By Marilou C. Vroman, CPA, CFE
If you’re an automotive dealer or manager, you’ve likely experienced – or at least heard stories of – a large parts write-off upon completion of a dealership parts physical inventory.
It’s fascinating. While an employee could lose his or her job over a $500 cash shortage from a deposit, a parts variance of $35,000 may result in nothing more than a temporary stir among the management team. After a brief search for the cause of the variance, it is often back to "business as usual" for many dealership organizations.
The ‘Backburner’ of Dealership Priorities
It seems at times that the Parts Department ends up on the backburner of dealership priorities. It’s a business that runs behind the scenes, with most of the action occurring at a counter that separates the parts inventory from the service bays. Of course, there is a retail counter and a friendly employee available to service customers sitting in the client waiting area adorned with branded polo shirts, hats, and key chains. And let's not forget the loyal body shop and independent repair shop down the road faithfully placing orders every week.
Yet, from a general management perspective, the vehicle showroom and the technicians turning their wrenches tend to receive the lion’s share of attention. Even as parts are reported on the manufacturer financial statement and in the DMS, the Parts Department is commonly referred to as "department number four," with New Vehicle Sales, Used Vehicle Sales, and the Service department coming in first, second and third, respectively. The Body Shop, if there is one, often follows in fifth place. Perhaps subconsciously, the operational focus of management tends to follow the same pattern, with the Parts Department getting the least amount of attention.
With most parts inventories averaging hundreds of thousands of dollars per franchise and considering the potential losses that dealerships are exposed to from mismanagement of this valuable inventory, department number four should periodically be considered priority number one for evaluation.
Parts Variance 101
The Parts Department manages two concurrent inventories: the perpetual physical inventory, otherwise known as the "Pad," and the general ledger (book) inventory, maintained by the Accounting Department. When a part is ordered, it is typically tracked in the pad as an order, and once it is physically received, the quantity and cost of the part is added to the pad. The Accounting Department will also add the cost of the purchased part to the general ledger inventory when the invoice for the part is submitted for payment. When the part is sold on a repair order or a counter ticket, the part will be removed from both the physical pad and the general ledger at the same time, creating a clean and consistent transaction trail.
In a perfect world, the parts pad and the general ledger value of parts would be the same. However, there are typically timing differences between order entry, physical receipt of the part, and entry or payment of the related invoice. This timing difference is one of several reasons why there is often a difference between the parts pad and the general ledger.
Additional causes of differences include parts billed on open repair orders or open parts counter tickets. These work-in-process parts are physically removed from the shelf and from the pad when billed to a transaction but have not yet been removed from the general ledger because the sale of the part is not recorded until the transaction is closed. Further, parts may have been returned to the manufacturer and therefore removed from the pad, but not yet removed from the general ledger until the credit has been received. Such scenarios will cause variances and need to be considered when reconciling the physical and accounting parts inventory.
What Do You Mean We Have $50,000 Parts Write Off?
Since dealerships do not operate in a perfect world, there are usually variances between the pad and the general ledger. These variances may be perfectly legitimate due to administrative reasons, or they may be a sign of something much worse. The parts variance can take the form of an overage or a shortage, and while you might think that an overage is good news… think again.
An overage, where the value of physical parts reported on hand exceeds the general ledger, it can be a sign that there is an underlying problem in how parts are being added to the books. An overage may be a sign of invoices that have not yet been entered by accounting, parts inaccurately represented in work in process, or problems with costing of the parts at the time of sale. An apparent overage carries a key risk: if an overzealous dealer or controller records the overage as income without due diligence, the result could be a future write off, once the variance is identified.
Conversely, if there is a shortage, where the value of physical parts on hand is less than the balance in the general ledger, an adjustment will likely need to be posted to reduce the value of the inventory on the books and take a hit directly to the bottom line. There are honest reasons why a shortage can occur, such as duplicate posting of vendor invoices, or physical errors such as missing the value of cores on hand. Parts variances that are cyclical, for example, with an overage one year and a shortage the next, are likely a result of administrative problems that can be resolved with improved procedures as outlined below. However, recurrent parts shortages may also be a sign of inventory theft or gross mismanagement. In the event of a variance in either direction, the Accounting and Parts Departments should collaborate to determine the cause before making any income adjustments to the books.
