UNIVERSITY OF JOHANNESBURG
DEPARTMENT OF ACCOUNTANCY
AUDITING 300/BCTA
2018
MODULE: Production & Inventory Cycle
PRODUCTION AND INVENTORY CYCLE
1.1 INTRODUCTION OF THE TOPIC
The production and inventory cycle is primarily concerned with mainly achieving the following
two objectives which is:
1. Taking custody of inventory as well as the safekeeping thereof
2. The recording of cost when dealing with a production or manufacturing environment.
To simplify these two objectives and let us look at examples whereby the production and
inventory cycle would be key in achieving the abovementioned objectives. Let us first take a
look at a simple example such as a retailer. The basic business model of a retailer is in most
cases is a fairly simple one. A retailer, purchases goods at a certain cost price cash or
sometimes at favourable credit terms, store the goods in a warehouse and then sells these
goods off to customers at cost plus profit mark up.
For the second example, let us take a look at a manufacturing company. A manufacturing
company buys in raw materials, use man- and/or machine hours as well as overheads to
transform the raw material into saleable finished goods. The finished goods are stored in a
warehouse and sold to customers at the manufacturing cost plus a certain percentage profit
mark up.
In both examples used, it should be obvious that at the heart of business is its inventory for
two specific reasons. First being that if the warehouse were to be burgled or were to burn
1
,down, the company in both examples would experience significant losses not only from an
operations perspective but also from a going concern perspective. The second reason is that
inventory in both these examples would be quite significant account balances at year end and
would be one of the accounts the auditor would most likely want to gain sufficient audit
evidence over because it has the potential to misstate the financial statements of the entities
to which the examples are applicable to.
It therefore should make sense that this cycle is important from the perspectives of controlling
the transfer of goods, the protection of goods from damage or loss and theft or in provide the
inputs to inventory cost calculation.
At this point that you are reminded that it is important for you to understand the link between
what you have studied up until this point because the production and inventory cycle brings
together two cycle already covered earlier in the semester and then adds additional
considerations specific to the type of inventory held. The two cycles referred to are the revenue
and receipts cycle as well as the purchases and payments cycle. Reasons for this is that the
company buys in goods which is covered in the purchases and payments cycle and then sell
of the finished product or goods purchased from suppliers at a markup which is representative
of the revenue and the receipts cycle.
Let us first take a look at what a production process is and by doing so gain an understanding
in order for us to better understand the cycle and the risks associated with it.
Please note that the focus of the module would be on a production process rather than from
a retail perspective. Most of the controls and risks identified with a production or manufacturing
process would be very similar to some of the risks to be encountered in a retail environment.
Furthermore, the words manufacturing and production will be used synonymously throughout
this module.
1.2 PRODUCTION (MANUFACTURING) PROCESS
The way that a business creates products and services is known as the production process.
There are three main parts to the production process as can be seen in the diagram below:
• Raw Material • Finished Goods
• Labour TRANSFORMATION • Services
• Machinery PROCESS
• Land
INPUTS OUTPUTS
A firm must purchase all the necessary inputs and then transform them into the product
(outputs) that it wishes to sell. For example a sport shirt manufacturer must buy the fabric,
pay someone for a design, invest in machinery, rent a factory and employ workers in order for
the sport shirts to be made and then sold.
2
, How well-organised a firm is at undertaking this transformation process will determine its
success. This is known as the productive efficiency of a firm and it will want to be as efficient
as possible in transforming its inputs into outputs (i.e. using the minimum number of inputs as
possible to achieve a set amount of output). This will reduce the cost per unit of production
and allow the firm to sell at a lower price.
Ultimately, the objective of the production process is to create goods and services that
meet the needs and wants of customers. The needs and wants of customers will be met if
a business can produce the correct number of products, in the shortest possible time, to the
best quality and all at a competitive price.
Inherent to any production process whether that the manufacturing of paper, cars, canned fruit
products, etc. would be risks that the auditor must familiarize him/herself with in order to design
effective audit procedures to effectively reduce the risk of material misstatement. Let us now
turn our attention to the risks associated with inventory, both manufactured inventory as well
as those both for resale.
Please note that the risks to be discussed is by no means an exhaustive summarization of
risks that could be associated with inventory. Relative to the type of industry and the inventory
types, there could definitely be more risks associated with inventory.
1.3 RISKS WITHIN THE CYCLE
Inventory can be lost or stolen due to:
o Inadequate physical controls
o Inadequate control over the transfer of inventory e.g. unauthorised issues from
stores or the warehouse
o Inadequate isolation of responsibility e.g. unable to establish who is
accountable for inventory at any particular stage
o Inadequate division of duties e.g. storeman responsible for custody and
recording of inventory enabling him to conceal inventory shortages.
Inventory deteriorates in value due to:
o Inadequate physical controls
o Its nature
Delays and inefficiencies in production due to type, quantity and quality:
o Incorrect raw materials used in the production process
o Non availability of raw material
o Poor quality of raw material
Unauthorised production taking place e.g. employees using company resources for
private use.
Inadequate recording of costs of production
The volumes and complexities of manufacturing transactions increase the risk of errors
and fraud.
The basis of costing of manufacturing operations is complex and while allocations of
direct expenditures – such as raw materials used and direct labour time – is relatively
straightforward, the allocation of overhead expenses may be more complex and
different bases of identification and measurement may be applied by different entities
in the industry, of which some may be more appropriate than others.
