Thesis University of Hargeisa

The Importance of Physical Counting in

Inventory Control

A research paper written as a partial fulfillment for

the requirements of the academic award of BBA

Submitted by
Mahad Hussein Abdi
July, 2010

UNIVERSITY OF HARGEISA
FUCULTY OF BUSINESS
ADMINISTRATION

Submitted to the Advisor

A/rahman Ali Hirsi

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CHAPTER ONE:
1. INTRODUCTION

1.1 Background of the study

This paper addresses the importance of physical counting in inventory control and
provides guidelines for conducting annual physical inventories, and is applicable to all
units that hold inventory for resale to external or internal customers. Annual physical
inventories not only help to ensure the accuracy of inventory balances reported in the
Business's financial records but also help you manage the activity in your area.

Physical counting in inventory control is placed on the procedures which have been
developed to ensure the highest possible degree of accuracy in knowing what (quantity)
and where (location) the material is stored at the distribution center. Management
techniques involved in planning, scheduling, and conducting physical inventories.This
will provide the background of appropriate physical inventory control specially
Somaliland small businesses. and to research the importance of physical counting in
inventory control.

Inventory merchandise is one of the largest current assets of a retail store or of a wholesale
business. The sale of this merchandise is the major source of revenue. In merchandising
company, the inventory consist of all goods owned and held for resale to customers. Inventory is
converted into cash within the company’s operating cycle and therefore, is regarded as acurrent
asset.

The business starts each period with beginning inventory; the goods that are left over
from the preceding period, during the period, the business purchases additional goods for
resale. Together beginning inventory and purchases make up goods available for sale.
The remaining portion or amount of inventory at the year-end is recognized as ending
inventory for the period.

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1.2 Research problem Statement

The research problem of this study focuses on how Somaliland Small enterprises control
their inventory and the importance of appropriate inventory accounting in the reliability
of corporate financial statements and also the techniques they use to control their
inventory. Therefore, the success of every enterprise organization depends on how its
inventory is managed effectively and efficiently to attain the goals of the organization.
Well managing businesses’ Inventories are most common factors that brings successful
organizational goal.
1.3 Purpose of the study
Physical Counting in Inventory Control is a system that provides an easy way to protect
potential loss of inventory. It also provides reliable corporate financial statements.
Therefore, the general purpose of this study is to research how appropriate and consistent
physical counting in inventory control contributes to the accurateness, trustworthiness of
businesses financial statements as well as reporting, and reduces inventory losses.

1.3.1 Specific objectives of the Paper

o To Study inventory control of small businesses in Somaliland.
o To understand how small businesses use costing methods of inventory.
o To explore the importance of physical counting in inventory control.
o To identify effects of inventory errors on the financial statement.
o To know the usefulness of physical inventory control.
o To identify the benefits of Accurate physical inventory

1.4. Method of data collection:

This research is descriptive research project, as its major purpose is to get a better
understanding of the importance of physical counting in inventory control. The design
used on this research is collecting and analyzing both secondary and primary data. Most
of the secondary data from books, internet and reports about the importance of physical

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counting in inventory . While the primary data was basically from questionnaire this
study were used questionnaire-based method to collect detailed information regarding the
topic. The methodology employed by this study is developed by taking into account the
specific social and cultural context of Somaliland businesses. Issues and capability of the
researcher, the time-frame and the availability of resources are also taken into account.
1.5 Significance of the study:
The importance of physical counting in inventory control is to safe guard the assets.
Physical assets such as, inventory can be stolen, misused or accidentally destroyed unless
they are protected adequate control. Therefore appropriate counting would provide
physical securities for inventory and ensure that security is maintained.
1.6 Limitations of the study:
Limitation of the paper emerged from numerous probable sources as following articles
illustrate:
1. Unwillingness of companies and businesses to be questioned.
Many businesses were reluctant to be questioned about their accounting system and also
their accounting for inventory. When you arrive at their offices and talk about the study,
if not reject to reply quite skeptical responses are provided in a way of having the
sensation that there is a hidden agenda behind this research paper.
2. Misperception and Understandability
Misperception and understandability was another limitation that faced the study to be
conducted smoothly. Most of the people are research illiterate, and it is difficult to
conduct research as people have bad attitude towards the questionnaire.
3. Time, cost and environment circumstance.
As the essay and primary objective of this research paper is quite broad and large enough,
it deserves more time and cost definitely. Also, since the country has experienced long
struggle for independence, all infrastructures and facilities which might be supportive
sources and tactics for the successful of this study had utterly or nearly been obliterated.
Thus, there is precisely scarcity of facilities adequate for condensing the efficiency of this
research.

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1.7 Organization of the study

In the first section (Introduction), there is familiarizing segment that introduces the reader
to the topic of Physical counting in inventory control and its role in reducing the
inventory mismanagement; accordingly, this section shall brief the ways that an
appropriate accounting for inventory help the reliability of financial statements.

In the Introduction part, the researcher shows the aims, problem statement, significance
of the study, limitation of the study and organization of the study.

In the Second section (literature Review), it is given more about what has been said about
the topic by earlier researchers, including different findings from multiple authors who
devoted more time on the subject matter of this topic. In this section, related periodicals,
journal articles and professional publications will be cited. Therefore, this section is a
reference to the academic conclusions drawn from the issue, which is the interest of the
paper.

In the third section, the research paper will be described the research methodology that
uses the research design, the source of research paper, and the kind of sampling used of
the study.

In the fourth section, the research paper deals with the result of the findings and a
detailed analysis of the information obtained, so as to enable the reader to capture the
whole picture of the study. In five section will include well-founded recommendations.
And conclusions of the study. The researcher shall enlist all relevant points that sound
him convenient and helpful for later researches.