Reduce Your Risk of Variances
To minimize the likelihood of variances, and the risk of parts theft, take the following steps throughout the year to improve consistency between the pad and the general ledger.
The Accounting Department's Role
Look at the parts pad. It is certainly not common for accounting clerks to venture into the unknown world of the parts pad – but what a great way to enhance your dealership operational skills and add value to the internal control environment! The Accounting Department will typically just accept an invoice, with proper supporting documentation of course, and simply enter it into the payables system for processing. But in an environment where a parts variance is looming, an additional checkpoint would be to verify whether a part has been added to the physical inventory prior to processing payment to the vendor. High priced, highly marketable items such as wheel sets, accessories and electronics would be of particular interest. We have seen multiple instances of purchased parts not making it into the parts inventory until being questioned. At times, payment to is required up front before a part is shipped by the vendor. In this case, a cross reference to a repair order or counter ticket for which the part is purchased would be the data to test. It’s critically important to ensure that the purchase has been properly authorized and appears reasonable.
Reconcile regularly. The Accounting Department, along with the parts manager, should reconcile the parts pad to the general ledger monthly. If there is a variance which perpetuates from one month to the next, it should be investigated at that time, rather than waiting for the parts physical.
Validate the disposition of obsolete parts. Yes, obsolete parts still have value. While the dealership policy may be to write off these parts, the disposal of obsolete parts should be well documented and verified. Once a dollar value write off has been established, these items should be charged out in detail on a counter ticket, and a disposal plan for these items should be documented. It would be unfair to the dealer to absorb a write-off of $20,000 worth of parts, only to find a counterperson selling these items online for a personal gain of $10,000. Further, if a manager sells “obsolete” parts at $.25 on the dollar, test a few of the high dollar value items that were sold at a loss to see if they have had recent demand and sales. You might be surprised to find that $4,000 wheel set that was sold for $1,000 was not necessarily obsolete after all.
Count the inventory. An employee outside of the Parts Department should conduct regular surprise bin counts, selecting random bins once per week to perform a test count. The results should be reviewed with the Parts Manager.
The Parts Department's Role
Perform an annual physical conducted by a third party. In-house parts physicals may be tempting due to the reduced cost; however, the best count will be performed by professionals who are unbiased regarding the outcome of the count. Hire a reputable company to perform the physical and consider rotating companies every few years to keep a fresh perspective on the count, and the price of the services rendered.
Examine the monthly parts reconciliation. The parts manager should request backup for the dollars that are being reported by the accounting staff and vice versa to verify the reconciliation is being calculated properly. Verify that the parts included in work in process are accurate. Validate large dollar value parts that have been charged out on open RO's are in the shop and have been installed in a vehicle onsite. Misappropriation of a part is much easier when it is billed to an open repair order that no one has had to pay for.
Check with the controller regarding payment status of regular parts vendors. The parts manager should verify that all invoices have been properly submitted and timely payments made to parts vendors. Late or missing payments may cause variances between the pad and general ledger and strain the relationship with the vendor. Periodically review select reconciled vendor statements and check for aged unrecorded items.
Examine the price appreciation and depreciation reports. The DMS will generate this report, but it is of no value if the on-hand quantity of the parts is inaccurate. Examine the parts price changes to ensure that the total dollar amount reported is accurate before the Accounting Department makes an adjustment.
Practice "MBWA." Manage your Parts Department by walking around. Inspect for unlocked doors, easy access to parts by non-parts personnel, and disorganized bins. The likelihood of theft decreases significantly when personnel know they are being watched. Consider providing an incentive to parts personnel for maintaining accurate bin counts and reward the team for a favorable outcome of the parts physical.
Watch for unusual adjustment activity in the pad. Test the parts pad for frequent plus or minus adjustments, miscellaneous part numbers being used, and large cost or quantity adjustments immediately prior to or following the physical inventory. Watch for unusual or frequent credit memos, excess discounting practices or high frequency of transactions with a specific body shop or retail customer.
Department Number Four, No More
Picture this: The last part has been counted. The final variance has been run. The physical inventory report has been issued, with no material adjustment necessary. A true and accurate count of one of the dealership’s most important assets has been successfully completed. Results like this can catapult "department number four" to number one status.
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