Book Order Form | Table of Contents | Preface | Chapter 1 | Chapter 2 | Chapter 3 | Chapter 4 | | Chapter 5 | Chapter 6 | Chapter 7 | Chapter 8 | Appendix A | Appendix B | Glossary

    This is the dreaded bellow of a President or CEO who has seen the latest inventory figures. Whenever a financial report includes a section on inventory status, Upper Management and the Directors invariably gasp at a dollar value which they believe to be too high. The Board Room knows numbers don’t lie, and so each time they are published it is a reminder to beat up on Manufacturing.

    Why? Because a bloated inventory has the potential of deflating the value of the company.

    Upper Management will always believe the inventory is out of control, because they do not understand its make up or dynamics. Inventory is often perceived as an idle asset. It just sits there, not earning any return for the company. If Upper Management had their druthers, the inventory would be zero, which is completely impractical in any manufacturing company. When Sammy Sales signs that unforeseen order, how can it get filled if the cupboards are bare?

    There is no doubt that inventory can be a problem. I have earned a living in management consulting for years with the phrase, "You have an inventory problem." In initial interviews with clients I can lean back with that know-it-all expression on my face, the dreaded words "Inventory Problem" hanging in the air, and watch the nodding heads around the Board Room, their minds filled with the unspoken thought, "Thank heaven this guy really knows what he is talking about."

    In all my years of experience in management and as a consultant, I have found more blame (whether justified or not) being heaped upon the Heads of Manufacturing than any other department manager. Sammy Sales can be forgiven for continually missing forecasts; Andy Accounting will get away with delayed reporting; and Eddie Engineering may never meet a budget or completion date; but it is Max Manufacturing who will be called on the carpet over the company’s perceived inventory problems because inventory is his responsibility. Because the manufacturing inventory is so visible, both in financial reports and in components, parts and products, it gets spotlighted; however, the degree of the problem is often blown out of perspective.

    In laying blame on the Head of Manufacturing for inventory related problems, Upper Management generally ignores all the other non-manufacturing elements of inventory. A manufacturing company’s inventory can be made up of hundreds and even thousands of different parts and components scattered around in numerous locations, both in and outside the company. More importantly, Manufacturing is not the sole arbiter of all these items. The Manufacturing Department does determine what elements are ordered and utilized in the production process, but it does not control all the possible locations that pigeon hole the elements.

    The lesson? Don’t overreact!

Whenever a CEO, Director or President perceives Inventory as a problem the first question to be addressed is always, "to what degree is the inventory a problem?" Once an answer is found, a rational decision can be made as to how much energy and money should be invested to clear up the problem.

    It is important to understand the inventory in detail and its impact on cash management and operating performance. Many responsible general managers can quote payroll figures to the penny, and they have a fix on direct and indirect operating expenses. This leaves the inventory category as the only potential surprise. On judgment day, Inventory can bite them in the butt and blow apart profit forecasts if they have not assigned the proper energy and resources to planning and controlling it.

    Nothing is more devastating at year end than when great profit results come in and suddenly you realize that an inventory write off is necessary, blowing all the rosy results out of a calm blue sea. It is too late to take corrective action because the problem really did not occur at year end and can’t be solved by an executive decision on the spot. The inventory mistakes occurred along the way and festered month after month because they were not recognized and addressed properly.

    Adjusting the accounting records by making the necessary corrections and adjustments is a partial solution, but the root of the problem must be understood and overcome. I get annoyed when Accounting makes the adjustments and closes the books with pats on backs and smug congratulations all around—"That takes care of that; we are now Accounting correct."

    It might look good on paper, but the real impact is on the owners, shareholders and personnel who read those monthly results and believe they are correct. Any unfavorable adjustment of inventory reflects on the profit-ability of the company. For example, if an inventory write down represents 2 % of the sales dollars, one can conclude that each month the costs were understated by an average of 2%, and thus the profit was over-stated by 2% all along the way.

    POOF…There go the profits!

    And worse, if no one understands the role inventory played in creating this mess, the decline will not end with this year’s write off.

    These are all good questions that need to be answered before managers can understand and optimize the inventory in their company. Getting to the answer will lead us to consider what part of the inventory can be controlled by the Head of Manufacturing, and whether or not he or she is doing a good job of it.

