Inventory Management Systems - Statistical Data Included

Internal Auditor, Dec, 2000 by R. Scott Bjork

Inventory reductions can lead to significant savings and increased performance, provided the right approach is taken. A seven-step process for evaluating inventory management can help auditors to steer the organization toward optimal efficiency.

Inventory is often a company's largest current asset and the single largest contributor of working capital requirements. If inventory is properly managed, working capital requirements are reduced and cash flow is increased, enhancing the organization's chances to prosper and grow. On the other hand, mismanagement of inventory often leads to declining cash flow and a loss in market share to competitors.

In efforts to improve inventory management, many companies have invested millions in enterprise resource planning (ERP) systems, which allow employees to use one software package with a number of integrated modules, rather than multiple, conflicting systems with different operating platforms and data formats.

Unfortunately, expectations that purchasing the system guarantees fast turnarounds and dramatic payoffs are usually doomed. The ERP system is only a management tool--one that must be effectively applied and integrated to achieve success.

Internal auditing can help to ensure positive results by evaluating the organization's inventory management system. A comprehensive assessment will provide management with a clear and attainable action plan for achieving the desired inventory reduction and maximizing efficiency.

BOOSTING FINANCIAL PERFORMANCE

Inventory refers to the total sum that the company has invested in purchasing items that it intends to sell. An inventory management system is the practice of planning, directing, and controlling inventory so that it maximizes the company's cash flow and profitability.

One very important measurement determines how effectively the company's inventory management system is operating. That measurement is often referred to as either inventory turnover, days inventory on hand (DOH), or days sales inventory on hand (DSI). Although several methods can be used to calculate inventory turnover, as shown in the formulas below, they all measure how efficiently inventory is moving through the organization.

The importance of inventory turns cannot be overstated. The "Turnover" section of the "Inventory Management" chart on page 42 shows how a company could reduce its cash investment in inventory by $150 million ($200 million minus $50 million) if inventory turns improved yet yielded the same gross profit.

Findings from a recent benchmark project involving five companies indicate that cash flow could increase by as much as $192 million if they achieved "best in class" status within their industry:

DAYS SALES       INVENTORY
INVENTORY        SAVINGS
                 (in millions)
Best in Class 31
Company A     79 $192
Company B     46 $54
Company C     43 $43
Company D     39 $32

With internal auditing's help, the company may be able to realize the savings often touted by ERP consultants.

ORGANIZATIONAL STRUCTURE

The factors that prevent improvements in the inventory management system are not usually related to the ERP software tools that are purchased and implemented, but rather to the way the company is organized and managed. Reduction in inventory requires business process change--and it is at that point that organizational structure, employees, and the internal audit department come into play.

Inventory is the most difficult working capital component to manage because many of the contributing "owners" that affect it are cross-functional, as illustrated in the "Management System" diagram on page 43. Because no single functional area owns the inventory process, the involvement of the internal audit department is likely to be valuable.

SEVEN STEPS

Effective internal audit assessments of company inventory management systems can be defined by a seven-step process.

1. Obtain management commitment. Management must clearly communicate the company's vision, strategy, and short- and long-term goals and objectives. Many functional areas impact inventory, yet no one functional area owns the inventory process. To improve the inventory management system, senior management must lead the way; be highly visible; communicate clearly; and deliver focused, full-time leadership.

2. Develop process objectives and deploy the team. The internal audit department should identify an internal audit representative and a representative from each functional area, including sales and marketing, engineering, purchasing, planning and production, and finance and cost accounting.

Once the team for each functional area has been established, the group should determine process objectives, milestones, and due dates. An illustration of typical process objectives by functional area can best be described in the "Value Chain" section of the "Inventory Management" chart on pages 42-43.

3. Identify the process. The team should identify and evaluate all the inventory-related activities within the functional area. Benchmark data should then be acquired for all key processes or activities, and comparisons should be made between current activities and those of the "best in class."