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CHAPTER TWO:
2. LITERATURE REVIEW

2.1. Origins of the word inventory

Inventory is the stock of any item or resource used in an organization or held in the
ordinary course of business or goods that can be used in the production of the goods to be
sold include: raw materials, finished products, component parts, supplies, and work-in-
process. The word inventory was first recorded in 1601. The French term inventaire.

An inventory system is the set of policies and controls that monitor levels of inventory
and determines what levels should be maintained, when stock should be replenished, and
how large orders should be. The scope of inventory management also concerns the fine
lines between replenishment lead time, carrying costs of inventory, asset management,
inventory forecasting, inventory valuation, inventory visibility, future inventory price
forecasting, physical inventory, available physical space for inventory, quality
management, replenishment, returns and defective goods and demand forecasting.

2.2. Introduction to physical inventory count

The physical inventory count required by a periodic system is taken once a year at the
end of the year. However, most companies need more current information regarding their
inventory levels to protect against stock outs or over purchasing and to aid in the
preparation of monthly or quarterly financial data. As a consequence, many companies
use a modified perpetual inventory system in which increases and decreases in quantities
only- not dollar amounts – are kept inventory records1

2.3. The Importance of Physical Inventories

One of the least enjoyable aspects of retailing is performing physical inventories. It is a
laborious and tedious task that requires extra hours when you and your staff are most
tired and irritable. Frankly, it's about as much fun as brushing your teeth with battery
1
www.google.com, www.wikipedia.org--free online encyclopedia
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acid! While this overstates the obvious, what isn't always obvious is that most of the
work and burden is not in the actual count itself but in the preparation, audit and analysis
of the inventory.

Accurate and timely physical inventories are one of the most important responsibilities
in assuring profitability and success for a retailer. An inaccurate inventory can be the
difference between profit and loss. Not only can the current year's performance be
misstated, but an inaccurate inventory in one year results in inaccuracy in subsequent
years. For example, overstating inventory as the result of a miscount this year will not
only overstate profits (and potentially taxes) for the current year, it will show up in the
next year when last year's overage turns into shrinkage. In the meantime, buying and
business decisions will have been made based on erroneous information which can have
an even more adverse effect on profits.

Essential to the success of any inventory management system is that for proper analytical
decisions to be made they must be based upon accurate data. Garbage in; garbage out. It
doesn't take much of an error, for example, if fall suits are counted as spring suits to
throw off stock levels and effective buying decisions to assure that the right product mix
is available to meet your sales goals for the current and coming season. The implication is
even more obvious for basics such as cosmetics. Improper counts not only inaccurately
report current earnings, but become the basis upon which future errors and losses will be
reported.

Performance, and at least indirectly compensation, of everyone from the executives to

the buyers to the sales associates, to the receiving room and administrative staff is
affected by a physical inventory. If your staff can trust the accuracy of your inventory
control system they will save time.

Instead of running to the floor or stock room to check on a product's availability or

performance they need to be confident in the system's book inventory. All can quickly
see that freeing up this time can result in improving controls and accuracy - and even
more important - customer service. As important as accurate counts are to running an

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effective merchandising system, the acceptable error rate for effective merchandising is
much more forgiving than what is acceptable from a financial point of view on a
company's financial statement.

Inventory specialists usually find that if your book inventory is within 3% of actual
inventory, you have the basis for an effective merchandising system. However, if you
turn your inventory twice a year the national inventory shrinkage of about 1.7% (of sales)
is more than what is considered ideal for effective merchandising system. The bottom
line is that controlling shrinkage and inventory can be the difference between opening
another store and closing the doors of a last store. At 1.7% of sales, shrinkage costs the
average consumer about $450 a year; that's over $30 billion dollars a year in the United
States alone. The cost is probably two to three times higher for retailers and their staff
who bear the brunt of this cost first.

However, as independent retailers who remain closer to their inventory, staff, and, most
importantly, customers through higher service levels, we should expect much smaller
shrinkage numbers as it is much easier for us to control than large, big box operators -
who promote high traffic to survive. While accuracy in physical counts is an important
indicator for identifying the source of shrinkage, the timeliness and frequency of physical
counts can be even more important. Once the importance of physical counts is
understood, proper counting procedures need to be established and documented for a well
controlled and supervised physical count.(Tim Smyth,January 2006)

2.4. Accurate Physical Counts

Contribute to Better Customer Service
Everyone in your organization must realize that the primary purpose of a physical
inventory is not to please your accountant or the Internal Revenue Service. It is to verify
that the on-hand quantity of each item in your computer reflects what is actually on the
shelf. When a customer calls to see if you have 100 pieces of an item in stock, and your
computer shows that 150 are available, does your salesperson drop the phone and run out
to the warehouse to see what’s actually on the shelf? How many more calls could be
answered if your salespeople weren’t taking these frequent field trips to the warehouse?
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And, do you really believe that your customers enjoy listening to five minutes of top 40
hits (or your claims of providing superior customer service) while they sit on hold?
Salesmen need to be able to trust the accuracy of the stock quantities in your computer. If
they believe what they see on the screen, they’ll sit at their desks and handle more
customer inquiries (or even originate some sales calls). Just as important, your customer
can get on with his business.

2.5. Accurate Physical Counts

Are Necessary for Effective Replenishment
Most computer systems produce very impressive buying reports. These reports show you
how much of each item the computer thinks is in each warehouse, how much will be
demanded by customers in the near future, and how much should be ordered from a
vendor or central warehouse. What happens if the quantities in the computer are wrong?
Disaster! No matter how sophisticated the software, the wrong quantities, of the wrong
products, will be ordered.

