An alphabetical outline of the hazards of Inventory
and solutions to Inventory problems

• Banks: Cleaning up the inventory may not sit well with the Bank since bank managers are concerned about covering loans with collateral. A reduction in inventory value, even though it improves the business performance, may hurt a loan.
    

• Cash Cow: An out-of-control, larger-than-necessary inventory can be turned into a positive factor and serve as a source of cash if it is corralled and brought into control.
    

• Cash Flow: Cash used to build unnecessary inventory uses capital that could be vital to other investment needs.
    

• Company Valuation: A year-end write-down can have a significant impact on the value of a company. The following example is taken from the files of an actual, company.

The President of a growing company valued at 20 times earnings was entertaining offers of a buyout.

In their start-up innocence, inventory reserve was not in their vocabulary. There was no attempt to control direct material expenditures or indirect expenses. When the write-down was deducted from the PBT, everything fell like dominos. The new PBT was $330,000, and with a 40% tax base the PAT was $198,000. As a result the company lost $1.8 million in value.

Further diligence determined that since the value of some of the physical inventory was suspect, the adjustment to the book value had not gone far enough. The more the true inventory value was pursued, the deal to sell the company dissipated as if it were a mirage.

• Cycle Inventory Counts: The counting process of a physical inventory takes time. It ties up people and even delays revenue reports. However, taking the physical inventory at least once during a fiscal year is an absolute necessity. But more importantly, doing it only once is risky business. When an inventory profile reveals a small percentage of parts representing a large percentage of the dollar value the inventory should undergo cycle counting. Take a few items to count at a time—weekly or monthly— on a running basis and compare the count to the accounting book value. Counting these higher priced items is a quick way of keeping track of inventory balances and avoiding the year-end shock of write-downs. Tracking the more expensive items on a frequent and regular interval is more manageable than doing an entire count. Making the count as you go along keeps everyone sane and keeps the inventory surprises to a minimum. It is not a bad idea to have personnel outside of Manufacturing participate in cycle counts. Remember my two mottos of business: "No surprises please." and "Someone is always trying to beat the system."
    

• Documentation Control: Documentation is the bible for any inventory control system. It starts with accurate Bills of Material and an effective drawing numbering system that identifies each part and assembly in inventory.
    

• Effective (Effectivity) Date: A good inventory control system requires linking the effective date of a change to parts already in inventory so that parts are not frivolously replaced, causing obsolescence of the existing part and a subsequent inventory write-down.
    

• Financial Liquidity: Inventory is not liquid. When it comes to paying bills, inventory can be an anchor. It has an inertia that can only be turned into energy, i.e. real dollars, when used over time—after the product is sold, shipped and paid for. Banks and finance companies are becoming less and less interested in loaning money using inventory as collateral and practically never against the value of the WIP. The big fear of lenders is that inventories are unique to the company that purchased them. If a lender is forced to take them over as collateral, they never yield anywhere near the original cost in the open market.
    

• Hazards of a Big Inventory:
  Excessive probability of obsolescence
  Higher unbalanced mix
  Long term aging
  Interest costs on borrowed capital
  Pilferage and scrapping more likely
  Cost of extra space for storage
  Potential for vendor liabilities when making adjustments.
     

• Inventory Adjustments: Adjustments to inventory will be needed, no matter how well the inventory is planned and controlled. Therefore, write-offs should be considered and factored in for pricing and profit planning as a normal cost of doing business.
    

• Investment: At times, a modest investment in extra inventory can bring about increases in efficiency and productivity, making the investment worthwhile.
    

• Manufacturing Cycle: A step-by-step plan of the manufacturing process is needed to optimize inventory and material planning.
    

• Manufacturing Lead Time: The time to deliver a product from the acceptance of an order to delivery must be competitive in the marketplace.
    

• Marketing and Inventory: The responsibility for inventory control starts with an official revenue forecast, a policy setting the frequency of allowed changes to the schedule and a policy on purchasing material to a forecast on-the-come, i.e. with no order to cover it.
    

