There are so many components to inventory cost calculations, involving so many cost records, that there is a high risk of costing error. Principal control system targets include ensuring a proper cost roll-up, appropriately assigning fixed costs to inventory, and both consistently and appropriately assigning overhead costs to inventory. The following controls address these issues:
Audit inventory material costs. Inventory costs are usually assigned either through a standard costing procedure or as part of some inventory layering concept such as LIFO or FIFO. In the case of standard costs, one should regularly compare assigned costs to the actual cost of materials purchased to see if any standard costs should be updated to bring them more in line with actual costs incurred. If it is company policy to update standard costs only at lengthy intervals, then one should verify that the variance between actual and standard costs is being written off to the cost of goods sold. If inventory layering is used to store inventory costs, then one should periodically audit the costs in the most recently used layers, tracing inventory costs back to specific supplier invoices.
Audit prices paid. A member of the purchasing department may make an arrangement with a supplier to receive a kickback in exchange for directing business to the supplier. Because the supplier absorbs the cost of the kickback, this generally leads to higher component prices. This type of fraud is extremely difficult to detect. One possibility is to conduct a periodic audit of prices paid to see if any per-unit prices are inordinately high.
Rotate purchasing assignments. As just noted, it is difficult to detect kickback schemes. One can at least make it more difficult for suppliers to enter into kickback schemes by periodically rotating supplier assignments to different members of the purchasing department. Under this approach, it is more likely that a supplier who is used to paying kickbacks will eventually run into a newly assigned staff person who has no intention of accepting payments and who may also report any supplier suggestions about kickbacks to management.
Assign unique part numbers to customer-owned inventory. If a customer sends parts to a company for inclusion in a finished product and the company already owns similar or identical parts, the chances are good that the existing part numbers will be assigned to the customer-owned parts, resulting in a valuation of the parts when they should be recorded at zero cost. The best way around this problem is to assign a unique part number to the customer owned items at the receiving dock and prominently label the items with this part number. Then assign a zero cost to the unique part number, thereby keeping any value from being assigned to it.
Compare un-extended product costs to those for prior periods. Product costs of all types can change for a variety of reasons. An easy way to spot these changes is to create and regularly review a report comparing the un-extended cost of each product to its cost in a prior period. Any significant changes can then be traced back to the underlying costing information to see exactly what caused each change. The main problem with this control is that many less expensive accounting systems do not retain historical inventory records. If so, the information should be exported to an electronic spreadsheet or separate database once a month, where historical records can then be kept.
Review sorted list of extended product costs in declining dollar order. This report is more commonly available than the historical tracking report noted in the previous list item, but contains less information. The report lists the extended cost of all inventory on hand for each inventory item, sorted in declining order of cost. By scanning the report, one can readily spot items that have unusually large or small valuations. However, finding these items requires some knowledge of what costs were in previous periods. Also, a lengthy inventory list makes it difficult to efficiently locate costing problems. Thus, this report is inferior to the un-extended historical cost comparison report from a control perspective.
Control updates to bill of material and labor routing costs. The key sources of costing information are the bill of materials and labor routing records for each product. One can easily modify these records in order to substantially alter inventory costs. To prevent such changes from occurring, strict security access should be placed on these records. If the accounting software has a change tracking feature that stores data about who made changes and what changes were made, then be sure to use this feature. If this feature is used, periodically print a report (if available) detailing all changes made to the records and scan it for evidence of unauthorized access.
Keep bill of material accuracy levels at a minimum of 98%. The bills of material are critical for determining the value of inventory as it moves through the work-in-process stages of production and eventually arrives in the finished goods area, because they itemize every possible component that comprises each product. These records should be regularly compared to actual product components to verify that they are correct, and their accuracy should be tracked.
Review inventory layering calculations. Most inventory layering systems are automatically maintained through a computer system and cannot be altered. In these cases, there is no need to verify the layering calculations. However, if the layering information is manually maintained, one should schedule periodic reviews of the underlying calculations to ensure proper cost layering. This usually involves tracing costs back to specific supplier invoices. However, one should also trace supplier invoices forward to the layering calculations, because it is quite possible that invoices have been excluded from the calculations. Also verify consistency in the allocation of freight costs to inventory items in the layering calculations.
Fixed-cost assignment: Audit production setup cost calculations. If production setup costs are included in inventory unit costs, substantial costing errors could be made if the assumed number of units produced in a production run is incorrect. For example, if the cost of a production setup is $1,000 and the production run is 1,000 units, then the setup cost should be $1 per unit. However, if someone wanted to artificially increase the cost of inventory in order to create a jump in profits, the assumed production run size could be reduced. In the example, if the production run assumption were dropped to 100 units, the cost per unit would increase tenfold to $10. A reasonable control over this problem is to regularly review setup cost calculations. An early warning indicator of this problem is to run a report comparing setup costs over time for each product to see if there are any sudden changes in costs. Also, access to the computer file storing this information should be strictly limited.
Overhead cost assignment: Verify the calculation and allocation of overhead cost pools. Overhead costs are usually assigned to inventory as the result of a manually derived summarization and allocation of overhead costs. This can be a lengthy calculation, which is subject to error. The best control over this process is a standard procedure that clearly defines which costs to include in the pools and precisely how these costs are to be allocated. In addition, one should regularly review the types of costs included in the calculations, verify that the correct proportions of these costs are included, and ensure that the costs are being correctly allocated to inventory. A further control is to track the total amount of overhead accumulated in each reporting period, because any sudden change in the amount may indicate an error in the overhead cost summarization.