If there is more of an item in the warehouse than is reflected in the computer, the product
will be ordered too soon, and the company’s money will be tied up in products you don’t
really need. Worse, if the on-hand quantity in the computer exceeds what is on the shelf,
the product will not be ordered at the proper time, and a stock out may occur. Even if it is
a valid excuse, few salespeople are tolerant and understanding when a buyer explains, "I
would have reordered the item, but the computer said we had plenty."

If a buyer has to make replenishment decisions with inaccurate stock balances, he cannot
succeed. He might as well be trying to find his way through Kansas with a map of New
Jersey! And like the "eye-ball" inspections for customer inquiries discussed earlier,
deciding what to order by going out to the warehouse and examining each bin is
extremely inefficient. Not only does it take too long, but you can’t review valuable
information in your computer such as upcoming customer orders, usage history, and
expected lead times.(Jon Schreibfeder ,1997)

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2.6. Physical Inventory Process

There are two basic approaches to assuring record accuracy. Wall-to-wall inventories
such as the annual inventories taken by many commercial retailers and cyclic inventories
where inventories are continuously taken. While the wall-to-wall concept frequently
works well in the private sector, it is inappropriate for DoD. Private businesses draw-
down on-hand quantities so there is less to count. They close their doors while
conducting wall-to-wall inventories. The Department of Defense can do neither, as its
supply system never stops. The DoD supply system must be operable 24 hours every day.

Physical inventories require counting the materiel in the storage location and comparing
that count to the quantity recorded in the accountable record. This is a very laborintensive
effort; therefore, resources must be carefully and selectively applied to ensure maximum
returns are derived from the investment. Since the DoD supply system never stops, strict
controls must be placed on what we call in-float documentation. When a decision is made
to physically inventory an item, a control date is established so that all inprocess
transactions affecting the physical materiel quantity and the accountable record quantity
are dated. This is done to identify whether these transactions occurred before or after the
physical count was made. They
must be properly considered when comparing the record on-hand asset balance to the
physical count.(DoDI 4140.1R, DoD Material Management Regulation.)

2.7. Conducting the Physical Count

2.7.1. Review counting instructions with the counting teams before they begin.
Provide examples of how to find codes, units of measure, quantities, etc. Demonstrate an
actual count. Explain the complete process, including reason for the count, storage area
and stock layout, numbering and distribution of inventory tags, collection, and
summarization of the count sheets.

2.7.2. Control of the inventory tags or count sheets helps ensure completeness
and accuracy of the count. 1. If inventory tags are used, confirm that each stack issued to
count teams is complete and in numerical sequence. A log should be kept of the tags
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issued to each team to ensure all are returned and accounted for, otherwise a tag with a
"real" count may be misplaced and you may not be aware of it.
2. Complete inventory tags in pen to prevent erasures. Correct errors by lining out the
error, writing the correct entry, and initialing the change. If an entire tag must be redone,
the tag should be marked "ERROR – DO NOT COUNT" and a new tag created for the
item. No inventory tags should be discarded. 3. Collect the completed inventory tags
from each team at the end of the second counts, confirming against the log that the same
tags issued have been returned and that no tags are missing.

2.7.3. Count items twice to provide as accurate a count as possible. Each count team
should be assigned to a specific area for their first count, then perform a second count in
another area to confirm that area's first count. Discrepancies should immediately be
brought to the manager's attention. Third and fourth counts may be necessary to obtain an
accurate count.(Physical Inventory Guidelines Rev. 3, 27-MAR-2009)

2.8. Accounting for Inventory Purchases and Sales

To begin a more detailed study of inventory accounting, we must first establish a solid
understanding of perpetual and periodic systems. The accounting procedures for
recording purchases and sales using both a periodic and a perpetual inventory system are
detailedin this section.

2.8.1. Overview of Perpetual and Periodic Systems

Some businesses track changes in inventory levels on a continuous basis, recording each
individual purchase and sale to maintain a running total of the inventory balance. This is
called a perpetual inventory system. Other businesses rely on quarterly or yearly
inventory counts to reveal which inventory items have been sold. This is called a periodic
inventory system.

2.8.2. Perpetual System: You own a discount appliance superstore. Your biggest-
selling items are washers, dryers, refrigerators, microwaves, and dishwashers. You

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advertise your weekly sale items on local TV stations, and your sales volume is quite
heavy. You have 50 salespeople who work independently of one another. You have
found that customers get very upset if they come to buy an advertised item and you have
run out. In this business environment, would it make sense to keep a running total of the
quantity remaining of each inventory item and update it each time a sale is made? Yes,
the benefit of having current information on each inventory item would make it
worthwhile to spend a little extra time to update the inventory records when a sale is
made. This appliance store would probably use a perpetual inventory system.

With a perpetual system, inventory records are updated whenever a purchase or a sale is
made. In this way, the inventory records at any given time reflect how many of each
inventory item should be in the warehouse or out on the store shelves. A perpetual system
is most often used when each individual inventory item has a relatively high value or
when there are large costs to running out of or overstocking specific items.
(http://www.sears.com;)

2.8.3. Periodic System: is a system of inventory in which updates are made on a

periodic basis. This differs from perpetual inventory systems, where updates are made as
seen fit. In Periodic Inventory System no effort is made to keep up-to-date records of
either the inventory or the cost of goods sold. Instead, these amounts are determined only
periodically-usually at the end of each year.

