Inventory Control System
What Is an Inventory Control System?
Inventory control systems are critical for businesses due to the importance of the inventory, which is a major asset. It is through the inventory that most of a business’s operating activities take place.
Therefore, it is crucial to establish effective control systems to safeguard the inventory (e.g., to minimize costs and to prevent fraud, theft, damages to physical units, and manipulation of inventory records). These control systems are known as inventory control systems.
To address these requirements, enterprises generally introduce both internal control systems and management control systems for the inventory.
Internal control systems and management control systems are introduced to minimize costs and to prevent fraud, theft, damages, and manipulation of inventory records.
Internal Control Systems
Internal control systems relate to the types of control systems to be introduced by a business to protect the inventory from loss and to ensure the accuracy of inventory records.
Internal control systems for the inventory may include various features. This section highlights several of these features.
First, an individual (or several staff) should be made responsible for the inventory and its condition by designing a control system for accountability. This minimizes the likelihood of damaged inventory going unnoticed or inventory being stolen.
Second, a control should be introduced to make the receiving department responsible for checking the quality and quantity of the inventory received. The signature of the responsible person should be recorded to ensure accountability and the accuracy of bills and invoices.
If the goods are to be stored, the warehouse manager assumes the responsibility for goods transferred, attesting to the number and condition of any inventory received.
Third, the transfer report should be independent of the reporting department. This ensures a comparison of the items received and their quality and quantity.
Fourth, only the authorized requisitions should be honored by the warehouse department for the transfer of goods. This ensures that the warehouse department is relieved of the responsibility and that it gets transferred to the requisitioning department.
Fifth, proper fire control systems, alarm systems, guards, night watchmen, and other protective measures should be in place.
Sixth, the general principle of the control system should be that no single individual (or group of individuals) should control the records and physical units simultaneously.
As such, the records department should have no access to the physical inventory, and these two departments should directly send the reports to the accounting department, enabling proper checks to be established.
Finally, personnel in the accounting department should never have access to inventory units (and vice versa). This safeguards against fraudulent practices and maladjustments.
In a nutshell, the separation of duties when handling and accounting for inventory is critical to the integrity of a system of internal controls. If robust internal control systems are not established, the inventory will fall easy prey to theft, fraud, and pilferage.
Management Control Systems
Management control systems are needed to ensure that an optimal inventory size is maintained. This is because overly large inventories lead to high carrying costs and reduced income. Likewise, carrying low inventory levels leads to loss of business, which again reduces income.
Management control systems must be able to achieve two things:
- To determine the optimal quantity of the inventory to be purchased or manufactured
- To decide on the optimal price for items in the inventory
Maintaining proper inventory levels plays a significant role in cutting inventory costs and increasing business income. If proper management control systems are not established, then the enterprise runs the risk of carrying an excessive inventory.
An excessive inventory will lead to substantial carrying costs in the form of higher property taxes, higher insurance premiums, higher handling, and storage costs, and other administrative costs.
If an enterprise carries too little inventory, it will lose sales and customers. In this way, just as an overly large inventory produces high carrying costs that lead to unnecessary losses, an overly small inventory causes loss of business, resulting in lost or lower income.
Evidently, then, carrying unsuitably high or low levels of inventory is dangerous to an enterprise as they act as a double-edged sword.
For this reason, management control systems are used to ensure an optimal inventory size. If such a system is not introduced, the internal control system may break down. This can lead to theft, pilferage, damage, and obsolescence, which in turn causes heavy losses.
In management control systems, various mathematical models are used to identify two key metrics:
- Economic order point (EOP): The level of inventory that triggers a new order
- Economic order quantity (EOQ): The quantity to be ordered to minimize handling costs while maximizing quantity discounts and other savings
As such, through the careful introduction of a model tailored to the enterprise, it is possible to establish proper management control. This prevents the enterprise from risking losses due to a suboptimal system for carrying inventory.
At the same time, choosing an appropriate model that requires no modification helps the enterprise to maintain the optimal level of inventory.
Wrap Up: Inventory Control System
- To ensure proper control, an inventory may be classified as ABC, VED, FSN, or SDE. This classification assists decision-making.
- The efficiency of inventory management is measured by calculating the inventory turnover ratio or average inventory holding period.
- Inventory control systems are classified as internal control systems and management control systems.
- Internal control systems should be able to prevent theft, damage, pilferage, and obsolescence.
- Management control systems should provide tools to determine optimal levels of inventory to enhance the efficiency of inventory management.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.