Manufacturing External Audits: Common Inventory Challenges

Manufacturing external audits can be challenging due to time-consuming physical inventory counts, poor inventory management, inaccurate standard costs, and outdated IT systems that make data retrieval and testing more difficult. Manufacturers can improve inventory efficiency by consulting with external auditors for insights into best practices related to cycle counting, strengthening inventory controls, updating standard costs, and investing in modern inventory management or enterprise resource planning systems. Manufacturers should learn how to address inventory challenges before any external audit.

Inventory challenge 1: Time-consuming physical inventory counts

External auditors are required to observe manufacturer inventory counts. They analyze and test those counts for accuracy and determine how well the count matches inventory records. But a physical count of a company’s entire inventory – often performed annually – can be time-consuming and disruptive, since the business might shut down for several days or longer during the count.

If a manufacturer cannot perform the count at year-end because the organization is too busy to shut down, it must perform an inventory rollback or rollforward procedure to determine the year-end inventory quantities, thus requiring auditors to spend time testing the inventory rollback or rollforward.

Solutions:

• Cycle counting can be performed in place of a physical count. With this method, a manufacturer counts its inventory in small amounts over the year with all inventory items being counted at least once throughout the year rather than all at once.
• Investing in inventory management software or automation technologies also might speed up inventory counts, increase accuracy, and limit human error.
• Manufacturers should consult with their external auditor to learn how similar companies approach inventory counts and make the process more efficient.

Inventory challenge 2: Poor inventory management

An external audit will proceed far more smoothly for a manufacturer that closely tracks, in real time, the quantity and cost of materials in its warehouses, where they’re located, how they’re being used, and what inventory will be needed in the near future.

Conversely, poor inventory management is a top contributor to external audit complexity. A lack of inventory controls, discrepancies across locations, poor labeling, and other issues make inventory testing more challenging for an auditor. These challenges might require an auditor to pursue additional observation and testing.

Solutions:

• Company management can address inventory issues in myriad ways – from inventory software to smarter purchasing and storage solutions – and reap numerous business benefits.
• Manufacturers should consult with external auditors with deep experience in their industry who will have insights into navigating inventory management challenges – because they’ve likely already encountered similar challenges with previous clients – and can demonstrate skilled judgment. They’ll know which questions to ask, where to seek additional information, and which managers to pull into discussions, saving time and reducing frustration.

Auditors must test and verify that inventory values are accurate. But when the standard costs (predetermined costs as opposed to actual costs) assigned by the company are outdated or inaccurate, price testing becomes more complex. For example, in a volatile economy, the price of freight, labor, and raw materials can fluctuate dramatically. Incorrect standard costing can lead to dramatically undervalued or overvalued inventory at standard and variances that can be hard to test.

Another potential complexity: Inventory cost variances can be capitalized, but companies need a clear process in place to capture variances and capitalize them on the balance sheet. Without well-defined processes, external auditors might spend unplanned time and effort auditing capitalized variances.

Solutions:

• Companies might need to update their standard costs more frequently than once a year (a typical practice) to reflect the latest market prices.
• Companies also can consider a more granular cost review of a specific item when its cost changes by a certain percentage (for example, 10%).
• Manufacturers can consult with external auditors that have manufacturing experience to identify standard cost discrepancies and best practices.

Inventory challenge 4: Outdated or limited IT systems

Manufacturers with older IT systems might struggle to pull important data needed by the external auditor. For example, a more limited system might not be able to access complete purchase histories, or an older system might alter a transaction date, making it difficult to pinpoint the age of an inventory item. Auditors and management then must take valuable time to troubleshoot these issues.

Solutions:

• A manufacturer should consider an upgrade to its enterprise resource planning system or other IT tools that help manage core business processes.
• Manufacturers might select a technology platform – such as Microsoft Power BI^™ – to import and analyze raw data (sales usage, sales by item, last purchased, last used) for audit purposes.

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This article was originally published on July 20, 2023, and was reviewed and updated.