Offcuts, a bad batch, a weld cut out and redone. The material is used up, but the books still show it on the shelf.
• Receiving paperwork that's never posted. The material is on the rack but the packing slip is in someone's truck.
• Out-of-date costs. Standard costs set two years ago, before material prices moved, so every unit is valued wrong.
• Units of measure. Bought by the tonne, used by the sheet, counted by the piece, and the conversion in the system is wrong.

Example: a year-end surprise

A Red Deer manufacturer of grain-handling equipment counts its inventory every December. For three years running, the count has come in $60,000 to $90,000 below the books. Each year, the whole difference is written off in December, so the year's profit drops by that much at the last minute.

When the shop started cycle counting, the gap turned out to have three sources:

• about half was unrecorded scrap from plasma cutting, mostly offcuts too small to reuse
• a third was receipts never posted against purchase orders
• the rest was a unit-of-measure error on one high-volume tube size

Once each source was fixed, the year-end adjustment fell to under $8,000.

A routine that keeps them together

Cycle counts, monthly

Count a handful of items every month instead of everything once a year:

• Rank items by value. The top 20% of items usually hold 70% to 80% of the dollars. Count those monthly.
• Count the rest quarterly or twice a year.
• Investigate every difference right away, while people still remember what happened.

One person owns receiving

One person makes sure every delivery is matched to a purchase order and posted the same day. No posting, no putting it on the rack.

Record scrap as it happens

A simple scrap log at each cutting station, with item, quantity and reason, entered weekly. It also tells you which jobs and machines produce the most waste. That's a job costing insight as much as an inventory one.

Review costs twice a year

Update material and labour costs so the inventory value, and your margins, reflect today's prices.

Year-end valuation for tax

At year-end, the value you put on your inventory directly affects your taxable income. Overstate it and you pay tax on profit you don't have. The Income Tax Act sets the rules.

Lower of cost and market

Inventory is generally valued at the lower of its cost and its fair market value, compared item by item (or by class, where items can't be told apart). Alternatively, all the inventory of the business can be valued at fair market value. Whichever method you use, you have to use it consistently from year to year. Changing it needs the CRA's agreement.

What counts as cost:

• First-in, first-out (FIFO), average cost, or specific item cost are accepted.
• Last-in, first-out (LIFO) is not accepted for Canadian tax.
• For goods you make, cost includes materials, direct labour and a share of manufacturing overhead. Leaving the overhead out understates your inventory.

Obsolete and damaged stock

Old, damaged or slow-moving stock can be written down, but how you do it matters:

• Write down specific items to what they'd realistically sell for (their net realizable value), and keep evidence: the count sheet, condition notes, quotes from scrap dealers, sale prices of similar goods.
• A general "reserve for obsolescence" isn't deductible. "We'll knock 10% off everything over a year old" won't hold up.

Example: the old hydraulic cylinders

The Red Deer shop has 140 hydraulic cylinders for a discontinued model, at a cost of $310 each ($43,400). A dealer will take them for $75 each.

Writing them down to $75 each ($10,500) is a $32,900 deduction this year, with the dealer's quote kept as evidence. Better still, selling them clears the space and the insurance on them.

The bottom line

Inventory you can trust gives you accurate margins, a borrowing base your lender believes (see reporting for owners and lenders), and a year-end with no surprises. If you'd like help setting up cycle counts, cleaning up item costs or valuing year-end inventory properly, see how we help manufacturers.