As the inventory records are not updated as transactions occur, there is no need of
Inventory Subsidiary Ledger. The foundation of the periodic inventory system is the
taking of a complete physical inventory at year-end. This physical count determines the
amount of inventory appearing in the balance sheet. The cost of goods sold for the entire
year then is determined by a Short Computation.( Robert F. Meigs, Jan R. Williams, 2009)

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2.9. Preparing and Planning for Physical Inventory

The most important element to a successful and accurate physical inventory is proper
planning and preparation. Written procedures that are understood by all involved is a
good first step that will help to assure a well controlled and disciplined count and allow
you to focus on an accurate count which will be more efficient and take less time. The
more time you spend on the preparation of a count, the less time it will take to perform
the count and the more likely you will have an accurate count and minimize re-counts.

2.9.1. Schedule the Count Date Set the count date well in advance so everyone
has time to prepare for it and schedule around it. Avoid busy seasonal times and times
when your team may not be available or will be preoccupied and less likely to be focused
on the task at hand. If you have multiple stores or stock locations, multiple dates can be
selected. Often this is preferable, especially as it allows your management staff to be
available for supervision.

2.9.2. Human Resource Considerations While you must consider the

availability and experience of your staff, you must also consider the importance of checks
and balances and personal accountability. If internal theft is a problem, you can't depend
on a completely accurate count; it's like letting the fool guard the warehouse. Where ever
possible, you should rotate your staff to areas for which they don't have direct
responsibility. Exchanging store personnel to other stores is ideal for multiple store
locations. Even where this isn't practical, consideration should be made to separating
close friends on separate teams if collusion is a possibility.

Of course, third party inventory services provide an alternate resource. They have an
advantage of being independent and have no tracks to cover. On the other hand, they do
not know the merchandise and physical stock locations as well as your own staff. Third
party services are usually most effective when they work closely with your staff. For
example, the service can take detailed counts and your staff can perform verification
counts to double check their work. (Bergman, R.P 1988)

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2.10. Inventory Accounting Methods

2.10.1. Specific Identification

Specific Identification is a method of finding out ending inventory cost. It requires a

very detailed physical count, so that the company knows exactly how many of each
goods brought on specific dates remained at year end inventory. When this information is
found, the amounts of goods are multiplied by their purchase cost at their purchase date,
to get a number for the ending inventory cost. On theory, this method is the best method,
since it relates the ending inventory goods directly to the specific price they were bought
for. However, this method allows management to easily manipulate ending inventory
cost, since they can choose to report that the cheaper goods were sold first, hence
increasing ending inventory cost and lowering cost of goods sold.

This will increase the income. Alternatively, management can choose to report lower
income, to reduce the taxes they needed to pay. This method is also very hard to use on
interchangeable goods. For example, it is hard to relate shipping and storage costs to a
specific inventory item. These number will need to be estimated, and hence reducing the
specific identification’s benefit of being extremely specific.

2.10.2. Moving-Average Unit Cost

Moving- Average Unit Cost is a method of calculating ending inventory cost. Assume
that both beginning inventory and beginning inventory cost are known. From them the
Cost per Unit of Beginning Inventory can be calculated. During the year, multiple
purchases were made. Each time, purchase costs are added to beginning inventory cost to
get Cost of Current Inventory. Similarly, the number of units bought is added to
beginning inventory to get Current Goods Available for Sale. After each purchase, Cost
of Current Inventory is divided by Current Goods Available for Sale to get Current Cost
per Unit on Goods. Also during the year, multiple sales happened. The Current Goods
Available for Sale is deducted by the amount of goods sold, and the Cost of Current
Inventory is deducted by the amount of goods sold times the latest (before this sale)

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Current Cost per Unit on Goods. This deducted amount is added to cost of goods sold. At
the end of the year, the last Cost per Unit on Goods, along with a physical count, is used
to determine ending inventory cost. (John Wiley & Sons Canada, Ltd, 2007,)

2.10.3. First-In, First-Out

The FIFO method assumes that goods are used in the order in which they are purchased.
In other words, it assumes that the first goods purchased are the first used (in a
manufacturing concern) or sold (in a merchandizing concern). The inventory remaining
must therefore represent the most recent purchases. For example; If we sold milk,
it is not hard to imagine that we would try to sell the oldest milk (the
first milk that came into the store) first. In that instance, the FIFO
method would follow the physical flow of the goods. To use FIFO, it is
necessary to keep detailed records of the number of units in each
receipt of inventory and each sale. To illustrate FIFO, LIFO, and
weighted average, we will use the same set of figures: Jan. 4 Receive
1,000 units at a cost of $35 each , Jan. 5 Receive 1,250 units at a cost of $40
each, Jan. 7 Sell 500 units, Jan. 8 Sell 750 units , Jan. 9 Receive 2,000 units at
a cost of $42 each, Jan. 10 Sell 1,000 units.

There is nothing difficult about figuring out how much the units that were sold
cost, if you keep track and go through each step carefully. We can even
check our calculations, since we
know that whatever was not sold must still remain in the store, and under
FIFO the last units in will be the units that will still remain in inventory. The
chronology of what happens to the
units is shown in Figure 2-1. During the period of time this example covers,
the company purchased 4,250 units (1,000 _ 1,250 _ 2,000) at a total cost of
$169,000 ($35,000 _ $50,000 _ $84,000) and sold 2,250 units (500 _ 750 _
1,000). There are 2,000 units left in inventory (4,250_2,250). The value of the
units remaining in inventory will be an asset on the Balance Sheet, and the
Cost of

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Figure 2-1
Date Receive Price Total Sell Balance

Jan. 4 1,000 35 35,000 1,000

Jan. 5 1,250 40 50,000 2,250

Jan. 7 500 1,750

Jan. 8 750 1,000

Jan. 9 2,000 42 84,000 3,000

Jan. 10 1,000 2,000

Total 4,250 169,000 2,250 2,000

goods sold will be an expense on the Income Statement. The inventory costing
assumption allows us to assign a cost to the units that were sold and also to value the
units left in inventory. The amount we take from Inventory and charge to Cost of goods
sold plus the balance left in Inventory must equal $169,000, the total value of the units
purchased for resale. The inventory costing assumption allows us to split the $169,000
(which includes inventory purchased at different times at various prices) between the
Inventory account (a Balance Sheet item representing what’s left) and the Cost of goods
sold account (an Income Statement item representing what was sold).

