The Five Gateways of Inventory Control

Operational controls and their impact on the financial statements represent a significant challenge for management accountants. The authors present a case study of an industrial manufacturer and its external auditors. They describe the company’s five “gateways” of inventory control and their critical importance to materials management and the annual inventory check.

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A major challenge for management accountants, CPAs, and manufacturing companies is the control of operations and the resulting impact on an entity’s financial statements. The causal effects of standard operating procedures, work instructions, and shop floor decisions impact the financial performance of inventory-centric companies. The lifeblood of many companies is inventory, and a dual focus is needed to maintain sufficient levels of raw materials to produce finished goods for customer expectations while minimizing the investment of cash in slow moving or obsolete inventory. Considerable effort is expended by corporate administration and plant management to drive continuous process improvement through lean principles and the reduction of process variation.

The overarching theme of this article is the significance that the Big Four external auditor placed on the validation of these gateways at an international automotive manufacturer and supplier of batteries. In this case study, the external auditors stated on more than one occasion that “the reliability of the financial statements revolved around the execution and results of the annual physical inventory.” The process of the actual physical inventory was considered vital in gaining an understanding that the three-day period of the annual inventory was well planned, organized, and conducted in an orderly, effective, and efficient manner. Multiple representatives from both internal and external audit were present at annual physical inventories to observe the process, ask questions, conduct test counts, and prepare reconciliations of book (perpetual) to actual (periodic). One might view the physical inventory of purchased parts, raw materials, work-in-process, and finished goods as the umbrella that encompasses all five gateways described in this article. Any variances in a physical inventory may be traced to a failure at one of these five checkpoints.

Background

At the former Exide Technologies’ plant in Bristol, Tennessee, the responsibility and accountability fell squarely on the shoulders of the plant manager, production manager, controller, and materials manager to manage the inventory and manufacture product to meet customer orders. The site controller was particularly looked to as the one knowledgeable in financial reporting, budgeting, forecasting, and the overall business leader for the facility. It was common for the departments of quality assurance, engineering, facilities maintenance, distribution, human resources, and environmental health to rely on the controller and the accounting department to supply insight into key performance indicators in terms of both dollars and units.

The Bristol plant grew to nearly 1,000 employees at the peak of the facility’s lead (Pb) acid battery manufacturing. The Sarbanes-Oxley Act, and specifically SOX Section 404: Management Assessment of Internal Control, dramatically increased the accountability of various processes at the manufacturing plant level ( The evolution of basic policies and procedures through adaptation to new and complex reporting requirements were gradual and allowed for thoughtful improvements. Arguably the most complicated and time-consuming aspect of SOX compliance occurred when the controller and plant manager reviewed and signed off on a large number of controls each quarter, called an Exide Internal Control Environment (EICE) checklist. Most of the processes the controller was accountable to check on were asset-related and revolved around inventory and fixed assets. An assessment by the auditors of not only the physical inventory but also the quarterly internal control checklist would indicate if the financials were in compliance and not harboring any material weaknesses.

The five gateways of inventory movement (illustrated in Exhibit 1) are as follows: 1) raw materials (RM) and purchase parts receipt, 2) internal failure (scrap) reporting, 3) production reporting, 4) bill of material (BOM) accuracy, and 5) shipping of finished goods. Monitoring these five gateways was critical for materials management and an annual physical inventory that resulted in minimal financial write-offs. The annual periodic inventory would serve as a final check point to verify the internal controls were in place and working as designed by internal audit, external auditors, and best practices among peer plants and in the industry.

Gateway 1—Receipt of Raw Materials and Purchased Parts

The potential for loss of inventory could be as simple as overstatement of goods received onto the books. A purchase order (PO) with a receipt of the same quantity that is more than what was shipped and received will result in a loss at some point. Inventory verification was not limited to cycle counts of various significant raw materials, work-in-process (WIP), and finished goods (FG) but included verification of raw material and purchase parts on the receiving docks. For example, it was a daily routine that nearly 30 truckloads of lead (Pb) would be delivered with various alloys and receiving tickets specified the pounds and unique part numbers. One of the EICE checklist verifications called for the dock workers to document the physical weighing of one shipment of each alloy daily. A shipment would consist of lead (Pb) “hogs” weighing 2,000 lbs. each (a term smelters used to designate blocks of lead). The hogs casted by the supplier might vary from 1,900–2,100 lbs., depending on the rounding of the top and the amount of dross. The controller’s job was to ascertain that weighing was being performed daily and compared to what was entered into the ERP software. If Exide had a PO with a supplier for 2,000 lbs. and the receiver on the docks scanned in 2,000 without weighing the load, but then the actual delivery was only 1,900 lbs., this would represent a 100 lb. loss that would be caught at cycle count or at the annual physical inventory. Exide would bear not only the cost of 100 lbs. paid for and not delivered but the plant would incur an inventory loss.

