Inventory audits aren’t among the most interesting parts of running a retail business, but they’re essential to its success. Look at it this way: if you thought you had $1,000, but discovered you only have $500, you’d be upset. The same applies to your inventory.
This guide explains the importance of inventory counts, inventory audit procedures you can use, a checklist you can follow, and challenges to consider.
Table of Contents
What is an inventory audit?
An inventory audit is a process of cross-checking your actual inventory levels against your financial records. It also helps you make sure that your physical inventory matches what’s in your inventory system.
There are many reasons why your inventory records might be off, and the only way to spot any inaccuracies is to conduct regular inventory audits. You can run an internal audit or conduct it at the request of an outside auditor. You can also hire a third-party company that offers inventory services.
Auditing your inventory shows you your true inventory levels (the stock you have on hand at your store or in your warehouse) and gives you a snapshot of the health of your supply chain.
When you run inventory audits on a regular basis, you can spot specific SKU numbers that tend to have more issues than others, and catch discrepancies before they become a bigger problem.
Importance of inventory audits
Now that you know what an inventory audit is, let’s look at why they’re important for your retail store.
1. You can ensure inventory accuracy
The biggest benefit of regular inventory audits is that they give you peace of mind. Your business decisions are often driven by data, and each inventory audit gives you real-time data to plan from.
Here are some elements of your store that rely on this data:
- Demand forecasting and planning product lines, marketing campaigns, staffing, and more
- Safety stock you need to have on hand to prevent stockouts
- The ideal reorder point based on product demand
- Store layout and product display
💡 TIP: Shopify POS comes with tools to help you control and manage your inventory across multiple store locations, your online store, and warehouse. Count inventory, forecast demand, set low stock alerts, know which items are selling or sitting on shelves, and more.
2. You can identify shrinkage
Shrinkage is what you have when your store has fewer inventory items than are listed in your records. Main causes of inventory shrinkage include shoplifting, employee theft, administrative errors, vendor fraud, and product damage.
The National Retail Federation reported that losses from theft and fraud totaled $61.7 billion in 2019, up from $50.6 billion the year prior.
If you don’t catch shrinkage on time, you might end up with phantom inventory, or inventory you thought you had on hand, based on your inventory management system.
Noticing shrinkage on time means you can reconcile your records and order new inventory quickly, instead of having an unexpected stockout. It also gives you an opportunity to investigate and solve the causes of shrinkage.
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3. It’s required for public companies
Inventory audits are required for public companies if their inventory is classified as a current asset on the company’s balance sheet. For more information about your country’s requirements and auditing standards, search for guidance from financial organizations and experts. In the US, for example, you can find up-to-date information on AICPA, the American Institute of CPAs.
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11 inventory audit procedures
- ABC analysis
- Cut-off analysis
- Physical inventory count
- Cycle count
- Analytical procedures
- Overhead analysis
- Freight cost analysis
- Finished goods cost analysis
- Product reconciliation
- Match invoices to shipping log
- Inventory layers
When it’s time to do an inventory audit, you can choose and combine different inventory audit procedures. Your choices will depend on your company’s needs, industry, and audit frequency.
1. ABC analysis
ABC analysis is an inventory categorization method that groups items based on value:
- A = 20% of stock that represents 80% of your revenue
- B = 30% of stock that represents 15% of your revenue
- C = 50% of stock that represents 5% of your revenue
A marks high-value items for your store, while C marks low-value items. By knowing which products belong to which category, you can prioritize inventory audits accordingly and even organize your back room or warehouse to facilitate them.
2. Cut-off analysis
Cut-off analysis involves pausing warehouse operations like shipping and receiving while you conduct a physical inventory count. This way, you can ensure that all financial reporting is up to date, and that no transactions or inventory changes slip through the cracks.
3. Physical inventory count
A physical inventory count involves manually counting the stock in your store, from the sales floor to the back room, and comparing the physical inventory levels to those recorded in your point-of-sale (POS) system and/or inventory management system. This also takes into account stock levels for different product variants, like colors and sizes.
A full physical count can disrupt day-to-day operations because it counts every item in the store. Still, it’s the most common inventory audit procedure.
4. Cycle count
Cycle count is the process of counting a small group of products at a specific time without having to disrupt business operations. It’s done regularly on a predefined number of products and makes it easy to focus on valuable products and keep their inventory levels accurate.
5. Analytical procedures
Analytical procedures involve financial and operational metrics like inventory turnover ratio, gross margins, unit cost of inventory from the previous years, and inventory days on hand (DOH).
6. Overhead analysis
Overhead analysis takes into account the indirect costs of running your retail business. This includes rent, utilities, insurance, and other costs, not including salaries and direct materials.
