Many of the problems associated with inventory originate with the initial decisions to set safety stock levels, add product options, and design new components into products. Although these decisions fall outside of the traditional control systems for inventory, they play a key role in the amount of a company’s inventory investment, and so are included here. All controls noted relate to the addition of stock to inventory:
Reject all purchases that are not pre-approved. A major flaw in the purchasing systems of many companies is that all supplier deliveries are accepted at the receiving dock, irrespective of the presence of authorizing paperwork. Many of these deliveries are verbally authorized orders from employees throughout the company, many of whom are not authorized to make such purchases. This problem can be eliminated by enforcing a rule that all items received must have a corresponding purchase order on file that has been authorized by the purchasing department. By doing so, the purchasing staff can verify that there is a need for each item requisitioned and that it is bought at a reasonable price from a certified supplier.
Revise safety stock levels for seasonal items. The most common approach to setting safety stock levels is to run a historical usage analysis over the past few years and use that information to decide on an average safety stock level. However, this approach ignores sudden drops in demand caused by seasonality, leaving too much inventory on hand. If demand permanently drops thereafter, safety stock levels will be too high and may represent a risk of obsolescence. A potential control is to mandate quarterly adjustments to safety stock levels of seasonal items, thereby more closely matching supply to demand.
Reduce the number of products and product options. Each incremental product that a company chooses to sell requires the storage of more parts. This is a particular problem if there are many variations on the basic product, mandating storage of each product version. To control the number of these inventory additions, schedule a periodic product profitability review and cancel unprofitable products; the determination of un-profitability should certainly include an analysis of the amount of working capital tied up in inventory that is uniquely associated with a particular product.
Standardize parts. When engineers design new products, they may not consider using existing components. The result is a plethora of similar but separately tracked components, each of which requires some investment in on hand inventory. An excellent control over these unwanted inventory additions is to require a parts standardization review as an integral step in the development of any new product. To reinforce the concept, consider including the minimization of the total number of on-hand component parts in the bonus plan of the engineering manager.
Coordinate engineering change orders with on-hand balances. When the engineering staff implements a change order, new parts are added to a product while the replaced items are no longer needed and remain in stock for prolonged periods. In an environment where engineering change orders are common, a nearly mandatory control is to verify the remaining on-hand balance of any components being rendered obsolete, so that the change orders can be implemented in conjunction with the maximum depletion of existing stocks.
Turn off reordering flags for cancelled components. Many computer systems contain a flag in the item master file, indicating that the system should automatically create a purchase order to replenish on-hand stocks when a minimum stock level is reached. However, this contravenes a company’s intent in attempting to dispose of any obsolete items, because the system will reorder what is no longer needed. Therefore, a good control is to incorporate in the obsolete inventory disposition procedure a line item stating that the reordering flag be turned off as soon as an item is declared obsolete.
Compare open purchase orders to current requirements. The purchasing staff may have placed purchase orders that are no longer needed, because the production schedule was changed subsequent to placement of the purchase orders. This problem is automatically spotted by a material requirements planning system, which generates a report listing those purchase orders that should be closed. However, in the absence of an MRP system, a process should be in place to frequently compare open purchase orders to current requirements, resulting in the elimination of unneeded inventory receipts.
Reward managers based on a reduced working capital investment. One of the classic frauds is to greatly increase the size of value-added on-hand inventory, so that more overhead costs are assigned to the inventory instead of flowing through the cost of goods sold and reducing reported profits. To avoid this problem, an excellent passive control is to include the reduction of a company’s working capital investment in the management bonus plan. By doing so, anyone increasing inventory levels to manipulate profits would end up reducing his profit because of the increased investment in working capital.