Michael Goldman & Associates, L.L.C. - Consulting
& CPA Services
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Goldman's Critical Support - Winter 2001 Fix Inventory
Problems Before They Balloon to a C Inventory
mismanagement is one of the most common causes of company decline. Buyers and
purchasers often have many incentives to maintain excessive inventory levels,
which usually leads to a vicious cycle of lower margins, reduced cash flow, and
less efficient inventory management. This article will describe how that cycle
gets started, as well as a number of strategies that can pull a company out of
the cycle. The
acquisition of product for resale, whether it is purchased or manufactured, can
be a company’s largest single disbursement item. Inventory management involves
powerful groups within the company, almost all of whom have incentives to
maximize the investment in inventory. Buyers and operations management, for
example, favor bulk purchases that give them better buying power, allow longer
and more efficient production runs, and minimize the potentially adverse effects
of production-line downtime or interrupted supplier delivery schedules. Sales
management, usually the most optimistic faction in the company, wants a large
inventory to support the always-imminent explosion in demand, and has no greater
fear than the words “out of stock.” Aggressive salespeople also insist on
carrying an inventory of slow-moving items to serve customers who may
want them, or to demonstrate a wider range of service than competitors. All
these groups can lose sight of the simple fact that inventory has value only
when it is sold. The
cycle begins Excessive
inventory levels usually lead to lower profits (as margins are reduced to
liquidate slow-moving items) and cash drain. When inventory just sits there, the
money that was used to pay for it is tied up, the cash that is spent to store
and handle it is wasted, and the opportunity to sell a more profitable product
is missed. Sitting
on the shelf, inventory declines in value due to obsolescence, changing
fashions, seasonality, wear and tear, etc. When its value declines, management
actually has less incentive to sell it. Accounting systems usually do not
recognize the loss of value until a sale is consummated. And if the inventory is
secured by an asset-based loan with a higher lending value than the sales value
of the particular items, it will actually cost the company more cash, via the
reduced borrowing base, than the company will realize upon sale of the
distressed items. Those
factors that deter a company from selling its distressed inventory help
perpetuate the vicious circle that generates even more distressed inventory. As
the company’s cash position deteriorates, suppliers of the better products,
exploiting their market position, will be first to place the company on credit
watch. This will cause management to focus on windows of buying opportunity and
to buy larger quantities than are economically sensible; or cause buyers to buy
what they can from the secondary suppliers who will still sell to them, instead
of buying the hot items that they can quickly sell to their customers. Either
way, the result is a perverse situation where inventory levels are rising while
sales are falling (persistent out-of-stocks on key items can permanently drive
away customers). Cash becomes scarcer, which renews the cycle of credit holds by
suppliers. Warning
signs Smart
managers use key ratios to spot potential inventory problems. The two key
measures of inventory productivity are: ·
The
turnover ratio. This is calculated by dividing cost of goods sold by average
inventory balance; and ·
The
number of days of inventory on hand. To calculate this, divide total inventory
by average daily sales. It
is important to calculate these ratios for small subsets of the inventory, or
else the problem items will be masked by the 20% of the inventory that typically
generates 80% of the sales. In
addition to declines in the measures of inventory productivity, other early
warning signs include changes in the inventory mix, changes in the sales mix,
and large book-to-physical differences (shrinkage) in the inventory. Strategies There
are a number of strategies that management should employ to minimize inventory
problems, arrest the cycle, and institute better inventory controls, including
the following: ·
Match
sales effort with cash capability. Too aggressive a sales effort can kill a
company by demanding a greater investment in working capital to support sales
(inventory and accounts receivable) than the company can fund with available
cash. ·
Manage
safety stocks. Consider the probability and costs of a stock-out compared to the
carrying cost of the items. Consider substitute items (how easily can the sale
be switched to a similar item?) and concentration of safety stock items (can
they be held centrally for fast distribution, or must each individual location
have its own safety stocks?). ·
Find the
most economical order quantity of each item or group of items. This depends on
demand for the item, the cost to purchase or manufacture it, and the carrying
cost of the item. ·
Enforce
an “ABC” system of inventory management that focuses buying or production on
the small amount of the inventory that generates the bulk of the turnover (the
"80-20 rule"). Make a corporate decision to accept stock-outs of lower
priority items. ·
Forecast
sales accurately in the greatest level of detail possible. Gather economic and
market information from customers, employees, suppliers, and industry sources.
Pay attention to trends and scrutinize the sales department’s tendency to
blame sales drops on temporary phenomena. ·
Rationalize
the assortment. Excess inventory problems are often caused by trying to sell too
many different items to too many different customers. ·
Review
the entire inventory procurement system to see where improvements can be made
– this includes logistics, lead-times, material handling, buying incentives,
supplier selection, replenishment routines, etc. ·
Supplier
relations. Suppliers with a higher risk of delivery disruptions should
compensate the buyer for larger purchases via lower prices, longer terms,
liberal return policies, and/or consignment warehouse stocking. These will help
the company conserve cash to offset other problems. ·
Understand
accounting system biases. For example, the retail method of accounting can
reward buyers more for buying than for selling, and most cost accounting systems
reward production managers for over-producing. Account for the costs of excess
inventory within the responsible manager’s incentive system. Most
importantly, management should pay constant attention to inventory and fix the
array of small problems that inevitably occur before they compound into large
problems. It is much easier to take a series of small hits (e.g., minor
stock-outs) than to suddenly wake up one day facing a massive crisis.
© Michael Goldman 2001 For more information, please go to www.michaelgoldman.com Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.
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