PHYSICAL INVENTORY COUNT PROCEDURES

Physical inventory count and purposes: three phases: Planning and preparation,
Execution, and Analysis of results.

Methods of conducting physical inventory count such as bar-code readers, count

cards, and count sheets.

1. Goals and reasons for conducting physical count of inventories

There is one day in the year when you and/or a group of your employees go to the
warehouses and attentively count (quantity, weight, etc.) and record every item (goods,
materials, supplies, etc.) there. Then any differences are investigated and necessary
adjustments are made. You probably agree that this is an expensive, hard and not
very pleasant, but very necessary process – an annual physical inventory count.  So
let’s consider why it is important to conduct a physical inventory count.

The most obvious reason is that you conduct a physical inventory count to check if the
inventory accounting records are accurate and complete at a particular time (every
item found in the warehouses is recorded and every recorded item is found in the
accounting records). However, physical inventory count is not only an accounting
requirement. When your accounting records show an accurate stock quantity, your
business is more likely to be profitable and successful as a whole. Customer relations
will be good because you can quickly ship required quantity of products to them. You
will also have better control of your stock levels and company’s money; you will be
able to order the goods in the right quantity at the proper time avoiding over- or
understock. So the goal of the annual inventory count is to obtain accurate
information about inventories on hand, which will help you to make right business
decision.

As there are advantages presented above, a full physical inventory count has its
disadvantages:

 Physical inventory count may be time and resource consuming (e.g. personnel
costs).
 Physical inventory count are more effective when manufacturing, shipping and
receiving activities are stopped, which again brings in the cost factor (e.g. lost
production).
 Physical inventory count procedures are usually performed one or several times
a year (normally once) and thus, accounting records are adjusted to match
actual quantities on hand just a few times during a year.  All other time, there
may be differences between accounting records and physical quantities.

An alternative to a full physical inventory count when all inventories is counted at a

point in time is inventory cycle counts when you count inventory in portions
throughout a year.  Cycle counts will be covered in greater detail in another article.
There are three phases of a physical inventory count:

1. Planning and preparation

2. Execution
3. Analysis of results

2. Physical inventory count planning and preparation

As we mentioned, a physical inventory count may be a time- and resources consuming

procedure, which requires proper planning. The planning helps you to make your
annual inventory count more effective. You should have a written policy regarding
the inventory count process (inventory plan, inventory instructions). In this policy
you determine a date of conducting the physical inventory count, assign responsible
persons and describe the methods to be used. You can use different approaches (full
inventory count or cycle count) to count different types of inventory; for example, one
method for finished goods, and another method for work-in-process (WIP) or for raw
materials. You also should publish the procedures and policies regarding
recording the counts, reconciling discrepancies, unknown items, emergency or
rush shipments, and auditor's approval requirements. Establishment and
documentation of counting procedures will allow you to control and supervise
physical inventory count properly.

It is beneficial to plan and prepare a physical inventory in advance:

 First, you should determine a date and time of conducting a physical inventory
count and inform your employees about it. Maybe your inventory counting will
take place on different days in case you have several remote warehouses. Select
a day when your company activities are at a low point.
 Second, you should form a counting team(s). At this stage, pay attention to
employees' experience and understanding of a physical inventory count process.
Let the experienced people make all counts and necessary calculations and less
experienced record the results of counting. Some training about material types,
counting methods, documentation will be also useful.
 Third, choose the method of conducting a physical inventory count. You should
use the information in the following table and decide which method is suitable
for your company.

Illustration 1: Methods of counting inventories

Method Description Advantages Disadvantages

Bar-code Use of bar-code The most efficient Expensive; special
readers readers allows method. Makes the computer software
 Method Description Advantages Disadvantages
reading and physical inventory and bar-code labels
recording the count process more are required.
counts directly to simple and accurate.
a computer. Counters can quickly
read and record
information. Reduces
human error;
eliminates counting in
teams; minimizes
shutdown time.
Count Index cards with Not so expensive as More advance
cards / information about bar-code readers; help preparation is needed
tags individual discover lost and (all cards must be in
product and misplaced material. the warehouse before
location are used the count begins).
during counting.
Count Pre-printed lists The easiest and More time consuming
sheets of inventory cheapest method. (searching, counting,
(usually comparing). No logical
generated by order of items in
company's count sheets.
software) are
used to record on A lot of time spent to
hand counts. find particular item
during "wall to wall"
counts. Items which
are not in the listing
or not in their place
could be missed.

It is important to ensure that all transactions (receipts, customer returns,

adjustments, etc.) have been recorded before you prepare and print count cards
or sheets for physical inventory. Any rush transactions could be entered or
processed only after the completion of physical inventory count. When you
generate count sheets and cards, leave spaces for names and signatures of the
counting team members for future accountability and tracking.

 You should also prepare the warehouse(s). Make sure that all
materials/products are in their proper places and can be clearly identified,
clean up the store area, label all shelves and locations. Slow-moving items can
be counted and marked a day before a full physical inventory. Identify
damaged, discounted and obsolete classes of items; place them separately from
other inventory (vendor return area). Prepare and provide the plan(s) of stock
locations.