    One of the biggest mistakes Directors make is assuming that all inventory is alike. It drives me crazy when one of them criticizes financial information because the figure for inventory turns (a.k.a. turnover) is far less than another company he knows about. The fact that the other company is a flower shop with no similarity to a manufacturing company doesn’t dampen their egos.

    Regardless of their background all Directors deal with numbers on a regular basis. They look for discrepancies in the monthly financial reports and love to comment on overages or shortfalls, perhaps in order to justify their existence. So after reviewing revenue and profit figures they invariably zero in on inventory as the source of the problem.

   The mistake comes from a misunderstanding of the true value of Inventory Turns. Because no two companies are exactly alike, inventory turns should only be used as a comparative guide, not an absolute measure of manufacturing performance.

    The Inventory Turns figure is a ratio obtained by dividing the amount of Inventory Dollars (total cost of all items in Inventory) by the Cost of Goods Shipped (COGS) on a monthly basis (see glossary for definitions).

    This calculation yields the number of months of Existing Inventory. When that figure is divided into twelve (months) we have the number of times a year the inventory would theoretically turn over and generate revenue.

    For example, a company with $600,000 of inventory and a theoretical monthly shipping rate of $100,000 has six months of inventory on hand. When six is divided into twelve months, we find the inventory will turn two times a year (6 ÷ 1 = 6, 12 ÷ 6 = 2).

   At first blush an inventory turn-over rate of two times a year appears low, but there is far more to the equation that needs to be explored. The larger the turn number, the greater the utilization of inventory. The greater the utilization, the less time inventory sits idle. Idle inventory uses invested capital which requires interest payments which add to operating costs.

In the above example the word theoretical is extremely important. The $100,000 per month may not be a static figure. In a company which is growing or downsizing, the Cost of Goods is a moving target. In the real world costs and revenue are constantly changing, and using a static, average figure for the COGS is dangerous. Refinements must always be made to the calculations. The best figure to use is the next month’s forecasted COGS, which should reflect the current market trend.

    More important to the bottom line is the fact that there are several elements of inventory not counted in the inventory figure which are not controlled by manufacturing and will never find their way into the manufactured product.

The result?

Manufacturing is unjustly beaten up for having low turn ratios because the parts of inventory they do not control are used to calculate the measure of their performance.

    Seldom does a company ship the exact product mix month after month. There are always ups and downs whether caused by market or economic factors outside of anyone’s control. Using the total dollars and average output is a quick figure of merit, but is not a true measure of inventory utilization.

    For example, a company that utilizes an off-shore facility for low-cost manufacturing might have several months of material in the pipeline, particularly if goods are being shipped back and forth by boat. This can create very low turns of the inventory and require several more months of inventory than if the manufacturing were done locally. The costs of carrying the large inventory -- cost of money, cost of space, risk of inventory shrinkage -- could be offset by the much lower cost of labor and overhead, thereby creating a more favorable overall cost of manufacturing.

    Having a high number of calculated inventory turns does not necessarily mean an inventory is highly utilized. Seldom, if ever, is the manufacturing inventory figure balanced to provide equal units of the products being developed. Elements of the inventory are purchased in varying volumes which create apparent stock imbalances. It is common to have component counts that result in unmatched sets or kits. These parts have tremendous inertia, just sitting on shelves or in warehouses never getting used or noticed except when they are counted over and over at each physical inventory. Counting components still in the original plastic bags, but now yellowing from age, should be a tip off to the inventory manager of unused and unuseful inventory.

    In addition imbalances to inventory are also created by late deliveries of incoming material, tardy product shipments and Purchasing personnel who look to gain lower prices by buying at higher volume.

    I shudder at the casual announcement companies make regarding inventory write-downs. "We are making an adjustment to our inventory," should read, "We have misstated our operating costs and profits on a continuing basis."

    Aging inventories do eventually have to be identified and written off. When this happens, the profit line is adversely affected, but the blow to profit can be anticipated and minimized by allocating a reserve figure which can be written off in small monthly portions.

    Even under this practice the tendency is to fall short at year end. On one hand, inventory write-downs are a cost of doing business and should be expected and planned. On the other hand, setting up write-down reserves has a direct hit on bottom line profit, and management is reluctant to overuse such reserves.

