According to the IRS and generally accepted accounting principles (“GAAP”), companies with physical inventory are required to, periodically, conduct an inventory count. There are two main methods by which a company can accomplish this goal: an annual physical inventory count, or periodic inventory cycle counting. Several factors should be weighed before deciding which method would be most efficient for your company. To understand the advantages and disadvantages of each method, you first need to understand the two types.
An annual physical inventory count is the process by which a company temporarily suspends operations over a few-day period to count of all stock keeping units (SKU’s). By shutting down operations during the count, this process restricts the movement of inventory throughout the warehouses, until counting is finalized. Full annual inventory counting is not as popular as it had been in the past, but still may be ideal for companies with smaller quantities of inventory. An advantage of an annual physical count is that, once you are finished with your count and make the appropriate corrections, you start the new year with a clean slate and an accurate beginning inventory quantity. A disadvantage of the annual physical count is the need for a temporary shutdown of the company’s main activities. Additionally, the annual counts can take a significant amount of time to complete, and there is always the risk of human error.
Cycle counting is the process of counting inventory throughout the year, dividing the project by location or inventory type. Cycle counts allow you to focus on a set of items daily, or weekly, instead of your whole inventory in a day or two period. By breaking the project down into more manageable parts, cycle counting allows you to count every item in your inventory at least once in a year and increase the accuracy of your count. Another significant advantage of this method is that a company can continue to operate the business while performing cycle counts. Communication on the movement of inventory needs to be ongoing to correctly and successfully count items. To effectively implement cycle counting, you need to develop a plan of how you will count the items and keep track of discrepancies throughout the year - it could be seasonal (the ABC Method), or systematic (daily, weekly, etc.). A common misconception is that, if you have inventory at a third-party warehouse, cycle counting does not need to be performed. This is partially incorrect; if the third-party warehouse performs their own cycle counts, their counts need to be evaluated and compared to the company’s record to ensure no missing, damaged, or extra quantities exist.
Once a counting process is set up, continuous evaluation of that process is required to avoid inefficiencies in the inventory cycle and to refine the inventory processes over time. With both methods, discrepancies would need to be evaluated and corrected within the company’s accounting systems. With annual physical counts, this process may take longer and cause delays in operations.
A digital era
Many companies have moved away from documenting counts with paper and pencils, mainly due to the risk of human error. Inventory cycle count software is now being used as a more effective tool to automate the process. Many accounting software programs have an add-on cycle count option, which can help to keep track of performed cycle counts, and sets up a schedule with a list of items to be counted, by day.
At Citrin Cooperman, we have clients that use both processes. Cycle counting has consistently remained the preferred method, because it is simpler and more cost effective. Take the time to evaluate the two methods with your business advisor, create a process that works for your company, and adopt the method that most effectively helps you keep your inventory counts current throughout the year.