If you spend enough time on the preparation of a count and explanation of the
importance of physical inventory to involved personnel, you will perform the count
quicker and will have an accurate count with minimum re-counts.
3. Executing a physical inventory count

There are some rules you need to follow to achieve an accurate and effective count:

 An employee who supervised or performed a physical inventory count process

must be an independent person. It means that an independent person cannot
be responsible for check in and sign receiving reports, for the daily security and
accountability of the inventory. You should rotate your personnel so they count
the areas for which they are not responsible directly. You can use the third
party inventory services to be sure of independence of your staff (particularly if
you suspect an internal theft).
 Counting employees should not be given access to the inventory quantities
recorded in the accounting records. This is called a blind count and helps to
eliminate guessing on the part of counters, as they would not know what the
quantity is.
 Stop your business operations (inventory transactions) on the day of counting
or exercise proper control over movement of inventories. Do not make any
movement of items/products either into or out of the warehouses (even if they
are misplaced). Do not fill orders or receive goods during the count process.
There is a great risk of missing any items or their double count.
 Proper control over count cards (tags) / sheets is needed. Ensure that all
cards / sheets issued to counting teams are sequentially numbered, accounted
for and returned after the counting process is finished including those which
were voided or unused. Also each tag may have two (or three) copies, one of
which is left on the counted inventory and one is returned to Finance to enter
into the system.
 Immediately compare your counts with accounting records, audit the counts
and conduct recounts if there are unacceptable differences (i.e. deviation from
accounting records is greater than a defined threshold in dollars or units as
stipulated in the company's policy).
 Mark counted items and locations. This will allow you to ensure inventory
completeness (i.e., no missing items or items counted twice), which is an
important aspect of any physical inventories.

When verifying your counts, pay special attention to fast-moving and volume items.
Such items usually have a greater risk of counting errors in comparison to slow-
moving items.

As soon as you or other responsible employee verifies that the counts in the
warehouses are accurate, the quantities can be entered in your computer. If you find
several counting errors in an area, the entire section should be recounted. When
verification is successfully completed, all counts are entered into the computer.

The next step you need to do is to print the discrepancy reports and review it
thoroughly. Sometimes errors could be made when counts are entered in your
computer system; for instance, there may be a posting error or a measure error such
as an item is counted in tons, pieces or meters, but is maintained in units in the
system.
4. Analyzing physical inventory count results

After you have identified all differences, it's time to investigate them. First of all, you
need to determine the source of discrepancies, and, then decide how to reduce them in
the future. Let's consider possible sources of differences. They can be the following:

 Internal theft - is a typical problem for retailers. As we mentioned above, you

should use external inventory specialists to identify internal theft. Good internal
control is needed to prevent this issue in the future. Such internal control
includes use of security cameras, control over store access, the receiving room
and the back door, and control over trash disposal. Also, the owner (a manager)
should lead by example and maintain appropriate discipline over recording the
transactions.
 Shoplifting - Use of security cameras and sensor tags will be very helpful to
significantly reduce this problem; and certainly proper customer service can
prevent shoplifting.
 Administrative error - can be identified through comparison of the differences
among locations (maybe there is a shortage in one and the overage in another
location at the same time).
 Vendor fraud - For example, a vendor sends a shipment of inventories and
indicates a quantity sent (in packed boxes) higher than what is actually in the
shipment. In such cases, the best control is to count all inventories received to
ensure that the actual quantity matches the number provided by the vendor in
the shipping documents.

Analysing the differences, you should estimate the effect they have on your business.
Some of them may have little effect; other may have significant effect and show the
areas where improvements are needed. You should have your method to trace an
accuracy of your inventory and identify the weaknesses. Two methods of accuracy
tracking are on-hand method and transactional method. On-hand method shows you
a percentage of error at the concrete point of time. Using this method, you divide total
difference amount by the total on-hand inventory amount. For example, after counting
you have a shortage of 15 items, when your total inventory amounted 150 items; thus,
the accuracy rate is 10% (=15 ÷ 150 x100%). Transactional method shows the
accuracy of your operations; it is a correlation of the difference amount and total
consumed inventory amount during the period. For instance, you have the same
shortage of 15 units, and you determined that the consumed inventory amount during
the count period is 250 units, so the accuracy rate is 6% (=15 ÷ 250 x 100%). In
practice, if inventory accuracy is within 3%, you may consider your inventory
management to be effective.

You are also recommended to save the results of previous physical counts for the
reason of comparing current and last count results and seeing the effect of
improvements in inventory management process.

After you have carefully investigated the discrepancies, you need to make
adjustments. Adjustments need to be made in the inventory listing (sub-ledger,
perpetual inventory records) and the ledger. For example, your physical inventory
result shows $17,200, while book inventory is $17,500. The $300 difference will be
adjusted in the sub-ledger (detailed inventory listing) by changing inventory parts with
differences for correct unit quantities. You should also make a following entry: debit
inventory shortage and credit inventory for $300. Note, however, that sometimes
accounting software will make an adjusting entry in the ledger automatically after you
have made necessary changes in the inventory sub-ledger. Consult your accounting
software documentation for more guidance.

Finally, it will be useful for you to analyze the inventory count process in total and
receive feedback from your employees. You can take into account this information
when planning the count for the next year and updating your inventory count policies
and procedures.