2.10.4. Last-In, First-Out

As you can imagine, LIFO is the opposite of FIFO. With LIFO,nwe assume that the last
units purchased are the first goods sold. In some cases, this might even approximate the
physical flow of the goods. If we sold firewood, for example, we might stack the wood in

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a storage area. All new inventory would be stacked on top. When someone wants to make
a purchase, we take the wood off the top, thereby giving the purchaser the units that were
the last in. When all is said and done, we debited $169,000 to Inventory for the
purchases (this is the same no matter what cost flow assumption is chosen). With LIFO,
we transferred $92,000 ($20,000 _ $30,000 _ $42,000) to Cost of goods sold, leaving
$77,000 as the balance in the Inventory account. As with FIFO, we can check our answer.
There are 2,000 units left. Under LIFO, the units sold are the last ones in; therefore, the
units remaining in inventory were the first ones in. The first units in were the January 4
purchase of 1,000 units at $35, for a total of $35,000. The January 5 purchase was used
up, so the remaining units came from the 2,000 units purchased on January 9 at $42 each.
There are 1,000 units left from this group, so 1,000 at $42 equals $42,000. Our
calculation of what the balance in the Inventory account should be is $35,000 plus
$42,000, which equals $77,000. We did it right again. When a company elects to use the
LIFO method, it is required to also keep track of what the balance in Inventory would be
if it had used the FIFO method. This is disclosed in the footnotes to the financial
statements. This is a fair amount of work and something of a burden, but if the company
chooses to use LIFO, it should be aware of this requirement.

2.10.5. Weighted Average

The weighted average cost flow assumption uses the weighted average of all units
purchased. Each time a purchase is made, a new weighted average is computed. The first
purchase occurs on January 4. We get 1,000 units at a cost of $35 each. The total value of
the order is $35,000. To find the weighted average, we take the total balance

of Inventory and divide by the total number of units.Total inventory value $35,000
divided by Total units 1,000 then the Weighted average is $ 35.00 When the purchase on
January 5 is made, we need to recompute the weighted average. We do this by taking the
total value of the purchases ($35,000_$50,000) and dividing by the total number of units
(1,000 _ 1,250): Total inventory value $85,000 Total units 2,250 and Weighted average
will be $ 37.78 Therefore, every pair of jeans would have the inventory price of $37.78,
regardless of whether they were actually bought in the $35 purchase or the $37.78
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purchase. This weighted average would remain unchanged until the next purchase occurs,
which would result in a new weighted average cost to be calculated. This inventory
accounting method is used primarily by companies that maintain a large supply of
undifferentiated inventory items such as fuels and grains. (Kieso and weygandt, ninth
edition)

2.11. Inventory Control Systems

2.11.1. Introduction
Inventory is a difficult asset to control—it arrives and departs company
premises daily, is scattered throughout the warehouse and production
areas (and possibly offsite storage locations), may contain obsolete or
scrap items, can involve thousands of part numbers, can include items
owned by suppliers or customers, and may be valued using a variety of
techniques for both direct and overhead costs. We use control systems
to make it less likely that the units and costs associated with inventory
are incorrect. This chapter begins with a discussion of control systems
and then describes a list of 68 possible inventory controls in such areas
as in-transit inventory, inventory storage, obsolete inventory, and
inventory transactions. Although it is not necessary to implement all of
the controls noted here, it is a representative list from which one can
pick those controls that are most likely to positively affect one’s
inventory accuracy.

2.11.2. What Is an Inventory Control System?

When dealing with inventory, one should be concerned about three
issues: (1) the physical quantity of goods in stock and (2) the cost at
which they are valued, as well as(3) the proper billing of shipped
goods. An inventory control system should be based on these issues.
First, its design should minimize the risk that inventory will be lost
through any number of means (e.g., pilferage, scrap losses, natural
disasters).
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This does not mean that a vast array of controls should be installed
that make it impossible to lose inventory, but at the price of burdening
the materials management process with a multitude of non-value-
added activities. On the contrary, one must customize the control
system so that sufficient controls are in place to mitigate the greatest
risks of inventory loss, while avoiding those controls that have
comparatively little impact on inventory losses. Second, the control
system should ensure that costs are fairly and consistently applied to
inventories. These controls can cover a wide array of areas, such as
automation of transaction data entry to avoid entry errors, locking
down access to the unit of measure field in the item master file, and
controlling the contents of the overhead cost accumulation pools.
Many of these controls do not require additional labor to maintain once
they are set up, so there can be considerably more controls over
inventory costs than may be the case over quantities.

Third, it should ensure that goods shipped are appropriately billed to

customers.
An inventory control system is less concerned with billing the correct
amount to customers; instead, the main point is to ensure that the
billing transaction is appropriately triggered by a shipment action. All
of these issues are affected by the accuracy of inventory-related
transactions, which are dealt with in the final section of this chapter.
The following sections describe many possible controls over various
aspects of inventory quantities and controls. They are intended to be a
pool of possibilities from which one can make selections, rather than a
mandatory array of control requirements.

