What Manufacturers Should Know About Inventory Fraud

May 13, 2019 By Troy Martin

The risk of fraud exists in every industry. Fraud may be perpetuated by a company as part of an effort to mislead its shareholders or, in some cases, it may be perpetuated by an employee who wants to steal from the company.

At Cook Martin Poulson, we have many clients in the manufacturing industry – and we think it’s important to talk about inventory fraud. What is it, what are the warning signs, and what can you do to prevent it?

What Manufacturers Should Know About Inventory Fraud

What is Inventory Fraud?

Inventory is likely to be one of the biggest categories on any manufacturer’s balance sheet. It’s notoriously difficult to track because raw materials, work in process, and completed components and products are constantly flowing in and out of warehouses and manufacturing facilities.

Even a small manufacturer may process thousands of transactions every year, and every transaction involves inventory. That means it’s an area ripe for fraud if you’re not careful. Transactions that involve inventory include:

  • Overhead allocations
  • Valuation adjustments
  • Write-offs

It’s common for employees, including those in accounting or management, to have access to inventory or – at least – to inventory account records. That means they have the access to what they need to commit fraud. If they also have the temptation, due to personal financial issues, resentment, or greed, then they may use their access inappropriately.

Inventory fraud can be committed in a variety of ways. Here are some examples:

  • Shipping partial orders directly to a company employee for resale on the internet
  • Skimming items from a customer’s order for resale
  • Making misleading or false journal entries to account for inventory that’s been stolen
  • Creating phony inventory to artificially boost a company’s value
  • Creating fake purchase orders and invoices

One famous example involves a pharmaceutical company called McKesson & Robbins. In the mid-1920s, the company was purchased by a scam artist named Philip Musica in 1924.

He put family members into key positions, and over the next 14 years they inflated inventory, created false purchase orders, and skimmed cash from the company coffers. By the time the fraud was discovered in 1938, auditors determined that the company had $19 million of fake inventory on their balance sheet. That works out to more than $300 million in 2019 dollars.

As you can see, inventory fraud can pose a problem for everybody involved in a company, from the officers and board members to customers and employees.

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What Are the Warning Signs of Inventory Fraud?

There are two keys to preventing inventory fraud. The first is to put stringent inventory controls in place to make it difficult for unscrupulous employees or officers to commit fraud. The second is to learn about the warning signs of inventory fraud.

One reason that manufacturers are vulnerable to inventory fraud is that they handle different kinds of inventory. That’s opposed to a retailer who might have only good that are ready for sale on hand. Manufacturers have three types of inventory:

  • Finished goods
  • Work-in-progress (WIP)
  • Raw materials

At any level, your inventory may be vulnerable to fraud. For example, WIP inventories may include charges for the raw materials used in manufacturing, as well as direct labor and overhead. They may also include additional charges if you outsource the production of one or more components to a different division of your company or to a third-party manufacturer.

The risk may also be affected by the techniques you use to account for your inventory of finished goods. Under Generally Accepted Accounting Principles (GAAP), you may choose to use any of the following:

  • The lower of cost or market
  • First in, first out (FIFO)
  • Last in, first out (LIFO)

As a rule of thumb, the more complex your inventory reporting process it is, the easier it will be for one or more employees to commit inventory fraud.

Let’s look at some of the risk factors for inventory fraud. They include:

  1. An attempt to obtain inventory-based financing. If someone in your company is suggesting an application for inventory-based financing. It’s important to be meticulous when you account for your inventory. Someone may be tempted to inflate the value of your company to get financing.
  2. Discrepancies in any inventory accounting. For example, if your inventory totals are stagnant or inventory balances are rising faster than sales, it may be a sign that something’s wrong.
  3. The same is true of shipping costs decreasing as a percentage of inventory. That may be a sign that someone’s skimming inventory from your warehouse instead of sending it to customers.

The final thing to look for is any employee who appears to be resentful or under intense personal stress. Many cases of inventory fraud start with someone who’s been pushed to an extreme state of stress and convinces themselves that stealing just a little inventory won’t hurt the company.

If you see any of these signs, you may want to perform periodic inventory counts or conduct an audit to make sure you have a handle on what’s going on with your inventory.

Tips for Preventing Inventory Fraud

The good news is that there are steps you can take to prevent inventory fraud in your company. Here they are.

Segregate Production and Shipping

The first thing you can do is to install a separation of powers when it comes to production and shipping. If the same people are responsible for both, it becomes far easier to commit fraud than it would be if they were separated.

For example, you might put a production supervisor in charge of entering production input and output in the system. Then, the plant manager could check and validate the data. The shipping supervisor could check the accuracy of all shipments, and the plant manager could conduct random checks of shipments to ensure accuracy.

Production Yield Analysis

Production yield measures the difference between actual output and standard output. Checking it can reveal shortages in your output based on raw materials and help you detect fraud early.

Structured Management Reporting

Every aspect of your manufacturing and shipping should be documented and reported. We recommend creating KPIs for every department. At regular meetings, department heads should report on their specific KPIs and the details should be reviewed. And, as noted above, the actual performance should be compared with standard output to ensure there aren’t any discrepancies.

Surprise Stock Counts

One of the best ways to prevent inventory fraud is to perform surprise stock counts. You probably already have scheduled inventory counts, but surprise counts add an element of unpredictability and discourage fraud at every level.

Automated Production Processes

Your production processes should interface directly with your enterprise resource planning (ERP) system. That way, raw materials are accounted for, as are finished products.

The good news is that most modern production machines can measure input and output automatically. If you use any manual processes, you’ll need to implement additional checks to minimize the risk of fraud.

Hire an Accounting Firm

Hiring a professional and impartial accounting firm can help you keep track of your inventory and put the proper systems in place to prevent fraud.

Protecting Against Inventory Fraud is Good for Everyone

It’s impossible to completely eradicate the risk of inventory fraud, but using the tips we’ve outlined here can help you reduce the chance that your company’s inventory will be stolen or misrepresented. Whether you are concerned about inventory fraud at your company or just want to learn more about the methods and ideas here, the friendly professionals at Cook Martin Poulson are ready to help you today.

Reach out to CMP to learn more about our accounting and tax services for the manufacturing industry.

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Troy Martin

Troy Martin

Troy is a shareholder of the firm in the Logan office of Cook Martin Poulson, PC. Troy works as a facilitator for family owned businesses through succession and strategic planning processes.

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