How to Conduct an Inventory Audit

September 13, 2023 - 11 minutes read

Six keys to conducting an effective inventory audit.

No inventory management system can function optimally without accurate, up-to-date information. An inventory audit ensures computer data and physical reality are aligned.

Inventory counts date back thousands of years to a time when clay tokens and tally sticks were used to represent physical inventory for items like livestock and building materials. Ancient farmers and artisans could never have imagined the modern inventory management software and barcoding tools that have now made it feasible to accurately track millions of items. Inventory audits take advantage of these modern tools to periodically verify inventory counts, quality, and integrity.

Breaking free from Stone Age inventory management practices hasn’t been easy, but the auditing processes developed over time have helped. The regulations and methods continue to evolve, so any business that stores and maintains inventory should understand the definition, scope, and options for inventory audits.

Are you ready to learn more about the basic steps of an inventory audit? Read on.

What is an inventory audit?

An inventory audit is a process used to verify a company’s ERP system and financial records match their actual material on hand or in transit. The company’s inventory tracking processes are also assessed during an audit. Inventory audits also include verification steps to review whether items are labeled correctly and have maintained their value. Using our Stone Age examples, this would amount to carefully reviewing the age and health of livestock or the condition of materials like lumber and clay.

For small businesses with limited inventory, a systematic review of all items in stock might suffice. For more complex businesses, additional auditing tools might be deployed, such as:

ABC Analysis: Items are classified into three different categories (A, B, C) based on their value. Higher-value items are audited more frequently.
Freight Cost Analysis: This process evaluates what the company is spending to transport items from one location to another. This is useful for multi-channel commerce companies operating in several locations.
Overhead Analysis: Hidden costs like rent, electricity, and insurance are not always considered when the focus is on saleable items, but the impact of these factors can also be assessed in an inventory audit.

Who needs an inventory audit?

All publicly traded companies in the U.S. must perform an inventory audit at least once per year to comply with federal regulations. Private companies are not subject to these requirements, but frequently complete the audits anyway to ensure their financial records are accurate and their inventory management software is effective.

“Beware of little expenses. A small leak will sink a great ship.” – Benjamin Franklin

Inventory audits vs. physical counts

Physical counts are typically part of the inventory auditing process, but they are not one and the same. By definition, an audit is a risk-based sampling process that produces a high level of confidence in the overall system. Sampling performed during an inventory audit might include physical counts along with a review of records like purchase orders and invoices.

Since an inventory audit also includes an in-depth assessment of product integrity, audits are typically performed less frequently than simple physical counts.

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Inventory audit steps

As the saying goes, “When you fail to plan, you plan to fail,” and this certainly applies to inventory auditing. Before you begin the auditing processes, it is best to review and discuss important questions like:

Why are you auditing?
Who will be doing the auditing?
What will they be auditing?
Where will they be auditing?

During the planning phase, you should also assess your inventory management software to determine how it will be utilized during the audit and whether it can support necessary audit recording and reporting functions.

Regardless of the tools and processes used, inventory audits generally include the following steps:

1. Determine the scope

The scope of your audit encompasses the inventory and records to be reviewed and the processes you will follow. Government regulations can guide public companies toward the correct level of auditing required for compliance, although the business needs of the company might call for a deeper dive. The factors contributing to the audit scope include:

Audit methodology: Will you sample items or complete a full count? Will high-value items be audited more rigorously?
Audit frequency: Determining a cadence that makes sense will help you decide what to include in any given audit.
Locations: Are you focusing on a single location or multiple sites? How will this impact the number of auditors and their travel logistics?
Audit resources: What training is required for auditors, and how will responsibilities be divided between internal and external auditors?

2. Complete the audit schedule

An inventory audit can disrupt operations by temporarily preventing items from being moved or sold and taking workers away from their usual responsibilities. Audit dates should be scheduled strategically, making use of natural breaks like holidays or slow seasons, if possible, to minimize the impact.

The size and type of the business and products also feed into audit scheduling, since more time and resources are needed for larger organizations. High inventory turnover might mandate a higher audit frequency. Historical data from past audits (if available) is useful during audit scheduling to baseline time and resource allocation.

3. Collect documentation

Defining the audit scope upfront will help you accelerate the auditing process by prepping documents and records. Inventory and order management software packages become important sources of information as you search for data corresponding to high-value assets and complex processes that are likely to be reviewed. Your inventory software will allow you to generate data and reports quickly during the audit.

A review of record keeping practices for completeness, accuracy, and compliance is another aspect of the audit that tests how well employees are trained on inventory control practices. So, all documentation should be handled just as carefully as the inventory it represents.

4. Physical counting

The physical inventory count is where the rubber hits the road during the audit. IRS tax regulations and Generally Accepted Accounting Principles (GAAP) require public companies to complete physical counts at least once a year, but cycle counting a subset of items at fixed intervals throughout the year is an advisable practice. The steps required to complete a physical count include:

Assigning teams to count in specific areas.
Preparing counting tools such as barcode scanners.
Tallying the actual number of items found in each location.
Monitoring counting activities and spot checking results.

Inventory management systems simplify the counting process by providing real-time information on item locations, protecting inventory data, and integrating barcode scanning technology to minimize data entry errors.

5. Audit reconciliation

No inventory control system is perfect, so it is likely that some discrepancies between expected and actual inventory will be found during the audit. Audit reconciliation is the process of tracking and adjusting for these discrepancies. It is also important to investigate the root cause of all discrepancies, especially when problems like theft or supplier fraud are suspected. Investigating discrepancies helps you to uncover any systemic problems or errors and resolve them.

6. Inventory audit reporting

Each inventory audit should be accompanied by a report that details the findings, results, and necessary follow-up actions. The report should include an executive summary that highlights key aspects of the audit concisely. Complete details on audit participants, processes followed, and corrective actions should also be included to support future audit planning and decision-making.

Inventory audits: final thoughts

“I think it’s very important to have a feedback loop, where you’re constantly thinking about what you’ve done and how you could be doing it better. I think that’s the single best piece of advice: constantly think about how you could be doing things better and questioning yourself.” – Elon Musk

Audits are not just for finding problems or errors, they also increase overall visibility. With each audit, any discrepancies or gaps should be welcomed as opportunities to strengthen your inventory management system. A well-executed inventory audit also serves as a critical tool for maintaining the accuracy of financial records, ensuring compliance, and protecting the business from fraud or theft.

Unlike a basic physical count, an inventory audit is performed with the customer experience in mind, ensuring both quantity and quality remain as expected. Effective inventory management software is the key to simplifying this complex yet valuable task.

The best inventory management software improves audit practices and results. If you are ready to move your inventory management practices to the next level, please contact us. Our solution experts are available to help you discover why inventory management has become an essential business function.