The Dust Audit

Inventory in business defined as “an economic figure that tracks the dollar amount of inventories held by retailers, wholesalers and manufacturers across the nation. Business inventories are essentially the amount of all products available to sell to other businesses and/or the end consumer. When tracked alongside a sales index, production activity in the near term can be predicted.1

To the investor inventory is studied by “tracking business inventories alongside sales, investors can interpret the direction of production demand going forward. If, for example, inventory growth is less than sales growth, production demand will increase, thus creating economic growth. The opposite could happen should inventory accumulation occur, which would cause national production to slow”.2

There are types of inventory, from raw materials on hand for the manufacturer, to finished goods, or stock on hand to the retailer or distributor. The economic and business academia have multiple methodologies for definitions of inventory in relation to number of times it turns over in a year (moves out of inventory and is bought again, or is ‘turned out”)

Most private companies take actual “inventory counts” several times a year, and most divisions of public companies do. Often they use methods of accounting, such as FIF (first in first out) to delineate inventory, and all keep accounting books where they define inventory value.

Value most typically is not lessened by holding inventory a longer period of time, often based on the false assumption that the inventory they bought now costs more to buy; some companies actually “increase” value of inventory, falsely, to show the increase in cost if they were to buy new.

As a business consulting company that works with firms that are often financially distressed, or near bankruptcy, or not reaching bank covenants we find that the misuse, misunderstanding, or manipulation of inventory value is a key method of either self-deception for the company, or planned deception to their creditors.

Hundreds of books are out, and management academia thrives on convoluted and complicated methods of ascertaining true value of inventory, or definition of “inventory turns”, and companies complicate inventory values even further when being sold and inventory “devaluation” often changes the final sale price dramatically as the “errors” are found. Often, due to how accounting books are kept, inventory is “argued” as to actual value during the due diligence of a merger, acquisition, or re-structuring.

We work very simply and ignore most methodology of inventory valuation that accounting firms offer, and are suspect always of what is called “outside audit” inventory evaluation, done by audit firms often on “spot checks”, rather than full service inventory count of everything. Audits are very valid only when done with a “full count” and without the influence of the firm being audited by “spot checks” for accuracy.

The accuracy of the count is valuable, but more valuable is the cost of the inventory and how long it has been held.

Ignoring the standard methods of audit has allowed The Evans Group LLC to uncover millions in “false data” with firms we’ve worked with over our 37 years of consulting.

The facts:

? Raw material must be valued as FIFO and priced at what the price paid was, not the current market value. Ex: Steel bought at $1.49 a pound on 1/1/13 that goes to $1.90 a pound should not be increased in inventory valuation, unless it is also lowered when the commodity price goes down.
? Parts, commodity pieces as part of manufacturing, must be evaluated separately in “number of turns” in inventory, meaning that a part may be held for several years or several months. The original cost of goods is the true value.
? Pieces, products, and “inventory” cost X, but at the end of one year, if they have not turned in inventory, cost as much as 25% more to the company not by the price of the product going up, but for the cost of holding the inventory longer than the normal turn ratio, and the cost of:

-holding and taking of useable space
-administrative cost to maintain books on the product
-inventory count costs (labor) to count the product numerous times, when a    normal turnover would have a lower labor cost.
-inventory that gathers “dust” is either not known it is there (poor product description) or simply not selling or being used, and the actual cost of the product after one year is up to 25% higher than the original cost.

? Many companies actually increase the value of “old inventory” to cover the burden of holding, when in reality the product is less in value, despite the higher cost by holding.
? If inventory is used as “collateral” for an ongoing bank loan many companies falsely, or on purpose, maintain the same value for something held in inventory for years, when in reality it’s cost has risen by holding, when it’s cost to buy new may be now less.
? Companies that “spot check” audit and do not evaluate the time period the product is held either cheat their own books and beliefs of value, OR do so intentionally to inflate inventory value for collateral.

The Dust Theory:

We trust no one. When we enter a company as consultants, whether the firm is doing great or poorly, our first review of financials asks these questions:

1. How often do you take a full physical count?
2. Do you double check your physical count to value on the books to prove it’s’ the true value?
3. Do you have a firm come in and professionally audit your inventory; if so, do they “spot check” or do a full inventory count?
4. Do you keep a date purchased as part of your inventory system; if not, why not?
5. Do you raise cost to cover increases in prices on inventory you hold or use FIFO (first in first out) methodology?
6. Do you use inventory as collateral for financing; if so, does your bank “trust” your count, or require a physical audit?

We then ask ten (10) people at the company that are involved in inventory the private question: “do you believe the inventory is accurate?”

Their answers are almost always “no”, or “I don’t know the value of the inventory”, or “we take inventory but everything is counted as new and “turning”.

The flag is up and we are ready to begin The Dust Audit.

It’s a very simple methodology and discloses mistakes, fraud, false conclusions or wrong/incomplete data.

We ask to take a “spot audit”. This surprises every client, and more flags are raised as they begin to “explain” how they keep their inventory count before we even begin.

Here’s how we do it:

1. Three people (or the amount of people necessary for the size of the inventory) using three tall “mover ladders” that allow the “counters” to hit the top shelves of the racking and work down.
2. We look for dust.
3. We make two assumptions about dust and begin our work:
   a. Is the work place/warehouse dusty by itself; if so, why?
   b. If the inventory we find “at the top of racks” is dusty, why?
4. We begin comparisons to how long the inventory that is dusty has been held (date of purchase) and how often X% of the inventory moves or turns to industry standards.
5. Hard questions are asked. We want to know why something is dusty and why it has not moved or turned, and with the exception of parts or raw materials (and often even those) we want to know why do you still have the product and despite its increased cost for holding are you depreciating the value for a “true inventory”?

There is no hard and fast rule and there are always exceptions but in 80% of the cases we find at least 20% (the 80/20 rule in action) of inventory is overvalued for the period it’s owned and the inventory valuation overall is thusly overvalued.

What’s the solution?

We want to know “why” first. Full disclosure and clarification/justification are key to our thinking, and depending upon what we “hear, see and smell’ in our dust audit we lead with the following rule of thumb:

Liquidate if the inventory is over a year old and take your losses. Do not hold inventory that is not turning unless you have the type of business that authenticates long holds, such as jewelry stores, or selling used equipment.

Liquidate by hiring a liquidator, or offering massive sales, or sending to an auction house.

Liquidate to stop the disease (lack of ease) of holding something you should not hold any longer. Take your losses to free up cash, to be honest with your own values, and to stop self-deception known as “it will sell, we’ll take a loss, and so we’ll just hold it”.

Top companies turn over bad inventory as quickly as good inventory as they know the bad inventory costs more to own than the good.

The dust audit stops deception and helps the company fine tune their inventory system, their buying habits, and frees cash flow by stopping the false valuations.

The Dust Audit is the most clear and simple way to bring truth to the eyes of the company, the financial statements, and what is healthy or sick inventory.

Getting dirty makes it clean.

Chip Evans, Ph.D

www.theevansgroupllc.com

1. Investopedia.com
2. Investopedia.com