When having exploratory conversations with potential customers, the following often arises “We need to be able to maintain negative inventories in our accounting software, because we _______”. Whatever reason fills in the blank, we often find that it is a result of a less-than-ideal business practice which was implemented in response to a lack of functionality and controls in the organization's current software.
Negative inventory is a situation where a company’s inventory records show that they have a negative quantity of a particular item. In other words, the recorded quantity of the item is less than the actual physical quantity on hand.
How do you end up with negative inventory?
Negative inventory can happen because of errors in your inventory tracking system, such as when items are incorrectly recorded as sold or when items are not properly recorded as received into inventory. However, some systems support bad business practices by allowing a company to record negative inventory which results in incorrect information in the system. Although some companies use it as an actual business practice, negative inventory is not - you can’t for example count negative twelve items if you go to the warehouse to look for them. While the ability to allow inventories to go into a negative position may seem to make certain processes easier to perform, it can cause problems throughout the company if not monitored and corrected appropriately. This is why many sophisticated inventory management systems don't allow negative inventory.
Some of the more common reasons companies want to track negative inventory include:
- Items shipped from a newly received inbound shipment before them having been received in the system. This could be a result of not having a chance to record a shipment which just came in or following a practice whereby shipments are not received in the system until all of the related invoices have been received to get accurate costs.
- Newly produced items are shipped before the production run is completed in the system.
- Items pulled from a kit and shipped as an individual product, again without recording the breakdown of the kit before shipping.
Business Impacts of Negative Inventory
While the above situations are often worked around with the sole goal being to get a shipment out the door and bring a business closer to receiving payment, there are several issues with going into a negative inventory position, including:
- An incorrect Balance Sheet (understated inventory account, understated payables)
- P&L reports will have incorrect COGS (true cost for the item sold is not known)
- Even after you adjust the inbound inventory later, inventory values will be wrong, whether you use FIFO or Average Costing among other methods
- True inventory can’t be known by users in the system (besides those who may know about a shipment on the dock)
- In practice, many companies running negative inventory in their software never get caught up, so the above persists perpetually
As a result of these issues, businesses may not be able to make effective business decisions, and in fact, can be making decisions based on incomplete and incorrect information.
Overall, negative inventory can cause several problems for a company including:
- Inaccurate financial statements
- Incorrect ordering decisions
- Difficulty fulfilling customer orders
How to Prevent Negative Inventory Issues
Many of the factors behind companies using "negative inventory" can be more appropriately dealt with by taking advantage of functionality available in Enterprise Resource Planning (ERP) software. ERP software is a great option for businesses that have outgrown introductory accounting systems and inventory software and don’t have the bandwidth to manage all the manual processes associated with using introductory systems. For example, landed cost tracking features allow users to properly cost the product and receive it into inventory before receiving all the related invoices, and reverse production functionality allows users to break a kit into its individual inventory items to sell the individual components. And the most common reason, the desire to send an invoice with the shipment, can easily be dealt with in multiple ways without actually posting transactions that would send inventory into a negative value in the software.
As a best practice, businesses should take advantage of the investigation stage of new software as an opportunistic time to review their existing business processes (including those involving negative inventory). Companies should look at why they do certain things the way they do as they may find that the answers regularly include “because we have always done it that way” or “we do it this way because that is how it needs to be done in our current system”. When these answers are brought forth, it’s time to take a hard look to see if there is a better way to perform certain tasks and whether proper ERP software can help. Chances are there will be more efficient ways to manage some processes and in general proper software will help a business obtain more accurate information for making business decisions.