Businesses that struggle with inaccurate inventory data, large year-end adjustments of physical inventory results, or a lengthy annual physical inventory process should consider adopting a cycle counting program or improving the one they have. A properly implemented cycle counting program can raise the performance and efficiency levels of a manufacturing or distribution business.

Although cycle counting wont guarantee immediate financial improvements, a program with strong managerial support that reflects the best practices described in this article could deliver most, if not all, of these benefits to an organization:

• Savings in personnel costs and plant downtime;
• More accurate inventory quantities;
• Reduced losses due to inventory shrinkage;
• More reliable financial reporting and conversion-cycle key performance indicators (KPIs); and
• Better decision making about reorder points, out-of-stock inventory and excess inventory.

Why Use Cycle Counting?

A companys use of cycle counting is comparable to a car owners adherence to a disciplined schedule of routine maintenance. It facilitates more efficient inventory management as well as the more timely identification of significant issues. Specifically, cycle counting involves making regular counts of inventory and using samples that are small relative to the amount of inventory the company carries at any point. By capturing and monitoring results on a frequent basis, a company can significantly improve the accuracy of its inventory quantities and financial reporting. When conducted in a routine, systematic manner, cycle counting provides reliable numbers and can eliminate the burden of full physical counts.

In particular, cycle counting can help a company reduce one of the principal drawbacks of an annual physical inventory count -- costly overtime or holiday hours paid to hourly employees. In turn, the employees who in the past would have spent countless hours, or even several days, focused on the planning, administration, and completion of the annual count are available to work on other projects. More important, cycle counting can also enable a business to avoid the costly side effects of full physical counts, which include restricted movement on the manufacturing floor and shutdowns of key operating activities like shipping and receiving. All of these results of cycle counting translate into real dollar savings.

Although management still must set aside time and personnel to perform cycle counting duties, the shorter, more frequent repetitions of cycle counting consume fewer resources and can enable management to use existing personnel during operational downtime. As a result, work force efficiencies might increase and the effect of stoppages in operating activities can be minimized.

Moreover, as time goes on, inventory variances should begin to diminish. The timely identification of significant discrepancies gives management the ability to react more quickly to purchasing, shipping or customer-service issues. With frequent randomized counts, the opportunities for theft decrease, while the ability to detect and monitor shrinkage issues, especially among inventory items that turn frequently, increases.

The Cycle Counting Program

A company must take into account several important considerations when developing and executing its cycle counting program.

Inventory Counting Procedures

To begin with, all inventory must be subjected to counting procedures at least once during the year. Many methods are available to cover all inventory efficiently, but the most popular is the ABC method. Under the method, a company designates inventory items based on value or number of inventory turns as A items, B items, or C items. The A items are considered most critical and are counted frequently throughout the year. Typically these are inventory items that turn over often or have high value. The C items typically have less movement or carry a lower value and therefore may be included in the count only once or twice during the year. Accordingly, the C items are expected to carry a lower risk of material differences. Any given inventory count includes a large number of A items, some B items and very few C items.

Whatever counting method is used, the frequency of inventory counts is important. The counting process ideally occurs on a daily basis -- weekly at a minimum. Many inventory-management systems that include a cycle counting module have a feature that provides for automated scheduling and selection of a sample of items to be counted in the daily cycle counts.

The automated selection process, however, must contain controls that prohibit or limit the ability of a user to override the selection of inventory items to be counted during a given day. These controls enable the organization to maintain the integrity of the counting process and the number of times inventory items are counted during a given year. If a scheduled item is not counted, or is swapped for an easy-to-count item or an item that is known to possess an accurate quantity, the validity of the sample is compromised. As a result, any issues residing beneath the surface like stock shortages, unidentified spoilage or unrecorded transactions could go undetected, greatly undermining the goals of the cycle counting program.

The organization should also perform blind counts to restrict the ability to make changes to the counted results. Blind counts are performed without knowledge of the quantity that is listed in the accounting records. If blind counts are not performed, the person performing the count may see the system quantity on the count sheet and simply match its count to the system quantity to avoid the hassle and additional time of investigating variances. By exercising discipline in performing blind counts, this risk is virtually eliminated. Some companies even use a double-blind counting system, which involves a second count team that recounts, on a blind basis, certain components or locations of inventory.