2.11.3. Inventory in Transit

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Inventory in transit is an area that is customarily ignored by control
system designers, because they tend to think only in terms of on-site
inventory. However, this can be a major problem area if the terms of
inbound or outbound shipment specify that the company retains
ownership of the goods either before or after its arrival at or departure
from the company premises. Thus, the key control issues include
identification of the ownership of any in-transit inventories, mitigation
of ownership risk, and inclusion of owned in-transit items in inventory
valuations. The following controls address these issues:

Ownership: Record intercompany inventory transfers in a central inventory database. If a

company shifts inventory from one subsidiary to another, it is possible that the inventory
will not be properly relieved from the shipping entity or added by the receiving entity,
either of which can cause unit record error. In addition, the receiving entity may record
the inventory at a different cost than the shipping entity. Both problems can be resolved
by recording inventory transfers in a central inventory database that is used by both
subsidiaries. However, these central databases are expensive to purchase and maintain,
and also require reliable online access by multiple locations.

Ownership: Audit both sides of all intercompany transfer transactions. As just noted, both
sides of an intercompany inventory transfer can incorrectly record the transaction,
resulting in incorrect consolidated financial results. One way to detect these issues after
the fact is to regularly schedule an internal audit review of both the shipping and
receiving transactions associated with a sample of intercompany transfers. These reviews
should result in recommendations to alter the recording system to eliminate errors.
Ownership: Require a customer signature on every bill-and-hold document.

If a company builds products but does not ship them, it can still claim revenue under the
assumption that customers have authorized the company to store the units on their behalf.
This approach can lead to significant abuse of revenue recognition, so a good
control is to require all customers to sign a bill and-hold transaction
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approval document. This document states that customers have
authorized the off-site storage and accept ownership of the goods.
(Walter T. Harrison, Charles T. Horngren)

2.12. Visiting Your Inventory

Prior to counting inventory it is important to reacquaint yourself with it. Go through each
display and ensure that inventory isn't misplaced, damaged or obsolete, and make sure all
merchandise is tagged. Not only will this save time during the counting process, but it
will provide an opportunity to clean up, re-steam, and markdown, or even return aged or
damaged inventory. When counting your inventory your focus should be solely on an
accurate count. In preparation for an inventory not only will it be more organized but it
will offer the opportunity to carefully review it for age, damage or other presentation
issues that prevent it from selling.

While you are at it, look behind the dressing room mirrors, under the chairs, in drawers,
behind displays and other discreet locations that may contain merchandise tags ripped off
of goods by thieves. While these goods won't be counted, the tags can be useful in
pinpointing the source of shrinkage. It's also a great opportunity to dust and clean those
hidden corners and crevices. Complete store physical inventory counts usually (they
should) occur immediately after a seasonal sale. Depending on the method used for
recording markdowns, consideration may need to be given to the price recorded on
unsold merchandise. This is usually a lesser problem when taking cycle counts. (Kulas, P.
1994)

2.13. Inventory Cycle Counting Program

The implementation of comprehensive cycle counting solutions can result in operational
Efficiency gains of anywhere from 5 to 10 percent. The opportunity to increase sales
through improved service levels while potentially reducing inventory levels in the DC is
a real benefit, making cycle counting an appealing best practice. It is more costly to
address inventory discrepancies after they have had a negative impact on the operation
than it is to resolve them proactively avoiding disruptions in the normal flow of

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processing. The ultimate goal of a cycle counting program is to achieve an absolute bin
(location) level inventory accuracy of 97 percent or greater, eliminate the need to do
wall-to-wall physical inventories, and to achieve this with the most efficient use of
resources possible. In order to achieve the goals stated above, a cycle counting program
has to deliver the following results:

• Uncover the root causes of inventory discrepancies and by taking timely

corrective action eliminate (or reduce) future inventory discrepancies.
• Increase distribution center (DC) labor efficiency, improve product flow and
improve customer service by enabling the identification of and correction of
inventory discrepancies prior to them impacting normal DC operations.
• Meet the requirements of the accounting department and external auditors for
procedural controls, count frequency, and inventory accuracy levels that will
allow for the elimination of wall-to-wall physical inventories.
• Provide the appropriate tools, processes and procedures needed to optimize the
deployment of inventory control resources, maximize cycle counting efficiency
and enable Inventory Control (IC) to swiftly identify and resolve the root causes
of inventory discrepancies.
• Educate the entire distribution team (top to bottom) of the importance of having
accurate bin level inventory numbers and the importance of successfully
implementing and executing the cycle counting program.
• Provide the means to track and report compliance and performance against a set
of predefined key metrics, and hold individuals accountable for achieving and
maintaining targeted inventory accuracy levels.
• Allow for reductions in safety stock levels as a result of improved accuracy and
improved service levels.

However; Inventory crosses a variety of functional areas, in some cases with little or no
distinction. Inventory policy is a strategic, corporate management issue with broad
supply-chain ramifications. Inventory control represents the tactical, day-to-day aspects
of executing the policies, as particularly focused in replenishment order releasing, the
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taking of physical inventories, and cycle counting. Without cycle counting, inventory
cannot be managed effectively.( By Jeff Rose)

CHAPTER THREE:
3. RESEARCH METHODOLOGY

3.1 Research Design

This research is descriptive research project, as its major purpose is to get a better
understanding of the importance of physical counting for their inventory control .this
study were used questionnaire-based method to collect detailed information regarding the
topic. The methodology employed by this study is developed by taking into account the
specific social and cultural context of Somaliland businesses. Issues and capability of the
researcher, the time-frame and the availability of resources are also taken into account.
The main tool used in this research paper is questionnaire to collect the relevant and
reliable data.