    Inventory write-down reserves do not necessarily indicate bad performance. Material obsolescence is a cost of doing business because every product design change and imperfect revenue forecast spawns unneeded and excess material. However, writing off the obsolete inventory suppresses the operating profit. So the inventory write-down reserves must be set aside to minimize the risk of inventory obsolescence hitting all at once. The write-down should be taken incrementally in anticipation of the inevitable year-end devaluation of inventory. But make sure the reserve amount is not so conservative that profit performance is overly impacted at year-end or that other aspects of operating the business are adversely affected.

    So how can you begin to strike that balance?

    Taking the physical inventory is a daunting task, but as part of the inventory control system it cannot be bypassed. Andy Accounting can only track inventory through the paperwork that comes across his desk. With thousands of transactions annually, the physical count has to be checked against the transaction records for obvious reasons. But taking a quarterly count, let alone a monthly one, could cost more than it would save.

    Year-end surprises can be minimized by analyzing a company’s history to determine the types of product it produces and the components or parts it purchases and adds to the inventory. Often a few parts make up a disproportionately large dollar value in the inventory. Checking these more expensive items on a monthly or even weekly basis rather than waiting for the annual physical inventory is an easy way to minimize the risk of large discrepancies in dollar value at year end. Accurate counting is essential, and as we will see next, not just a simple matter of numbers on the shelf.

    Even under the most meticulous manufacturing managers, parts do get lost and sloppiness in paperwork and data entry create annoying variances between the actual and book values. Even if the count is correct, changes in the value of the Costs of Goods creates differences and necessitate adjustments. The true value of the inventory can only be calculated after counts and cost adjustments are made. In effect the true value relates to the usefulness of the material in the inventory. For instance, always consider whether or not parts are obsolete or if the quantities available far exceed future needs so as to be labeled surplus material.

    Although there are standard methods to determine obsolete parts and surplus inventory, there are no absolute definitions for these categories applicable to all companies. The criteria used should be related to the nature of the company, the type of business, the market forces and company history.

    Obsolescence is related to material in the inventory which has not been used recently. In essence, they are parts not moving at all, parts that will most likely be thrown away eventually, thereby causing the inventory to be adjusted downward. The period used to evaluate obsolete inventory can be one year, six months or whatever seems practical in the individual case. The key factor that determines obsolescence is identifying all parts with no recent transaction "out" of inventory. Today, inventory computer systems and data bases can crank out reports on obsolete items with ease.

    Determining surplus inventory requires the help of the Marketing Department. Its personnel should provide a reasonable forecast of sales for an extended period. Any material in excess of that used in the projection can be considered "surplus."

    Whereas "obsolete" parts have little potential of ever being used, there is always hope that future needs will eliminate the "surplus" parts. Because of this, there is a tendency to hold on to the surplus parts both physically and at full value on the books. Be wary of this tendency.

    Obsolete and surplus material could be immediately purged from the inventory, but if there is real hope that it can be used, a good manager will at least set up the aforementioned reserve write-down to prevent those big surprises at year end.

    It is wisest to plan an eventual full write-down, because it is dangerous to believe that surplus and obsolete material can ever be sold at near book value. In my recent experience, companies have been offered as little as one cent on the dollar for their unwanted inventory.

    The perception of many accountants is to feel good if the actual physical inventory falls within a few percentage points of the dollar value being carried on the books. However, this practice causes problems too. Matching the physical count and value to the Accounting Book value is only a small part of inventory control. The difference between the dollar value of the physical inventory and the dollar value on the books, should be compared with the Cost of Goods used in shipments.

    For example if the Book value were $400,000 and the Physical count were $350,000, $50,000 would have to be written off. Now, Accounting may be happy because the write down reconciles the two values, however, that $50,000 is money the company could have used more effectively somewhere else.

    This difference did not just occur in the last month of the fiscal year. It accumulated month after month during the fiscal period and the cause remains unidentified. More importantly, the inventory may be obsolete, or worthless, or its value may suffer from falling prices in the market. So do not let the accountants feel too smug when the initial pass at the physical and book values are close. There is nothing to crow about until all of the calculations have been made, from changes in the costs of goods to identification of surplus and obsolete material.