3 Internal Control Functions for Manufacturing and Distribution

Three Internal Control Functions Every Manufacturer and Distributor Should Consider (article)

Inefficiencies in your operations can have the same impact on your business as a kink in a garden hose. Even a small disruption in operations can slow or even halt your output, which ultimately hurts your ability to fulfill obligations to clients.

Internal controls help you identify where the wrinkles are in your operations and why they are occurring. The consequences of inadequate controls—disruptions in the flow of the production process—are why manufacturers and distributors need to pay particular attention to their internal monitoring activities.

Good operational internal controls consist of the activities or procedures that illustrate whether operations are working together to meet your objectives. Operational control functions should address the gamut of your activities, from ordering of parts to third-party service providers. To enhance efficiency in their production line, manufacturers and distributors should start their operational internal control analysis with inventory, costing and purchasing. A solid base of controls in these three areas can have a ripple effect across your organization and help minimize the risks in your internal operating environment.

Inventory Controls

Your inventory of supplies, materials and products needs to be accurate in order for your business to run efficiently. To make sure your inventory reflects what you purchased and created, you need the right inventory management system.

Wall-to-wall inventorying leaves a lot of room for human error. Oftentimes, the approach uses employees who may not be familiar with the inventory being counted, where its located, what the right part numbers or units of measure are for each item, etc., which can lead to avoidable mistakes.  Those mistakes can cause poor purchasing decisions often leading to overstocking of certain parts while causing production to find shortages in others.

Cycle counting has long been considered a best practice, as it breaks up the task of verifying system inventory counts into manageable pieces. Items are divided up based on their importance to your operations. The top group would be the critical items (either by dollar value, or difficulty in obtaining the part, or various other considerations) you need for your production operations to function. Top tier items should have some items from that grouping counted daily or weekly with all items in that group being counted at least once or twice a month. The next group would be the items that are slightly less critical. This B group should be tracked so that all items in that group are counted at least four or six times per year. Nonessential pieces falling into lower tier groups should have all items in that group counted at least once or twice a year. Some companies may even have items that are counted less frequently than that.

Where cycle counting can get tricky is in implementation. Your management needs a plan to use cycle counting that’s built into the job descriptions of the employees tasked with inventorying your company’s products. Management also needs to support the initiative and require the deeper dives into any discrepancies found and identify the root cause of the discrepancies.

Cycle counting as an internal control can help identify when a mismatch between what should be there and what is actually there occurs. To get the most value out of the cycle counting approach, however, you also need activities that allow you to pinpoint what led to the error. Maybe it’s a flaw in your ordering system or a particular unintended mistake an employee keeps making that is causing the inventory count error in the system. After you pinpoint the reason and correct it, consider where else that behavior could be happening within your operations. You will often find that you resolve errors affecting many other inventory items by fully examining and correcting the errors that cause the one you identified during your cycle count.

Costing

The controls you use for costing will depend on the type of production you do and the costing methodology you choose to use. Larger companies tend to use standard cost, which sets up a predefined cost for purchases that carry through the bill of materials (BOM’s) into a predefined cost for the finished product. When using a standard cost methodology, you expense the difference between the price you actually paid for the part versus the amount you set for the standard cost of that part.  As an example, you may have a standard set for the part for $10/unit because that is your expected cost during the year based on your assumed volume of purchases. However, your first actual purchase of the year may be $12/unit for that part.  The $2 difference per unit between the actual purchase price and the standard cost in your system is referred to as “Purchase Price Variance (or “PPV”) and gets expensed in the period the part is purchased.

As a best practice, if your company uses the standard costing methodology you should monitor the purchase price variances very closely. Those PPVs are a control to help identify when your purchasing costs are not falling in line with what you expected when you did your budgeting at the start of the year.  You may find, for example, that you are grossly under/over estimating the actual cost to produce and distribute a certain product line and that gross margins are therefore over/under stated during the year.

Smaller companies tend to use average cost as a proxy for first in first out (FIFO) as their costing method. In average costing, if the first part costs you $250 to build and the second costs you $200 to build then the average cost of the two items in your inventory (or sold if you sold them both) would be $225 per unit.

Companies using average costing, as an internal control, should periodically “proof out” a sampling of the parts the system is costing. For example, if the system says the average cost is $190/unit but you can see the parts received were one part at $250/unit and one part at $200/unit you know the system should be recording the average of $225/unit, not $190/unit.  However, similar to the discussion on cycle counting, you should not just correct the system with the right average cost; you should also look for the root cause of why the system is reflecting the wrong cost. It may show, for example, that parts pulled out or put back from an internal department (such as R&D) affect the calculation differently. Once that is understood, you can work with the software vendor to determine how to do the same activity in a manner that does not negatively affect the average costing of the item.

Purchasing Controls

Control procedures are crucial to your company’s purchasing activities. Basic activities, such as segregating duties, can reduce your company’s risk of financial fraud. Employees responsible for making purchases, for example, should not be the same employees receiving the goods or handling payments to vendors.

Another purchase control that can be simple to implement is a periodic bidding process for suppliers and also for outsourced providers. You may choose to stay with a higher cost provider for very good reasons. Those reasons may be for things such as consistent delivery, ease of working with them, or many other factors that have intangible savings or benefits to you.  However, sending the work out to bid periodically will help you make sure you are either close to market or at least understand the premium you are choosing to pay for those intangible benefits. 

Find the Source of the Kink Faster

Maintaining a good system of operational internal controls helps you find the underlying cause of a particular problem in a more efficient manner.  For example, inventory errors found through cycle counting may reveal things such as purchasing overriding the system lead times in order to meet the build schedule.  Often the problem with that is that the supplier is only committed to the standard lead times in the system (before the override).  Finding the root cause of that inventory error, bringing the relevant parties together to resolve the root cause (for example the purchasing person, the production manager, and the vendor) can eliminate that same error from occurring with other vendors and parts. Fixing that root cause then leads to a better and more accurate inventory, better vendor relations, better employee morale, and a better ability to meet customer delivery targets. The ability to get to the source of the problem also quickly reduces the chance that your production problems will have an effect on your bottom line.

For more information about how to structure and implement effective internal controls, please contact your local CBIZ MHM professional.


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CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

Three Internal Control Functions Every Manufacturer and Distributor Should Consider (article)https://www.cbiz.com/Portals/0/Images/IP-THR~1.JPG?ver=2020-12-03-132226-407https://www.cbiz.com/Portals/0/Images/THUMBN~1-3.JPG?ver=2020-12-03-132222-787Inefficiencies in your operations can have the same impact on your business as a kink in a garden hose. Even a small disruption in operations can slow or even halt your output, which ultimately hurts your ability to fulfill obligations to clients....2015-06-12T16:17:00-05:00

Inefficiencies in your operations can have the same impact on your business as a kink in a garden hose. Even a small disruption in operations can slow or even halt your output, which ultimately hurts your ability to fulfill obligations to clients.

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