How to minimize the risk that year-end inventory shortfalls will catch you unawares

During the first year of running my own company, I thought we were doing really great. Then, at year end, I was shocked by a write-down of $66,000 in inventory that offset about a quarter of our pretax profits. I felt like I'd been kicked in the stomach. My illusion of having established control was shattered. Was it theft? Were our systems that screwed up? What was going on?

That was when I learned about accounting systems. In order to balance perfectly, they drive all sorts of errors into a misstatement of inventory throughout the year. Then, when you do your annual physical inventory and compare it with the books, you discover a discrepancy, usually a shortfall. For example, if you understate your costs when computing gross margins, it will show up on the books as more dollars of inventory than you actually have. If you understate product adjustment costs or scrap, that's another contribution to the shortfall. If a product is shipped and somehow not invoiced, same result. If a product is short-shipped by the vendor and not caught, more shortages. The list goes on and on. And until all the accounting and procedural causes for inventory shrinkage are cleared up, your month-to-month operating statements will be misleading.

I'd like to say it was easy, but at Battery & Tire Warehouse Inc., it took us four years before we straightened out our system completely. And it's a grungy job. There are dozens of places to look for slipups, and only a methodical plugging away at the possibilities will bring you any answers (see Finance, "The Case of the Disappearing Inventory," August 1986). In the end, we resorted to doing a physical inventory every month, and then comparing the physical counts with the books to see what progress we'd made in our internal controls. By comparing each stockkeeping unit, we also were able to reassure ourselves that our problem was not any major organized theft -- the unit count differences were pluses and minuses in a fairly random pattern typical of minor paperwork errors.

Our monthly operating statements now are reasonably clean and show what is actually happening. And personally, I have a much stronger feeling of control. That's why I've been surprised to learn over the past few years that many small and midsize companies experience year-end book-to-physical inventory shrinkage, but do little to attack it directly.

Some companies mask the year-end shrinkage problem by offsetting the loss with year-end windfalls, such as vendor rebates or FIFO (first in, first out) inflationary gains. We could have done that last year, for example, when our vendors raised their prices, which made our inventory worth $56,000 more. But what's the point of playing with numbers on the books? Such actions are useless if you're interested in getting the information you need to run your company. So we set up windfall gains as separate accounts and formally recognize shrinkage on its own.

A similarly useless game played by some managers is to build into their system automatic gains under the guise of conservatism. Back when I was in the Fortune 500 world, I was admonishing a division general manager for less than sterling profit results as the year was drawing to a close. His comment was, "Don't worry; we'll hit plan since we'll have a major year-end inventory pickup." I asked how he could be so sure. "Oh, we always have a major gain since we are conservative in our manufacturing costs and scrap rates." After being pulled down from the ceiling I asked, dumbfounded, "How the hell do we know what our inventory shortfall should be? Maybe we're experiencing major problems and we'll have no way to tell. What have we done to scrap controls?'

Don't get me wrong -- I think a certain amount of inventory shrinkage is inevitable. In our business as a $12-million distributor, we reserve $2,000 per month for shrinkage. This 0.2% covers miscellaneous breakage, some minor pilferage, mispulled product, and so on. The key point, though, is that we set up the reserve as a bona fide item on our books, so it can be compared with the actual shrinkage. To my mind, there are enough nasty surprises in running a business without adding inventory shrinkage to the list.

Charles J. Bodenstab is chief executive officer of Battery & Tire Warehouse Inc., in St. Paul. Previously, he held executive positions with United States Steel, General Cable, Kearney-National, and Gould.


Where the shrinkage occurred at Battery & Tire Warehouse

* The first things to pop up were adjustments. For some reason, we were failing to recognize that our vendors do not fully reimburse us for the total cost of an adjustment. The spread in cost versus reimbursement was adding to inventory shrinkage every time we ran through an adjustment -- and we deal in thousands of them.

* We were occasionally losing paperwork and failing to invoice products that had been shipped. These were bucks right out of our pocket, and a contribution to shrinkage.

* Sometimes we posted a wrong stock number but a correct description, which meant we shipped out one product but billed for another. Statistically the gains and losses should offset each other, but in reality, many customers nailed us for those in our favor and pocketed the ones in their favor. And, of course, the same thing happened when we accidentally pulled the wrong product from inventory.

* We started to do a more comprehensive check of incoming shipments from our suppliers and were surprised at the number of errors in both shipping quantities and prices. In each case we were losing profits and adding to our inventory problem.

* We had understated production costs at our truck-tire recap shop because we hadn't recognized sufficient scrap allowance and certain miscellaneous supplies. We were overstating our gross margin on every recap tire we sold and simultaneously adding to our year-end shrinkage.