Inventory Count Variance: How One Distributor Found the Gap

Inventory Count Variance: How One Distributor Found the Gap

The year-end count came in $125,000 below the books. On $2.4 million of inventory, that is an inventory count variance of about 5 percent, and the first guess in the room was theft.

Illustrative anonymized composite, drawn from recurring patterns rather than a single engagement. The firm named below was not involved in it. Nothing here is guaranteed or predictive.

It was not theft. It was five different problems, only one of which looked anything like shrink. The distributor in this composite sells building and plumbing supplies to contractors and keeps a perpetual inventory in its accounting system. The warehouse manager counted every shelf over two days in late December, and the controller who had left in the fall was not around to explain the books.

The firm that fits this kind of problem is System Six, a Seattle bookkeeping and fractional CFO firm that works with companies in the $1 million to $10 million revenue range. It is covered near the end, and the story comes first.

The Setup Behind the Inventory Count Variance: A Perpetual Inventory Nobody Reconciled

A perpetual inventory updates itself. Receive goods and the quantity goes up; ship them and it goes down. The books know what should be on the shelf at any moment, and a physical count tests whether that is true.

This company counted once a year. Between counts, nobody compared the system to the shelves, so errors accumulated quietly for twelve months and arrived all at once. The accounting system carried inventory at $2,410,000. The count, priced at the same unit costs, came to $2,285,000.

The limitation: a once-a-year count finds problems at the worst time. By the end of the year, the people who made the entries have forgotten them, and some of the errors are older than the audit trail.

Physical Inventory Count Reconciliation: Start With the Biggest Lines

The new fractional CFO did not start by recounting. She started by sorting the variance by SKU and dollar value, because a few items usually explain most of it. Of 3,100 items, 14 accounted for more than half the dollar variance.

That is the practical heart of physical inventory count reconciliation: do not average the gap across the warehouse, chase the lines that carry it. For each large variance, she asked the same four questions. Was the item received but not entered? Shipped but not invoiced? Entered in the wrong unit? Or simply not there?

The limitation: this works when item records are clean. Where one product has three SKUs from a past system migration, the variance may be split across them and look smaller than it is.

Where the Inventory Count Variance Actually Lived: $125,000 in Five Causes

Each cause had a different fix, which is why lumping them together as "shrink" would have been a mistake.

Cause	Amount	What it meant
Shipped in the last two days of December, invoiced in January	$38,000	Timing: goods gone, sale and cost posted a month late
Unit of measure error: bought by the case, sold by the each	$41,000	The books overstated quantity on one product family
Returns to vendors credited but not removed from inventory	$9,000	Quantity never reduced when goods went back
Damaged and missing product	$22,000	Genuine shrink
Count sheet errors, found on recount	$15,000	The count was wrong, not the books
Total variance	$125,000

Only $22,000 of the variance was the thing everybody feared. The largest line was a unit conversion that had been entered wrong when a supplier changed its packaging, so every receipt of that product family had overstated quantity for most of the year.

The limitation: these numbers describe one company's year. Another distributor's gap might be mostly shrink, and the right response there is different, such as tighter warehouse access or camera coverage.

Inventory Shrink Accounting: What Gets Adjusted and What Does Not

Only some of the $125,000 became a journal entry.

The $15,000 of count errors needed no entry. Recounting corrected the count. Posting an adjustment for it would have written off inventory that was still on the shelf.

The $38,000 of shipments was a cutoff correction. Those shipments belonged in December. Posting the sales and the related cost of goods sold to December put the cost where the revenue was, so the margin looked the same as it should have. It was a timing fix, not a loss.

The remaining $72,000 was a real adjustment to the cost of goods sold. That is the unit of measure error ($41,000), the returns ($9,000) and genuine shrink ($22,000). It reduced gross profit for the year, and it generally also reduces taxable income, since inventory feeds the cost of goods sold on the return, depending on the company's inventory method. Confirm with a tax preparer.

The limitation: lower profit on paper is a real cost of finding the error. Some owners are tempted to spread an adjustment across several months to soften it, and that is not an option when the error is a year-end one. Book it in the period where it belongs, and ask the tax preparer about the treatment.

The Fix: Cutoff, Units and Cycle Counts

The adjustment cleaned up last year. Three changes kept it from recurring.

A cutoff rule at receiving and shipping. In the last days of the year, every receiving document and shipping document is stamped with the date and entered the same day. The count team records the last document number processed in each direction, so the controller can see exactly what belonged in which period.

Locked unit-of-measure settings. The item master now carries a purchase unit, a selling unit and a conversion factor, and changing any of them requires a second person's approval. Packaging changes from a supplier trigger a check, not a surprise.

Cycle counts instead of one big count. The company now counts a slice of the warehouse every week, with the highest-dollar items counted most often. Differences are investigated within days, while the people involved still remember.

The limitation: cycle counts cost warehouse hours every week. They pay for themselves only if differences are actually investigated, not just recorded.

Where System Six Fits

System Six is based in Seattle, was founded in 2009 and has 41 employees. It serves businesses nationwide with revenue between $1 million and $10 million, with bookkeeping and fractional CFO work. The firm was itself acquired by a searcher in 2021, and its profile says it helps organizations modernizing a finance function after an acquisition.

Inventory reconciliation is the kind of work that lives between bookkeeping and finance leadership: someone has to keep the monthly books, and someone has to ask why a number does not tie to the warehouse. A firm that offers both is built for that handoff.

System Six does not yet have enough verified reviews on Sam's List for a count to be meaningful, so we do not cite one. System Six is a paid featured member of Sam's List. Judge the firm on its stated specialty, tenure and team size, and ask for references from companies with inventory.

The limitation, plainly: System Six lists a $1 million revenue minimum and pricing from a monthly fixed fee starting at $800, so smaller companies fall outside its range. A bookkeeping and fractional CFO engagement does not run your warehouse or count your shelves, and the firm's profile does not say inventory is a specialty, so ask directly about experience with companies like yours.

Frequently Asked Questions

What is an acceptable inventory count variance?

There is no universal number. It depends on the business, the product and the count method. A better test is whether every large variance has an explanation. A small variance with no explanation is more worrying than a larger one traced to a unit error and a cutoff problem.

What causes inventory count variance?

Common causes include receiving and shipping cutoff errors, unit of measure mistakes, returns not removed from the system, count errors, and real losses from damage or theft. Most variances are a mix. Sort by dollar value and investigate the biggest lines first.

How do you book an inventory adjustment after a count?

Adjust the inventory account to the counted value and record the difference in cost of goods sold, after confirming that count errors and cutoff timing are resolved first. Document the cause of each large item, and keep the count sheets and receiving and shipping records with the entry.

How often should a distributor count its inventory?

Many companies move from one annual count to cycle counts, a rotating slice of the warehouse every week or month, with high-value items counted most often. The right schedule depends on volume and risk. What matters is that differences are investigated while the details are fresh.

If your inventory has not been compared to your shelves in the last quarter, ask whoever keeps your books to reconcile your ten largest items this month. You can browse fractional CFOs on Sam's List, including the firm above.

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About the author: Kimberly Green is cofounder of Sam’s List, a directory and matching platform for financial professionals.