Other inventory-related checkpoints were expensed spare parts used in the repair and maintenance of production equipment. Although not listed on the balance sheet as inventory per se, these materials were expected to be controlled within a facility. SOX regulations, as interpreted by Exide’s internal and external auditors, expected monthly cycle counts to establish that spare parts inventory was being managed and controlled. The EICE checklist, promulgated by external and internal audit functions, specifically addressed this gateway with spot checks documented and approved by the plant manager and local controller each quarter.

Gateway 2—Internal Failure

Internal failure is also commonly referred to as scrap, or nonconforming product, in manufacturing environments. It is a normal outflow of processes that are inherently flawed. Six Sigma is a study of process variation and seeks to align company goals with shop floor operations in continually reducing scrap and increasing the velocity of output through a pull system of inventory. Statistical process control (SPC) drives much of the methodology today and accounting professionals play a major role in providing data and understanding the causal effects of production and scrap to the financial statements. In Exhibit 2 and Exhibit 3, the escalating cost of quality becomes most challenging, as the dollars snowball into failure. Internal failure is the only one directly related to inventory on the balance sheet; external failure is the other side of failure, resulting from warranty claims and potential liability issues outside of a facility’s four walls. Warranty claims may require replacement of the product or a cash refund, but this potential liability is irrelevant to the inventory balance as an asset on the company’s books.

A daily primary responsibility of the site controller was to walk the plant floor every morning to witness the current issues and determine how that would impact the weekly financial forecast. American manufacturing companies have adopted a Japanese concept called Gemba, whereby management must go to “the real place” to understand the issues, opportunities, and constraints facing the workers. These Gemba walks would reveal inventory stacked up between WIP centers, extraordinary unprocessed scrap, operators standing idle, and equipment being repaired as issues to be investigated by the accounting function. The evolving role of accounting professionals, and particularly management accountants, requires an understanding of the business, and leadership is required not just in the office but on the production and distribution floors.

Unfortunately, failures of internal control in the non-reporting of scrap will result in a build-up of faulty product on the books as inventory instead of cost of goods sold. One might say the debit stayed on the balance sheet and the debit belonged on the income statement. External auditors were always inquisitive concerning obsolete, scrap, and slow-moving product that remains in inventory at full value. Some best practices used by Exide included 24/7 cycle counters, quality assurance quarantine procedures for non-conforming product, and other system checks by non-production personnel.

The Exide corporate office sought, at the recommendation of its Big Four external auditor and internal auditor, to encourage the timely write-down of inventory to scrap, saleable, or recyclable values by instituting a Material Request Disposal Authorization (MDRA) process that enabled plants to write down product that was overproduced or unsold due to corporate build schedules. These scrap dollars’ expenses would be reclassified from the plant to the division level at the corporate office, since corporate planners were responsible for the scheduled over production. Blemished batteries could also be sold for 50% off the normal cost; this further encouraged plants to do the right thing and not harbor scrap on the books at full value.

Gateway 3—Production Reporting

Another important objective of the Gemba walks was to observe the production reporting processes that result in the creation of next-level WIP and the reduction of lower-level WIP. Each successive production level adds direct materials, direct labor, and overhead in the defined BOM and labor routings. Exide used direct labor as the cost driver to allocate the overhead pool based on industrial engineering time/motion studies. Production driven companies are frequently prone to overreport quantities manufactured or assembled in order to meet the required corporate schedules. Each pallet of production would generate a bar code label with the part number and quantity, thereby revealing the sub parts used in a particular product.

A best practice among Exide facilities world-wide was to employ cycle counters 24/7 in both manufacturing and distribution sides of the facility, to maintain control of the rack location of inventory produced. The unique bar codes would have a unique warehouse bin location where material handlers would “pick and put” these pallets in the appropriate locations. The role of the cycle counters was to continuously check the bin locations with the product located there with use of radio frequency identification (RFID) scanners. In order to maintain independence of the audit by these counters from production reporting, these cycle counters reported administratively to the materials manager. In addition, these counters reported functionally to the inventory accountant and controller for resolution of reporting issues in production and also internal failure.