Tolerance for Variances

Also critical to an effective cycle counting program is the development and implementation of a tolerance threshold for investigating count variances. A company should document count differences in both quantities and dollar amounts, and the differences should be measured on their gross (absolute) value. To be useful, the tolerance threshold should not be too high. If many individual differences are uncovered but the aggregate net quantity or dollar variance is minimal, an underlying issue is still causing the inventory variances. The fact that a net difference is low could simply be the fortunate result of the particular sample that was selected for counting. A sample on a different day could produce dramatically different results if the error frequency is similar but the differences are directionally consistent instead of netting out to a small difference

For example, a company counts 100 inventory items on one day and finds differences for 10 of the items. Some of the differences are overstated and some understated, so the net dollar difference is a small amount. The next day, again the company counts 100 inventory items and again finds differences for 10 of the items. This time, however, the differences for all 10 items are directionally consistent that is, they are all either overstated or all understated and therefore the overall difference is more significant.

This phenomenon -- where the key underlying problem is the error rate -- highlights the importance of evaluating the dollar differences in terms of their absolute value instead of net value. If a company can eventually achieve a variance rate of less than 1%, the system is likely to be accomplishing the desired objective. However, results and expectations can vary among businesses.

When implementing a tolerance threshold for count variances, it is important that the investigation process occur as designed and that the count discrepancy resolution process be documented well. The organization should determine error thresholds that automatically trigger both a second count by a different individual and an investigation of the cause of the error. An experienced separate individual should perform any second counts the program requires. Any differences that remain unreconciled after the second count and, after examining shipping and receiving activity, should be adjusted in the system.

A reason code should be entered in the system to allow management to evaluate the cause of differences over time. This code can be helpful if certain trends begin to reveal themselves after a few months of cycle counts. If problematic trends become obvious, management might determine that it is necessary to flag various locations or types of products and perform additional counts on these items. In some cases, it might be possible to increase test-count coverage by changing the characteristics in the cycle counting program (for example, changing a B item to an A item, or providing for certain flagged items to be selected on a more frequent basis).

Documentation and Testing

In addition, certain back-end procedures should be performed only by individuals not involved in the counting process. First, results of the cycle counts, including the results of follow-up procedures and variances by reason code, should be well-documented and maintained for the entire year. This documentation will help management make important decisions about the inventory items and the cycle counting program itself.

In addition, management should test the cycle counting program on a periodic basis (at least annually). Management should examine item classifications to determine that inventory items are classified appropriately to allow for sufficient frequency of counting. It should also study the program results and confirm that all inventory items have indeed been included in the program and counted during the annual period.

Finally, a detailed set of cycle counting instructions should be compiled, reviewed annually for accuracy and completeness, and communicated to the employees responsible for performing cycle counting.

Is It Right for You?

Implementing a cycle counting program can be an expensive process, and the decision to do so should involve members of the organizations finance, operations, and IT departments as well as the executive-level management team. But remember -- a cycle counting program is an investment in the organizations business processes and financial strength.

The improvements in count accuracy are likely to translate directly into improved year-round reliability of the organizations financial statements and key metrics such as gross profit, inventory turnover, departmental inventory levels and days inventory on hand. Management will be more aware of issues that arise and able to make well-informed decisions about purchasing, filling orders and other operational matters. In addition, the accounting and finance team will be able to make more educated decisions about inventory valuation and tax-oriented strategies and provide reliable reporting to other manufacturing or operations personnel.

David Wentzel, CPA, is with the Oak Brook, Ill., office of Crowe Horwath LLP (www.crowehorwath.com), one of the largest public accounting and consulting firms in the United States. He can be reached at david.wentzel@crowehorwath.com. Gene Hochberg, CPA, is a partner with Crowe Horwath LLP in Oak Brook, Ill. He can be reached at gene.hochberg@crowehorwath.com.

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