Types of Inventory Errors
There are a great many types of errors that can result in an incorrect inventory valuation. The result can be a significant understatement or overstatement of the ending inventory valuation, which translates into a misstatement of the reported profits of a business. It also changes the reported amount of ending inventory stated in the balance sheet.
Here are some of the more common errors to be aware of:
- Incorrect unit count. Perhaps the most obvious error, this is when the physical count of the inventory is incorrect, resulting in an excessively high or low inventory quantity that is then translated into a valuation error when you multiply it by the unit cost.
- Incorrect unit of measure. This is when you count a certain quantity and enter it into the accounting records, but the designated unit of measure in the item master file for that item is different from what you assumed. Thus, you may be counting in individual unit quantities, but the unit of measure in the computer is set to dozens, so your quantity is now incorrect by a factor of twelve. Other variations are using inches instead of centimeters, or ounces instead of pounds.
- Incorrect standard cost. In a standard costing system, you store the standard cost of an item in the item master file. If no one adjusts this number to match actual costs, then the inventory will be valued at a cost that does not match actual costs.
- Incorrect inventory layering. If you use an inventory cost layering system, such as FIFO or LIFO, the system has to assign a cost to an item based on the inventory layer in which it is located. System errors are possible here. If you are doing this manually, then you can assume a large proportion of operator errors.
- Incorrect part number. You may assume that something you are counting has a certain part number, and will assign the inventory count to that part number in the computer system. But what if it really has a different part number? Then you just made the double error of imposing the correct count on the wrong part, and of not assigning any count at all to the correct part number.
- Cycle counting adjustment error. A cycle counter may find an error in an inventory count and makes an adjustment in the accounting records to fix it. This is a problem if there is already an entry that has not yet been posted to the system, which would have already corrected the "error." This transactional delay can cause major problems when there is an active cycle counting system in place.
- Customer owned inventory. Customers may have some of their inventory at your location, so you may mistakenly count it as though it is your own inventory.
- Consignment inventory. You may have inventory on consignment at retailers, and forget to count it.
- Improper cutoff. Inventory may arrive at the receiving dock during a physical count, so you include it in the count. The trouble is, the corresponding supplier invoice may not yet have reached the accounting department, so you have just recorded inventory for which there is no cost.
- Transfer imbalance. The inventory system may be set up to require you to reduce the inventory quantity in one department, and separately increase the inventory quantity in another department when you are transferring inventory inside the company. If you do one but not the other, then either you have the same inventory item reported in two places at once, or it is not located anywhere at all.
- Incorrect scrap relief from backflushing. Backflushing is where you reduce the balances in inventory records based on the number of units of finished goods produced. It is based on the assumption that the standard component quantities listed in the bill of materials are correct; however, if scrap and spoilage is different, then incorrect unit quantities will be relieved from the inventory records. You need an excellent scrap reporting system to mitigate this problem.
If an inventory error has resulted in an increase in the recorded amount of ending inventory, this means that the cost of goods sold is understated, so that profits are overstated. Conversely, if an inventory error has resulted in a decrease in the recorded amount of ending inventory, this means that the cost of goods sold is overstated, so that profits are understated.