Assets & Inventory – When Your Merchandise Grows Legs

Occupational Fraud – (Part 7 of 7)

By Mark Palmer, President e:countable, LLC

While most of my focus in previous articles has been on fraud relating to cash, this article focuses on theft of inventory or assets.  Inventory based companies, especially those who sell products that are appealing to consumers, are very much at risk of product walking out the door.  What are some of the ways inventory grows legs?

Buyer Beware, or Beware of Buyer – One of the most important positions of an inventory based company is its buyer.  The buyer is the person responsible for making sure you have the product you need in order to make sales, without crushing cash-flow by buying too much product.

Years ago I was requested by the owner of a wholesale distributor with many SKU’s to help him understand why he was losing money.  Sales were growing modestly, but his gross profit was declining significantly.  The product cost he paid to his vendors had not increased much, and the product mix of his sales had not changed at all.  He religiously performed quarterly physical counts and there were never any significant variances between actual counts and what the perpetual inventory showed.  So why was his margin shrinking?

Before I started diving into any financial analysis, I asked about his processes and who had what authority.  His buyer had complete autonomy with keys and an alarm code, access to the building, and full access to all functionality of the inventory management software.  It was very normal for the buyer to work late, saying he could focus better when no one else was around.

After digging into the inventory software and seeing what reports were available, it became clear.  The buyer would steal product after hours since he worked late and had full access.  He knew that if he didn’t change the quantity-on-hand (QOH) when he stole product, the count variances at quarterly physical counts would raise a red flag, so he adjusted the QOH down by the quantity he stole.  But he took it one step further.  He also knew that the owner regularly looked at the total value of product on hand so if the owner saw the value decrease significantly, that may raise a red flag.  His solution: when the buyer adjusted QOH down by the amount he stole, he also adjusted the average cost per on-hand unit up.  As a result, even though there were fewer units on hand, the inventory valuation did not change.  Consequently, when the remaining products were sold, more cost flowed through the cost-of-goods-sold section of the income statement and gross profit fell.

Taking Out the Trash – When asked to look into inventory shrinkage of another distributor, the theft process was a little dirtier, figuratively speaking.  When warehouse personnel weren’t busy pulling orders for delivery, they were responsible for stocking shelves with product received, and cleaning up the warehouse.  Part of the cleanup process was to haul trash out to the dumpsters.  We found that one man would stock product on the shelf, but then fill the empty cases with product he was stealing.  He would mix the cases of stolen product with trash and take it all to the dumpster outside of the building.  Then, in the middle of the night, he would come back to dig the stolen product out of the dumpster.  One particular night, after doing his dumpster dive, he was greeted by a reception committee with lights flashing and guns drawn.  Verdict…guilty!!

So what can you do to prevent theft of your inventory? In the case of the buyer fraud example, the buyer absolutely should not have unsupervised access to inventory.  There should also be controls in place anytime adjustments to quantity-on-hand and landed costs are made; segregation of duties, tighter user permissions in the software, approval processes, and exception reporting.  All decent inventory systems have the ability to print reports showing changes or adjustments to QOH, average cost/FIFO, purchase price and sales price.  These exception reports should be reviewed regularly to identify problem areas and possible fraud.  A fundamental control with inventory management is the three-way match of purchase order to receiving document to invoice.  Of course, each of these operating functions should be segregated.

Conclusion.  In this 7 part series on Occupational Fraud we have covered many types of theft: cash deposits, skimming, false vendors, even business owners stealing from their own companies.  There are many other examples I could give but there are common threads running through most of the fraud I’ve encountered: a lack of good controls in job duties, lack of well defined procedures, and little or no controls in the software used to manage the business or keep the books.

Ultimately, while each type of fraud is unique they all have one thing in common:  actively involved and informed owners are the best line of defense against occupational fraud. Outsourcing your company’s bookkeeping function is one of the best ways to become an educated business owner and prevent theft from your business. If you’d like to learn more about how you can protect your business, give us a call at (757) 962-1080.

Mark Palmer: Bio