The Big Four audit team and internal audit personnel provided guidance; at one point, they opined that the annual physical inventory could be abolished due to the robustness of the cycle counting procedures used in conjunction with the SOX 404 EICE checklists.

Gateway 4—Bill of Material Accuracy

The fourth gateway is a frequently overlooked facet of manufacturing control because many people assume that if the data is in the ERP software it must be right. Ongoing verification of the bills of material for each manufactured product with the reality on the shop floor is crucial for managing inventory and the potential for loss (or gains). Competing objectives from quality assurance (QA) material usage, which incorporates ranges and cost accounting standards that use a single usage metric, add to the potential for inventory loss. Suppose the QA standard allows for 2.4–2.6 lbs. of lead to be used for a battery strap that connects the plates. The BOM pounds designated is 2.5 and is used for costing the product and in generating the purchase orders based on this standard usage. QA may, in conjunction with shop floor operators, cast the strap at the high end of the range because of a belief that more is better in making a stronger strap. Casting to a 2.6 lb. strap would result in a 0.1 lb. loss for every battery produced. Perhaps a newer mold is installed with engineered cavities to require less lead per strap with the same quality? Using a newer mold allowing casting to a 2.4 lb. strap would result in a 0.1 lb. gain per battery produced on that line. If 30,000 batteries built in one day could be a 3,000 lb. loss or 3,000 lb. gain, this would translate to more than $1,000 to the day’s bottom-line income.

Exide engaged in continuous improvement projects intended for increased throughput or reduction in process variation. A reduction of material used in a battery was also an area that corporate and plant engineering pursued as a cost reduction. Coined an ECO (Engineering Change Order), one project was titled “Get the Lead (Pb) Out” and focused on less lead to be used in certain batteries while maintaining quality and the service period. If the project would result in a lead reduction of 0.5 lbs. per unit this might be implemented mid-year and result in a gain of 0.5 lbs. per subject unit until the next cost standard roll. This would be classified as an ECO material gain and would explain why a particular lead alloy incurred a gain.

An additional facet indirectly related to BOM is the common use of substitutions for orders. If sufficient quantities of a cold cranking amp (CCA) for a certain Battery Council International (BCI) group size are not available but quantities of a larger size CCA are, a cost will be incurred. If the CCA ordered is 525 but only a 600 is in stock and the cost differential is $1.50, then fulfilling this order, at the same sales price, will result in a substitution loss. If this substitution transaction goes unreported, then an inventory loss will occur by the cycle counter or, if missed, at the annual physical inventory. These are a few examples of control and oversight accounting personnel must exercise in an environment and organizational structure where non-financial managers have direct control.

Gateway 5—Shipping Verification

The final gateway is a major threshold where fully priced inventory stock must be controlled as customers’ performance obligations are met. The transfer of ownership may occur at the facility’s docks or at delivery to the customers’ warehouses (this would impact revenue recognition, but that topic is outside the scope of this article). The essence of this fifth gateway is movement from inventory to cost of goods sold (COGS) and recording of sales revenue with accounts receivable.

Exide would typically have 125,000 orders open (individual batteries to be shipped) at any given time with many of those orders days out. The fulfillment of an order was very structured, with material handlers “picking” from warehouse inventory bin locations the various types and quantities for labeling and preparation on a distribution line. Once a shipment is assembled, the pallets would be “ship confirmed” in the ERP system, thereby crediting inventory and debiting cost of goods sold. The corresponding debit to the customer’s accounts receivable and credit to sales revenue would complete the transaction. Once all pallets are loaded on a truck, the door would be sealed with a tag number and the information would be communicated to the security guardhouse. A final check would be made by the guard including confirmation that the seal is in place. Physical custody of inventory as an asset snowballs in value to finished goods when the security of material movements is of utmost importance.

Conversations with the Big Four audit team revolved around revenue recognition and meeting the performance obligations for this gateway. A fuller discussion on when title passed to OEM customers, compared to after-market customers, is beyond the scope of this article but the external auditors played a major role in defining how to make accruals at month-end for batteries shipped and in transit at month-end that technically were still owned by Exide.

