Business owners receive the monthly profit and loss statement from their bookkeeper or accountant only to find that the profit makes no sense and the major issue is the gross profit margin.
This issue renders the profit and loss statement useless and leaves the business owner struggling to determine whether he is making a profit or not and important decisions becomes guesswork.
This is an all too common problem particularly for manufacturing businesses or businesses that hold high levels of inventory What is causing the variances? There could be several issues which are causing the confusing results but they relate to the following areas

• Incorrect Inventory Values
• The timing of when Inventory is moved in or out of the system, must be the same as when the inventory is recorded (purchase invoice from supplier or sales invoice to customer)
• Human error

Practical Examples of how these can be different Here are some common transactions that may be occurring.
Importantly some of the transactions are a TIMING DIFFERENCE (meaning that any difference they cause will "reverse" at a later period - this is therefore a loss or profit on paper only and no change to the business model is necessary, whilst some of the transactions are a REAL DIFFERENCE (meaning that it is a real loss or profit and a change to the business model, may be necessary).
1.
Incorrect Inventory Values Inventory is Valued at a different value than what you are paying for it

• The stock system has not been updated to reflect price increases, changed suppliers, exchange rate differences etc.
  Example: 1000 units of Product A purchased for $10 each and sold for $20 each.
  The price in the system has not been updated for 3 years and is showing the cost as $4 each.
  If these items are sold in the next month, the accounts will show the following Month 1: Gross Profit -$6,000 (Purchase $10,000 - Inventory $4,000) Month 2: Gross Profit +$16,000 (Sale $20,000 - Inventory $4,000) Total: Gross Profit +$10,000 Whilst the Month 1 and Month 2 results are incorrect, the end result is that the expected $10,000 gross profit is recorded - this is a TIMING difference only.
  However after receiving the gross profit results in Month 1, the business owner is likely to be in a panic wondering how he made a loss.
  
• Similarly if the actual cost of additional inputs such as direct labour, freight and packaging varies from the value assumed in your inventory calculation, variances will occur.
  These variances are likely to be REAL differences and therefore changes to your business are required.
  
• Solution
• Review your inventory values regularly (at least once a year, ideally each six months) to ensure they are accurate - for purchased inventory compare to supplier invoices.
  For manufactured inventory the assumptions in your calculation are correct.
  
• Direct labour must have a productivity measuring system
• All supplier increases (including increases to labour, packaging, freight) should be authorised by owner/senior manager and supplied to the person responsible for updating the inventory valuation file

2.
Timing between stock system movements and recording stock purchase and sales Inventory purchases have been recorded (i.
e.
the supplier invoice has been entered into the accounting system) but the inventory has not been received into the warehouse.
These issues can occur just before month end when there is either a delay in warehouse receiving (warehouse is full, receiving employee was absent, problem with the delivery, missing paperwork) or invoices are paid before the inventory is received (overseas purchases, supplier doesn't give credit) Solution

• Invoices should not be entered into the accounting system unless initialed by the receiving clerk
• A matching process be performed at month end, which compares invoices entered into the accounting system to goods received into the warehouse

3.
Human Error Common errors include

• Transferring in/out the wrong inventory unit (i.
  e.
  Product A instead of Product B)
• Inventory loss either accidental or intentional (theft)
• Incorrect counting at stock-take

Solution A combination of some or all of these

• Training: many employees do not understand the impacts of transferring the wrong product
• Accountability: communicate to inventory handlers that accuracy is their responsibility.
  Perhaps introduce a reward for significant improvement.
  
• Reporting: develop reports to measure the discrepancies
• Regular Counts: introduce spot checks, cyclical counts or more regular stock-takes.
  Review the results and analyse which products have the most issues, determine why and put a process in place which corrects this.
  

CONCLUSION Fixing an inaccurate inventory system is not quick, it often means correcting an issue, only to discover two more.
However, stick with the process, correct each issue as it's discovered and continue to do regular stock-takes or cyclical counts to re-set your stock quantities to the correct amount.
You MUST have accurate inventory and reporting to maximize the profits of your business - fixing a stock system will not only immediately improve the profit of the business but you'll also be able to make better decisions which will in turn generate more future profit.
DISCLAIMER: Many of the comments in this publication are general in nature and anyone intending to apply the information to practical circumstances should seek professional advice to independently verify their interpretation and the information's applicability to their circumstances.
The author expressly disclaims all and any liability and responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything, and of the consequences of anything done by any such person in reliance, whether wholly or partially upon the whole or any part of the contents of this publication.