Knowing your overhead costs helps you budget and plan for your store accordingly.
7. Freight cost analysis
Freight cost analysis looks at freight shipping costs, the time it takes for a product to be shipped, and instances of products that are lost or damaged in transport.
This is how you can keep track of your shipping costs and the inventory lead time. Shipping costs are typically part of the value of inventory, so knowing them is essential.
8. Finished goods cost analysis
Finished goods cost analysis is relevant for retailers who manufacture their own products. When a product is ready to be sold, its value can then be included in inventory for the current financial period, to ensure that accounting records are accurate.
9. Product reconciliation
Product reconciliation or inventory reconciliation involves making adjustments to any discrepancies between your inventory and/or financial statements and the physical inventory you have on hand.
As you reconcile your records, use the opportunity to keep track of products that may be more likely to divert from the inventory levels in your system. This way, you can track them more closely and frequently to avoid future discrepancies.
10. Match invoices to shipping log
Matching invoices to shipping logs is about matching the cost and amount of inventory you received with financial records from your invoices. This can be done at random to spot-check inventory for a specific time period.
This procedure confirms that the correct amount was charged at the right time and for the correct inventory.
11. Inventory layers
Inventory layers are the quantities of items received or grouped together in inventory that share the same costs. If you’re using FIFO (first-in, first-out) or LIFO (last-in, first-out) inventory management principles, it’s worth looking at the inventory layers you received and making sure they’re correct.
Inventory audit checklist
When you’re gearing up to conduct an inventory audit, use this checklist to prepare the materials you’ll need, execute the audit, and analyze its results.
The planning stage
- Create an inventory audit schedule
- Prepare your documents and data
- Assess and prepare your inventory
Create an inventory audit schedule
What is a frequency that makes sense for your store’s size? Which periods are slow enough to minimize disruption to your operations?
Prepare your documents and data
This includes balance sheets and invoices, as well as data from your inventory management software and your POS software.
Assess and prepare your inventory
Make sure all inventory is unpacked, all pallets are accessible, and no items are out of place. This will ensure you’re not leaving them out or counting them twice.
The execution stage
- Select inventory audit procedure(s)
- Choose who’s auditing
- Conduct the physical count
- Reconcile records that don’t match the physical count
Select inventory audit procedure(s)
Does your store need a full physical inventory count? Can you focus on high-value items from your ABC analysis, or implement a cycle count? Are there any other parameters, like freight or overhead analysis, that you want to include?
Choose who’s auditing
Are you conducting the audit internally or through an external service? Will there be an auditor present to observe and spot-check your process?
Conduct the physical count
During this stage, no inventory should be moved in or out of your store or warehouse. Take note of your counts using a POS app with inventory capabilities, like Shopify POS, or a tool like Excel.
Reconcile records that don’t match the physical count
This helps you start your next period fresh and keep track of items that tend to mismatch.
The analysis stage
- Record inventory audit results
- Compare findings with previous audits
- Identify potential causes of shrinkage
- Look for opportunities to improve inventory methods
Record inventory audit results
Take note of everything you count, but pay particular attention to products and categories that have discrepancies.
Compare findings with previous audits
Are there products that are more prone to mismatches, or suppliers whose products seem to be a frequent issue? Are some periods more of an issue than others (for example, a busy holiday season)?
Identify potential causes of shrinkage
Look at what might be causing shrinkage so you can minimize losses. For example, product damage and vendor fraud might come from supply chain issues, and dead stock could mean you overestimated product demand.
Look for opportunities to improve inventory methods
Use your findings to explore ways to manage your inventory more efficiently and organize your warehouse better to minimize shrinkage and discrepancies.
Inventory audit challenges
Audits are time-consuming
Counting every item in your store and back room takes a lot of time and focused effort. Not just that: they require you to shut down your operations, including closing your store and pausing inventory shipments.
There are two key ways to minimize the burden of inventory audits on your store: choose natural downtime to do them, and use tools and systems that simplify the process.
It’s hard to scale auditing as you grow
As your store grows to include bigger spaces, more SKUs, more employees, and new locations, inventory audits become a larger burden to handle.
In that case, it’s more realistic to implement lighter and more frequent inventory audit procedures, like cycle counts and ABC analysis. Another thing to consider is an inventory control system like perpetual inventory.
Audit your inventory with confidence
Inventory audits don’t have to be a draining, overwhelming experience. They’re a useful tool to prevent shrinkage and stockouts, and leave you with a sense of peace and confidence about your plans for the store.
Follow these tips and checklist items to get your store ready for a successful inventory audit. Equipped with the right tools and strategies, you can get it done in no time and refocus on serving your customers.
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