Inventory Management and Control Systems

Inventory Management and Internal Control

Inventory means the sum of those items of tangible property which:

• Are available for sale in an ordinary commercial transaction.
• Are in the process of production for such sales.
• Are available for current consumption in the production of goods or services available for sale.

Internal Control

Successful companies are very careful to protect their inventories. The elements of good internal control of inventories include:

1. Physical inventory count at least once a year, no matter what system is used.
2. Maintenance of efficient purchasing, receiving, and shipping procedures.
3. Storage of inventory to protect against theft, damage, or decomposition.
4. Permitting access only to authorized personnel.
5. Personnel with inventory access should not have access to accounting records.
6. Maintaining perpetual inventory records for goods of high unit cost.
7. Purchasing inventory in economic quantities.
8. Maintaining enough inventory available to prevent shortages, leading to lost sales.
9. Not maintaining an excessive inventory, thus preventing the expense of having money tied up in unnecessary items.

Perpetual Inventory System

• This system contrasts with the periodic inventory system. Under the perpetual inventory system, the inventory account is kept continuously updated.
• Under this system, an account is also maintained to show the cost of goods sold during the period. The Inventory account is debited for any purchase of goods. When selling merchandise, two entries are made: The first records sales revenue (debit to cash or accounts receivable, credit sales). The second reduces the balance of the inventory and records the cost of goods sold (debit to the account Cost of Goods Sold, credit Inventory).
• The perpetual inventory system has been traditionally used by companies selling high unit value goods such as cars, computers, or furniture. These firms make relatively few sales transactions daily, so the cost of recording each sale is manageable.
• In a company that sells large quantities of merchandise at low cost, recording the cost of each sales transaction is not feasible without a computer system. Therefore, companies such as grocery stores, department stores, and most small traders have traditionally used the periodic inventory system. However, today, computer terminals at the point of sale make it possible for almost all commercial businesses to maintain a perpetual inventory system.

Valuation of Inventory and Measurement of Income

The main objective of inventory control related to valuation is the determination of Gross Profit, which means the deduction of costs applicable to sales revenue.

To determine the gross profit, it is necessary to value inventories of goods. This achieves a goal: that the Balance Sheet reflects an appropriate value for the asset represented by the goods in stock.

Periodic Inventory System (Physical)

The basis of the periodic inventory system is the physical count of goods available at the end of the period. This procedure, known as taking a physical inventory, is inconvenient and costly. Therefore, a physical inventory is usually taken only at the end of the year.

Thus, the periodic inventory system conforms to the preparation of annual financial statements, but not to the preparation of accounting statements for shorter periods like months or quarters.

To determine the cost of goods sold by the periodic inventory system, accounting records must show (1) the cost of inventory at the beginning and end of the year, and (2) the cost of goods purchased during the year.