• Market Share: An increase in market share requires an investment in inventory.|
    

• Material Receipts: To improve inventory control, received material should be tracked on a daily basis and compared to the level of COGS. When checked against the numbers used in cost planning, a rational decision can be made concerning the current level of material purchases needed to sustain the project.
    

• Material Utilization: Two reports which can help track material utilization are:
  1. A comparison of material receipts to material projected in the cost of goods on a running monthly basis.
  2. A comparison of outstanding purchase orders to be received on a monthly basis to the material projected in the cost of goods sold.
    

• Net Worth: Because of the risk of the subsequent reduction in the asset base and a corresponding reduction in the net worth of the company, it is natural for some companies to avoid cleaning up (writing-off) the inventory. Inventory values on balance sheets are more likely overstated rather than understated, and present a false value of net worth.
    

• Poor Cost Controls: In companies with poor cost controls, valuation of the year-end inventory impacts the entire year and determines if there is a profit or loss. This year-end ritual has the President pacing for days like an expectant father until the final inventory numbers are available and the books are closed.
    

• Profit: Inventory has a significant impact on profit. It can even be used to control profit. Accounting systems that add labor and overhead to the work in process and finished goods can reduce operating expenses if more product is processed in Manufacturing than is shipped out the door. In months where significant labor and overhead are absorbed into inventory, the profit can be made to look outstanding. This is dangerous and gives faulty results and a false sense of success. It will eventually hurt the bottom line significantly if that excess inventory is not sold.
    

• Purchasing Departments and Buyer Mentality: Material and services are becoming a much larger part of the cost of sales. This is particularly true as strategic partnering for out-sourcing designs, manufacturing and services grow. The Purchasing department may be several tiers down in the organization. As a result, many companies stay too long with a "buyer mentality" rather than a Purchasing Management mentality. Left to his own ways, and to avoid being beaten up by managers, the buyer aspires to get the lowest price and to make sure deliveries are never late. This usually results in over-buying what is needed and paying for it too soon, a practice which plays against the need for controlling the inventory.

When the material requirements of the company get into the millions of dollars, a ten percent savings in material costs can mean several positive points of profit. An experienced Purchasing Manager with a more global viewpoint is needed.

The need for dealing with and satisfying many different and competing interests — Engineering, Marketing, annual vendor contracts, out-sourcing partners, multi-sources, and material cost control from womb to tomb — requires more experienced and savvy personnel at a high level in the organization than traditionally allowed. In today’s market, Purchasing needs greater leverage in order to make a positive impact on inventory decisions.

• Quality and Customer Perceptions: Law of Management Physics # 37: "The quality of a product as perceived by the customer goes down as the customer's need for the product goes down."

The longer it takes for the order to be filled, the greater the likelihood that the product "just isn’t what we expected." The same level of quality might have been acceptable in the past as long as the product was needed and delivered on time. A customer inventory problem becomes the supplier’s inventory problem based on new unfair rejections of material with quality levels that were previously acceptable.

• Receiving Dock Responsibility: Receiving clerks have to just say NO. The Receiving Dock should not receive material before the scheduled date or any material in excess of that which has been purchased. Often vendors want to improve their financial situation by shipping product to their customers ahead of time or even in quantities above that being purchased.
    

• Returns, Game: Companies will treat returned products in various ways depending on their accounting system. The method chosen has great impact on inventory and can give Upper Management another excuse to beat up on the Manufacturing manager.

When a customer reports his system is not working to a company with a great customer service culture, Sales replies, "No problem, we will have a replacement out before the day is over."

This is great for the customer, but until you get the original product back from the field, both the rejected product and the replacement sit on the books as part of the calculation of inventory turns. Someone in Marketing or Sales, not Manufacturing, issued the Return Material Authorization (RMA) to the customer.