The Umbrella of the Annual Physical Inventory

To ensure the operating responsibilities are being adhered to at each of the five gateways, the periodic annual physical inventory served as an umbrella that covered all internal controls. The annual count is conducted to verify the accuracy of the perpetual system and the manual inputs that standard work instructions drive in the day-to-day operations. Paramount to all companies is that written policies and procedures in effect must be followed with an end-of-year physical inventory validating the processes and gateways. A witness to the importance of this annual count is the presence of officials from internal audit, the external auditors, and supervision by the site controller. Materials planning and production personnel are excluded from the oversight due to potential conflicts of interest in the outcome.

Assurance that proper receiving and shipping cutoffs are followed and production/scrap reporting is completed prior to an inventory freeze on the books may be likened to slowing the flow of a stream. It is easiest to cross a stream when the water level is low and that is similar to the time that a physical inventory is conducted. Many firms seek to have this periodic count coincide with the fiscal year end to facilitate the recording and reporting processes for inventory. Companies elect a year end at a slow time for sales to facilitate year-end closings that will reduce the chance for errors. With expedited closing schedules, the probability for mistakes rises.

The primary problem was defining what a significant inventory variance is, in terms of dollars or as a percentage of total inventory value, and what course of action would be followed by corporate officials and external auditors when these thresholds were exceeded. The importance of the issue is, the outcome from a physical inventory count is a key measure of control of a corporation’s operational processes. An acceptable inventory loss indicates that all gateways are collectively accurate and ensures that financial reporting is without any material weaknesses. The financial leaders of manufacturing companies are very interested in gaining an understanding of corporate governance in that valuation of assets (particularly inventory). Exide used an ERP system with integrated financial software supporting materials planning, production reporting, costing, distribution, and financial reporting. Knowledge gained from these ongoing write downs provided improved estimates for contra allowance accounts for net realizable values and gave corporate leaders insight on which policies and procedures were in place when annual physical inventory losses exceeded the allowance set aside.

Takeaways

The annual physical inventory served as a final validation check point for the auditors to verify internal controls. Much insight was provided through the years by audit personnel to hone the processes for control of operations that result in reliable financial statements. Best practices from all of Exide’s North American plants were incorporated into standard work instructions with clear systems of checks and balances throughout all business processes. SOX section 404 highlighted the concern, visibility, and reporting requirements of internal controls and best practices. CPAs, CMAs, and other accounting staff knowledgeable at the manufacturing/distribution site level must work with auditors to ensure that robust processes are in place to make certain that findings are minimized and material weaknesses are eliminated.

Once an annual inventory is complete, a drill down into the data on the gains and losses by category and part number will reveal whether further investigations are needed:

• ▪ Is cycle counting a robust process?
• ▪ Are BOMs accurate for all alloys and production WIP?
• ▪ Are there significant losses of certain types of inventory and gains in others?
• ▪ Is the receiving dock following standard work instructions?
• ▪ Are the cycle counters covering all bin locations in a systematic manner?
• ▪ Is production reporting accurate?
• ▪ Is budgeting for prevention and appraisal costs sufficient to mitigate internal and external failure costs?
• ▪ Does the guardhouse perform the final check consistently and raise concern when issues arise?
• ▪ Is there a culture of following policies, procedures, and work instructions daily?
• ▪ Are workers comfortable with bringing issues to supervisors or staff?
• ▪ Is employee retention an issue, especially in key areas surrounding the gateways?
• ▪ Is a third party 1-800 fraud line needed for employees to address their concerns?

Physical inventory results should reveal no surprises. Ongoing communication with regard to internal control processes and validation is essential with internal audit, as they guide businesses into implementing best practices within the company and across the industry. Management accountants and controllers at the manufacturing and distribution level must be the leaders for operational and financial controls. If any issues are discovered, they should result in improvements that start at the plant level and are approved by division level management and internal audit.

The role that the Big Four played in reviewing Exide’s systems of internal control and SOX 404 compliance cannot be over emphasized. To place the burden of proof on financial statement accuracy of how each of these gateways of inventory control are continuously monitored and corrected is significant for accounting professionals. CPAs, CMAs, and other accounting experts must be business leaders and have a deep understanding of their business environment in order to provide input in crafting strong processes, policies, and procedures.

Strong controls require more than just technical expertise in accounting and business acumen. Ethical leadership is a must when professionals are developing relational skills with the various personalities they will encounter during their career. Exide had only one controller during its 19 years of existence in Bristol, during which time there were nine plant managers and an even higher number of other staff level managers. Understanding the business is essential in establishing gateways of control to ensure all stakeholders can rely on the financial statements.