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3.2 Data Collection
In data collection of this study, the source of information would be as follows: Primary
Research and secondary Research.
3.3 Primary Source
The first step to primary research is to define the objective followed by construction of
the questionnaire that will be used to carry out the research. This will include
carrying out a sample research within a randomly selected people. This is
primary done to ensure that the questionnaire is designed in line with the
objectives of the research. Now, after we have decided on the
questionnaire we decide on the target sample.
3.4 Secondary Source
Data is sourced from related internet sites, journals, online newspapers,
periodicals, and books and other academic publications relating to the
importance of physical counting on inventory control.
3.5 Sampling Method
This sampling method concentrates on Somaliland small business organizations only, and
those responded the questionnaires are in Hargeisa, because most organizational
headquarters are based in Hargeisa. This questionnaire consists of closed-ended questions
to get reliable responses from these companies. I would like to generalize the findings of
my sample to the population; the population chosen by the researcher was small business
organizations from the private sector. Samples populations are 15 companies.

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CHAPTER FOUR:
4. ANALYSIS AND FINDINGS:
We have already reviewed a literature of the importance of physical counting in
inventory control. We proceed this section that deals with the analysis of findings of the
study to collect detailed information then putting in a useful manner to make sense and
which conclusion and recommendation could be drawn. The study used survey-based
method as we use questionnaire to collect detailed information. The methodology
employed by the study was developed by taking into the account the social and cultural
context of Somaliland businesses. In conducting this research, fifteen businesses were
selected as sample.The participants of this study who filled questionnaire were included,
employee, accountants, and owners of that businesses. However, the data have been

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gathered, organized, edited, and analyzed by putting it into useful manner. So that the
researcher have the following findings

Q:1 What is the legal entity of your organization?

The legal entity of business enterprises can be classified in to three: Sole proprietorship,
partnership, and corporation. As indicated in figure 4.1, 8(53.4%) of Somaliland are sole
proprietorship business, 5(33.3%) are Partnership business, and the remaining 2(13.3%)
are corporation.
Figure 4.1. Legal entity of the business.

Q:2 What type of business your organization is?

As indicated in figure 4.2 of the below, 10(67%) of the business organizations are
merchandizing companies, 4(26%) of the companies studied are service companies, and
the remaining 1(7%) are manufacturing companies.

Figure 4.2. Type of business organization:

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8
7
6
Merchandise
5
4 Service
3 Manufacture
2
1
0
Merchandise Service Manufacture

Q:3 Does your organization use method of accounting inventory in each year?
The researcher tried to know if Somaliland business organizations use any method of
accounting for inventory consistently in each year. As Indicated in figure 4.3, 11(73.3%)
of the businesses said “Yes” they use a method of accounting for inventory consistently
Figure 4. 3. Use of method of accounting inventory consistently:

Yes
NO

Q:4 Does management review the reconciliation of physical inventory counts to the
inventory records?

After questionnaire, the researched found that Somaliland small businesses’ management
review the reconciliation of physical inventory counts to the inventory records as
indicated in figure 4.4. 8(53%) of Somaliland business replied “Yes” the review the
reconciliation of physical inventory counts to the inventory records and 7(47%) of
Somaliland business replied “No”
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Figure 4.4. Reconciliation of physical inventory counts to the inventory records.

10
9
8
7
6 Yes
5 NO
4
3
2
1
0
Yes NO

Q:5 How do you conduct your physical counting for inventory?

Physical counting for inventory is an essential to the success of the business operations,
therefore; every business must use physical counting for inventory as basis for controlling
their resources and measuring their accomplishment. In attempting to investigate if
Somaliland businesses use and implement physical counting in inventory control for their
operations. The researcher found as indicated in figure 4.5, that 8(54%) a business
conduct their physical counting for inventory” very good”. 5(34%) replied” good” and
the remaining, 2(12%) said “not bad”

Figure 4.5. Conducting physical counting for inventory

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Verygood
Good
Not bad

Q:6 Has management taken the appropriate steps to safeguard goods against risk of
loss by theft?

When we come to question six of this figure, 9(60%) of the respondents illustrated that
their management has taken the appropriate steps to safeguard goods against risk and said
“Yes” where 6(40%) of the respondents replied “No

Figure 4.6 the appropriate steps to safeguard goods against risk of loss.

12
10
8 Yes
6 NO
4
2
0
Yes NO

Q:7 Which inventory valuation method does your organization use?

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In the question below, there are different of accounting methods that companies can
account their inventories. As depicted in Figure 4.7, 6(40%) of the respondents said that
they account their inventory through FIFO method, 3(20%) of the respondents indicated
that inventory in counted in weighted average method, where 2(13%) of the respondents
showed that they account their inventory by using LIFO method, 3(20%)
of the respondents use Specific identification method, and the remaining 1(7%) of the
respondent said “None”.

Figure 4.7. Valuation of inventory method:

5
Specific identification
method
weighted average
0 method
LIFO method

FIFO method

NONE

Q:8 How do you compare the actual quantity received against the invoice?

The researcher tried to know how Somaliland small businesses compare the actual
quantity they receive against the invoice, however figure 4.8 of the below shows that that
7(47%) of the respondent compare “Very strong”, 5(33%) of the respondent said
“Strong” and the remaining 3(20%) said “Normal”

Figure 4.8 Comparison of the actual quantity received against the invoice.

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5
verystrong
4
Strong
3
Normal
2

0
verystrong Strong Normal

Q: 9 Do you prepare receiving note when goods are received?

As depicted in figure 4.9 of the below that 9(60%) of the respondents said “Yes” and
6(40%) of the respondents said “No”
Figure 4.9 Preparing receiving note when goods are received.