In one of my experiences, a product worth several thousands of dollars sat at a customer site for weeks. Once the customer received the replacement, the original product was pushed off into a corner and forgotten. When the product was finally located, it still took an unreasonably long time to get it back because the customer’s Information Systems Manager did not know how to ship anything out of his company.

Another example of the Returns Game are trade-ins. When new and improved product is sold for a trade in, the trade in, comes back and is placed in inventory at some arbitrary value determined by Accounting. This obsolete product can sit in inventory forever. Again, this is held against the Manufacturing manager for having too much in inventory even though it was a Marketing decision that created the additional item.

To clean up this inventory quagmire, pressure can be put on the departments directly responsible for RMA disposition. Marketing and Sales can be assigned on paper the inventory values of all product floating in the field until they resolve the problem by affecting its return. Manufacturing’s attention is best attracted by subtracting the dollar value of the return item from their month’s shipping credits until final disposition is made. This gets everyone responsible for RMA inventory working to solve the nagging returns problem.

• Standard Costs: There are many more techniques and definitions of standard costs and scores of books written on the subject of cost accounting than I can provide here. One trend is apparent. Today the emphasis is more on material than labor. In the past, before high levels of automation and the availability of low-cost off-shore labor, scores of industrial engineers were working to reduce labor in-house. Now the cost cutting emphasis has shifted to purchasing departments and material costs. As automation and out-sourcing strategies increase, so does the emphasis on the accuracy of material cost accounting. There are now many situations where the material costs far exceed the labor content of a product. In fact, reasonable savings in material can exceed the entire labor content. The end result can be that a 10% decrease in material costs (expenses) will translate into a major increase in the bottom line performance. Standard cost activities should concentrate on material.
    

• Valuation: There are numerous methods for estimating the book value of inventory. An accounting system must provide for variations in purchase prices in order to determine what value should be assigned to the inventory and the figure for Cost Of Goods Sold used in shipment and revenue reports. Over time the material purchases will vary in price based on the volume of commitments and the timing of deliveries.

Accounting analysis should be done when the latest purchase price is different from items already in inventory at a standard cost. Material prices are constantly changing. When Purchasing obtains the same material for varying prices, the latest purchase price and the standard (previous) price are different. Accounting has to cope with different values used in the Cost of Goods figures.

Several methods can be used to determine the ultimate value of the inventory:

1. The price of the first items purchased.

2. The price of the last items purchased.

3. An average cost based on all the prices paid for all the material in inventory.

Whatever system is used, product cost adjustments have to be made based on the prices that are presently available at the time the product is shipped. Either the Cost of Goods Sold (COGS) or the inventory costs in place have to be adjusted. There are two possible results:

1. A short term adjustment to COGS out-the-door which impacts profit based on the material shipped and occurs each subsequent shipment thereafter.
2. A short term adjustment to the inventory for all the remaining affected inventory which has a one time impact on the profit at the time of the adjustment.

In most cases, the least near-term and long-term impact is achieved by using average costs rather than adjusting the standard cost on an on-going basis.

Today sophisticated management information systems can easily adjust the average cost of all the different prices for a component on a running basis, either by averaging at the front-end as new material comes in with varying prices, or at the back end, by averaging the cost of material left in inventory as material is used in the COGS. In this way the average cost of the inventory is always present. The idea is to keep close to the average price on a current basis, eliminating big savings in the year-end inventory.

• Write-down Reserves: Controlling materials in inventory is difficult, therefore good accounting practices will regularly set aside a portion of potentially useless inventory as reserves to be written-off throughout the year. Excess inventory puts an unnecessary burden on cash resources that could be used more effectively and steals precious capital that could be used elsewhere including new product development. It is shameful for managers to have to scramble feverishly to look for outside capital, when it could be found internally by making better use of the assets related to inventory. Reserves cannot prevent devaluation or shrinkage of the elements that make up the inventory, but it lessens the impact of writing down excess and obsolete inventory all at one time.