3
DEPARTMENT OF ACCOUNTANCY
AUDITING 300/BCTA
2018
MODULE: Production & Inventory Cycle
PRODUCTION AND INVENTORY CYCLE
1.1 INTRODUCTION OF THE TOPIC
The production and inventory cycle is primarily concerned with mainly achieving the following
two objectives which is:
1. Taking custody of inventory as well as the safekeeping thereof
2. The recording of cost when dealing with a production or manufacturing environment.
To simplify these two objectives and let us look at examples whereby the production and
inventory cycle would be key in achieving the abovementioned objectives. Let us first take a
look at a simple example such as a retailer. The basic business model of a retailer is in most
cases is a fairly simple one. A retailer, purchases goods at a certain cost price cash or
sometimes at favourable credit terms, store the goods in a warehouse and then sells these
goods off to customers at cost plus profit mark up.
For the second example, let us take a look at a manufacturing company. A manufacturing
company buys in raw materials, use man- and/or machine hours as well as overheads to
transform the raw material into saleable finished goods. The finished goods are stored in a
warehouse and sold to customers at the manufacturing cost plus a certain percentage profit
mark up.
In both examples used, it should be obvious that at the heart of business is its inventory for
two specific reasons. First being that if the warehouse were to be burgled or were to burn
1
,down, the company in both examples would experience significant losses not only from an
operations perspective but also from a going concern perspective. The second reason is that
inventory in both these examples would be quite significant account balances at year end and
would be one of the accounts the auditor would most likely want to gain sufficient audit
evidence over because it has the potential to misstate the financial statements of the entities
to which the examples are applicable to.
It therefore should make sense that this cycle is important from the perspectives of controlling
the transfer of goods, the protection of goods from damage or loss and theft or in provide the
inputs to inventory cost calculation.
At this point that you are reminded that it is important for you to understand the link between
what you have studied up until this point because the production and inventory cycle brings
together two cycle already covered earlier in the semester and then adds additional
considerations specific to the type of inventory held. The two cycles referred to are the revenue
and receipts cycle as well as the purchases and payments cycle. Reasons for this is that the
company buys in goods which is covered in the purchases and payments cycle and then sell
of the finished product or goods purchased from suppliers at a markup which is representative
of the revenue and the receipts cycle.
Let us first take a look at what a production process is and by doing so gain an understanding
in order for us to better understand the cycle and the risks associated with it.
Please note that the focus of the module would be on a production process rather than from
a retail perspective. Most of the controls and risks identified with a production or manufacturing
process would be very similar to some of the risks to be encountered in a retail environment.
Furthermore, the words manufacturing and production will be used synonymously throughout
this module.
1.2 PRODUCTION (MANUFACTURING) PROCESS
The way that a business creates products and services is known as the production process.
There are three main parts to the production process as can be seen in the diagram below:
• Raw Material • Finished Goods
• Labour TRANSFORMATION • Services
• Machinery PROCESS
• Land
INPUTS OUTPUTS
A firm must purchase all the necessary inputs and then transform them into the product
(outputs) that it wishes to sell. For example a sport shirt manufacturer must buy the fabric,
pay someone for a design, invest in machinery, rent a factory and employ workers in order for
the sport shirts to be made and then sold.
2
, How well-organised a firm is at undertaking this transformation process will determine its
success. This is known as the productive efficiency of a firm and it will want to be as efficient
as possible in transforming its inputs into outputs (i.e. using the minimum number of inputs as
possible to achieve a set amount of output). This will reduce the cost per unit of production
and allow the firm to sell at a lower price.
Ultimately, the objective of the production process is to create goods and services that
meet the needs and wants of customers. The needs and wants of customers will be met if
a business can produce the correct number of products, in the shortest possible time, to the
best quality and all at a competitive price.
Inherent to any production process whether that the manufacturing of paper, cars, canned fruit
products, etc. would be risks that the auditor must familiarize him/herself with in order to design
effective audit procedures to effectively reduce the risk of material misstatement. Let us now
turn our attention to the risks associated with inventory, both manufactured inventory as well
as those both for resale.
Please note that the risks to be discussed is by no means an exhaustive summarization of
risks that could be associated with inventory. Relative to the type of industry and the inventory
types, there could definitely be more risks associated with inventory.
1.3 RISKS WITHIN THE CYCLE
Inventory can be lost or stolen due to:
o Inadequate physical controls
o Inadequate control over the transfer of inventory e.g. unauthorised issues from
stores or the warehouse
o Inadequate isolation of responsibility e.g. unable to establish who is
accountable for inventory at any particular stage
o Inadequate division of duties e.g. storeman responsible for custody and
recording of inventory enabling him to conceal inventory shortages.
Inventory deteriorates in value due to:
o Inadequate physical controls
o Its nature
Delays and inefficiencies in production due to type, quantity and quality:
o Incorrect raw materials used in the production process
o Non availability of raw material
o Poor quality of raw material
Unauthorised production taking place e.g. employees using company resources for
private use.
Inadequate recording of costs of production
The volumes and complexities of manufacturing transactions increase the risk of errors
and fraud.
The basis of costing of manufacturing operations is complex and while allocations of
direct expenditures – such as raw materials used and direct labour time – is relatively
straightforward, the allocation of overhead expenses may be more complex and
different bases of identification and measurement may be applied by different entities
in the industry, of which some may be more appropriate than others.
3
