Tuesday, September 27, 2016

Audit observation - predicting inventory level precisely to avoid stock-holding costs

Excessive purchase of inventory have a number of consequences on the Company.

Working capital of the Company would be distorted. If a company holds a inventory that takes more than 6 months to sell, the company need to incur warehousing costs + interest costs if the inventory is purchased based on overdraft + opportunity costs ( i.e. the company would be able to use the same amount of money to purchase other inventories). Why not consider to house lower amount of inventory?

However, this is not easy due to a number of reasons:

- The supplier may requires minimum purchase of quantities. In this context, we suggest our audit client to speak to the suppliers.

- It is costly to predict the right level of inventory. To derive a sufficiently precise optimal inventory level is a scientific exercise - your inventory system should be able to support you on this. However, is it costly to develop and maintain such system?

- Purchasing department should work closely with warehousing department closely to determine the right amount of inventory.

In a distribution business - a good supply chain management will be able to give some company a good margin to continue the business in the competitive industry.