Yes
No

Q:10 Which inventory status recording system do you adopt?

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The researcher tried to figure out which inventory system does Somaliland businesses
adopt. However, the study found as depicted in Figure 4.10, 10(67%) of the respondents
said that they use periodic inventory system for their business operations, where 5(33%)
of the respondents said that they use perpetual inventory system for their businesses.

Figure 4.10 Inventory recording system:

Perpetual system
Periodic system

Q:11 It is important for your physical counting in inventory control:

In this point the researcher suggested these businesses that physical counting in inventory
control is important, and 8(53%) of the respondent said “Strongly agree”, 3(20%) of the
respondent “Agree”, 2(13%) of the respondent “Strongly disagree”, 1(7%) of the
respondent said “Neutral”, and 1(7%) of the respondent “Disagree”

Figure 4.11 Importance of physical counting in inventory control:

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8
7
6
Strongly agree
5
Agree
4
Strongly disagree
3
Neutral
2
Disagree
1
0
Strongly Agree Strongly Neutral Disagree
agree disagree

Q:12 How do you make your inventory Control Systems?:

Really when businesses dealing with inventory, one should be concerned about three
issues: first, the physical quantity of goods in stock, second, the cost at which they are
valued, as well as the proper billing of shipped goods. Therefore inventory control system
should be based on these three issues.

It is better to use inventory control system because this reduces the risk that inventory
will be lost through any number of means, it also controls that costs are fairly and
consistently applied to inventories. Finally, it ensures that goods shipped are
appropriately billed to customers.

To provide a great deal of evidence the researcher tried to identify what type of inventory
control system Somaliland business organizations uses. As depicted in figure 4.12.
10(67%) of the businesses organizations said that they use “Manual system” Where
5(33%) of the respondents said “Computerized system”

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Figure 4.12 Inventory Control Systems:

Computerized
Manual

Q:13 Who manages the financial information of your company’s inventory?:

The management of financial information of company’s inventory is very essential.
As depicted in figure 4.13, 7(47%) of the respondents indicated that authorized person
manages financial information of company’s inventory, 3(20%) of the respondents
answered that accounting personnel manages the financial information of a company’s
inventory, 5(33%) of the respondents showed that store-keeper manages the financial
information of the company’s inventory.
Figure 4.13 Management of financial information of the company’s inventory:

7
6
5
4 Accountingpersonnel
3 Authorized person
2 Store keeper
1
0
Accounting Authorized Store keeper
personnel person

Q:14 Are goods adequately protected against physical deterioration?:

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Protection of goods against physical deterioration is an integral part of physical inventory
control so that the researcher tried to identify whethere Somaliland small business
adequately protected against physical deterioration or not, 15(100%) of the respondents
said “Yes”
Figure 4.14 Protection of physical deterioration:

16
14
12
10 Yes
8 No
6
4
2
0
Yes No

Q:15 Are all inventory classes on hand physically counted on periodic bases?:
As depicted in Figure 4.15 of the below 10(67%) of the respondents said “Yes” that they
all inventory classes on hand are physically counted on a periodic basis where 5(33%) of
the respondents said “No”
Figure 4.15 Counting inventory classes:

Yes
No

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CHAPTER FIVE:
5. CONCLUSION AND RECOMMENDATION
5.1. Conclusion

The purpose of these study was to research the importance of physical counting in
inventory control and how Somaliland business account their inventory , after the
data is collected , analyzed and idea is gained. The following conclusions can be
drawn.

• Forms of the business organizations are sole proprietorship, partnership and

corporation, however; the majority of Somaliland business organizations are sole
proprietorship.

• Every business organization, whether it is public or private needs inventory to

carry out it is activities. Therefore, physical counting in inventory control plays an
integral part of every business organization. In addition, proper accounting for
physical inventory count needs appropriate accounting method. However most
of the organization that we have studied indicated that they use appropriate
accounting procedures.

• Companies use different methods of inventory valuation. However most of

Somaliland businesses use Frist in Frist out method (FIFO).

• Business organizations record their inventory either periodic or perpetual by

using computerized accounting system or manual accounting system, how
ever, most of Somaliland use periodic system through computerized accounting
system, more over authorized person manages the financial information of
company’s inventory.

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• Preparing receiving note when goods are received takes important role for the
correctness of their inventory. How ever, most of Somaliland business prepare
receiving note.

• Most of the Somaliland businesses are merchandisers, this is shows that the
export of the country is very low.

5.2. Recommendation

• To establish corporations so as to make export of goods high.

• The research recommend that organizations to use perpetual inventory system,
because it gives them continues record of changes in inventory in the
inventory account. That is all purchases and sales of goods are recorded
directly in the inventory account as they occur, and it will be easier to make
physical counting and to find accurate inventory in the financial statement.

• To adopt the technological change, they must use their recording systems
particularly financial recording of the business into computerized system,
because this system is less error and less time consuming than manual
system.

• The researcher strongly recommends the business organization to keep in

mind the importance of physical counting in inventory control because
Physical inventory is a program designed to assist managers in maintaining
accountability and custody of stocks.

• Physical inventory personnel must be trained to understand the importance of

the control of materiel and documentation into and out of the storage activity.

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• To make a detailed planning, coordination, and adequate supervision of the

inventory function is necessary to ensure success of the inventory program.

• To establish a master schedule that sets the beginning and

completion dates for both the counting process and the
inventory reconciliation.

• Ensure that there are no hazards in the warehouse that could be dangerous
during the inventory count, such as boxes to trip over, wet floors, items that
could fall, etc.

• In general, the inventory counting process and the reconciliation should be

supervised or performed by an independent person.

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