Handling Inventory Audits for Manufacturing Firms

By Maire Loughran from Auditing For Dummies

If your audit client manufactures items, it doesn’t have a merchandise inventory. Manufacturers have three other types of inventory you need to know how to handle as an auditor. These three types are as follows.

Raw materials: Everything a manufacturer buys to make a product is classified as raw materials. If the company manufactures blue jeans, typical raw materials include denim, thread, zippers, and buttons. The raw material inventory only includes items that haven’t yet been put into the production process.
Work in process: This inventory category includes all raw materials that are in various stages of development. For example, for a blue jean manufacturing company, it would include denim pattern pieces ready to be sewn together and those that are partially constructed. The work in process inventory also includes the cost of the labor to do the work, as well as manufacturing overhead, which is a catchall phrase for any other expenses the company has that indirectly relate to making the products. For instance, manufacturing overhead may include utility costs for the manufacturing plant, depreciation of factory equipment, and the cost of supervisory labor. Your client values its work in process inventory based on how far each product has been processed.
Finished goods: When items are completely ready for sale but not yet shipped to customers, they’re finished goods. The finished goods inventory also consists of the cost of raw materials, labor, and manufacturing overhead for the entire product.

Any finished goods that haven’t been matched with a customer are part of the manufacturer’s inventory. But suppose the finished goods have a buyer and are boxed and sitting on the loading dock floor, waiting for a shipping company pickup. Who owns the finished goods then? Your first instinct may be that the customer owns the inventory because it has agreed to purchase it, but that’s not necessarily true.

As an auditor, when you check management assertions for the inventory valuation, a very important factor is who owns the inventory at any point in time. To make this determination, you need to find out whether the terms of the sale are for Free on Board (FOB) shipping point or FOB destination. The question here is whether the buyer or seller pays for the shipping and loading costs, the answer to which tells you a lot about the business relationship between the parties and gives you a solid basis for deciding who owns the inventory sitting on your client’s loading dock.

Here’s a definition of these two terms:

FOB shipping point: Ownership transfers to the buyer at the shipping point to the common carrier. Ordinarily, these items are shipped freight collect, which means the buyer pays for shipping and loading. Bottom line: Any goods sitting on your client’s loading dock awaiting pickup are not part of the client’s inventory.

Keeping this definition in mind, you have to check for any FOB shipping point inventory additions that your client should include in its inventory when it’s the customer and the inventory is sitting on the vendor’s loading dock. You do so by looking for the FOB designation on your client’s purchase orders.
FOB destination: The customer owns the inventory only after the items have hit its own loading dock. So any unshipped merchandise sitting on your client’s loading dock is still your client’s inventory. Items shipped FOB destination are typically freight prepaid, meaning that the seller pays the freight.