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Ask the Expert: What’s the Best Way to Account for Inventory?

May 13, 2020
Cycle counts are a better process.

Question: “What is the best way to account for inventory—once a year physical or cycle counts?”

Answer: I spent many years during my career arguing for cycle counting and losing to the financial folks who insisted on physical counts. Never mind that taking these inventories cost the company $100,000-plus a year just to count everything. (Of course, this doesn’t take into account the carrying cost of inventory, which can be substantial.) Year after year we all held our breaths around the staff table awaiting the results of the physical inventories across all plants and warehouses.

It became the definition of insanity, doing the same thing over and over and hoping for a different outcome. Several times “the losses” taken one year turned into a nearly identical “gain” the following year or vice versa. During those years when the results were plus or minus a reasonable number, there was an air of satisfaction around the staff table that we’d had a “good inventory.” The reality is that we were just lucky because there was no connection to what might happen the following year. Insanity indeed.

In the 1990s, when “World Class Manufacturing” was the global cry for excellence, operations and financial leaders finally got on the same page and began to structure cycle counts as a better process for inventory accounting. The paradigm had changed.

Editor's Note: Do you have a question for Larry Fast, our Ask the Expert: Lean Leadership columnist? Ask it here

This new mindset, some helpful reading, e.g., Zero Inventory by Robert (“Doc”) Hall, the educational support of organizations such as APICS (name changed to Association for Supply Chain Management in 2018) and with the emergence of the supply chain organization structure, cycle counting became the best way to manage inventories more effectively and more efficiently.

What Is Cycle Counting?

Traditional physical inventories require counting every item of inventory, once per year, regardless of whether it’s an A item or a B or C item. Cycle counting audits are done daily with frequency determined by inventory ranking. 

Inventory Management Policy – What To Count and When

The “new” inventory paradigm requires inventory managers and accountants to use the Pareto principle (80-20 rule) to determine the makeup of the inventory. In this context that means 80% of the overall usage value is based on about 20% of total items. (Please keep in mind that what follows applies to cycle counting of all raw material, work-in-process (WIP) and finished goods inventories.)

“A” items are based on 70% to 80% of the annual purchases, which often accounts for only 10% to 20% of total inventory items. These are the items that support the highest number of inventory turns, the largest inventory costs and the highest level of customer service for your best customers. Reorders should be frequent, i.e., daily or weekly reorders. Stockouts have an immediate impact on “A” item service levels and shop floor scheduling. Be sure you have a robust sales and operations planning process (S&OP) to plan materials and scheduling. This, of course, requires the sales and marketing team to actively participate and provide better forecasts. One of the most common failings is that a sales rep calls on a customer and is told of a promotion being planned for your company’s products. The S&OP team receives no such information for planning purposes. The promotion starts and soon thereafter these items are out of stock in the warehouse and all hell breaks loose with sales exhorting manufacturing to make more. Does this story ring a bell in your company?

“B” items are items with a medium usage value. They typically represent 15% to 25% of annual consumption value and about 30% of the total inventory items.

B items benefit from an intermediate status between A and C. An important aspect of class B is the monitoring of potential evolution toward class A or, in the contrary, toward the class C. Supply chain planners should do an annual review to confirm or change items to a different category.

“C” items are those materials with the lowest usage value. The lower 5% to 10% of the usage accounts for about 50% of total inventory items. These are for items that customers buy only once or twice a year. (Depending on the availability of supplier inventories, you may be able to order some “C” items when an order is entered. This might be an “A” item for the supplier. However, many (most?) of these items you simply should not stock and only order raw materials when a sales order is received.)

Rule of Thumb

A typical rule of thumb is to cycle count all A items monthly, B items quarterly and C items annually. On A items it is a continuous process, done on all shifts, so be sure enough people are trained on the process, its importance and the accountability that goes with it. When you finish the cycle, simply start over and do it again. Finally, poka yoke (mistake proof) the process and document it.

“Whether your company decides to adopt an inventory process such as FIFO (First In First Out) or LIFO (Last In First Out), just be certain you don’t have a FISH policy (First In Still Here). --Larry E. Fast

“Why do people not have time to do it right, but always have time to do it over?” --Author Unknown

“Effective leadership is putting first things first. Effective management is discipline, carrying it out.” -- Stephen Covey

Larry Fast answers your questions in the IndustryWeek feature Ask the Expert: Lean Leadership. Fast is founder and president of Pathways to Manufacturing Excellence and a veteran of 35 years in the wire and cable industry. He is the author of The 12 Principles of Manufacturing Excellence, A Lean Leader's Guide to Achieving and Sustaining Excellence, 2nd. Edition.

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