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

    As important as inventory is, the financial report packages supplied to Directors and Shareholders, seldom if ever go into detail about its composition or even provide an analysis of inventory related details. Whenever limited definitions of the inventory are given, conclusions on value and product turns are usually misguided. In the face of such vagaries inventory discussions just die away while the problems persist.

    It has always amazed me how some manufacturing companies can fit their sizeable inventory into limited definitions. In my experience, Accountants seem reluctant to have too many categories. Perhaps that is because the greater the breakdown, the more work for them. If left to his own, Andy Accounting would assign only three classifications to inventory: Raw Material, Work In Process (WIP) and Finished Goods (FG). In fact, I have found that the fewer the categories, the more the Manufacturing manager is blamed for having a bloated inventory or one that is out of control. The fewer classifications, the less likely an analysis will provide a true measure of his performance. Such a limited breakdown does not reveal the effect other departments have on the overall inventory figure or reveal their responsibility for creating a situation that is entirely beyond Manufacturing control.

    Inventory items spread far beyond the manufacturing floor— to engineering, vendors, marketing and customers—and the more it fans out, the less chance of its utilization at the original cost or value. Since Max Manufacturing has no control over these items, manufacturing performance should not be measured on the turn-over rate of the entire inventory. It is a gross error to divide the entire inventory dollars by the inventory used in the Cost of Sales (COGS), and hold the head of Manufacturing accountable for inventory turns.

    In order to define and quantify the total cost of the inventory, it is necessary to go far beyond the production run rate. Inventory planning requires more than just looking at revenue projections. Many issues are often excluded in operating plans. Consider these needs: demos for marketing, products for evaluation, spares and maintenance support, and samples for engineering evaluation.

    Accountants are proud of their systems when they manage to get the book value close to the physical inventory, but, as I have already pointed out, this is short sighted. Poor inventory accounting can destroy a company without management knowing what is happening. The danger comes when inventory numbers on the balance sheet are believed without question. Accepting the global figure without substantial and detailed breakdown is suicidal. No one can ever know how well the company is actually doing without knowing what makes up the inventory, what elements can actually be used and what values can be assigned when the bits and pieces are turned into finished and sold product.

    The lesson: Real manufacturing inventory must be segregated from non-manufacturing, and evaluated properly before anyone hammers the Head of Manufacturing for nonperformance.

    My best advice: call together the heads of the various divisions—Marketing, Manufacturing, Accounting, Engineering—and introduce them to the following concepts and categories.

    The following list of inventory classifications is not exhaustive, but the categories are common to most manufacturing businesses. Those elements not under the control of Manufacturing are indicated by an asterisk (*).

    Raw Material: The components and parts waiting to be used in the production of finished goods. Although raw material is under the physical control of Manufacturing, parts are normally ordered to a forecast provided by Mike Marketing, which is not controlled by Manufacturing.

    When questioned about it, Max’s defense is: "I am a good soldier and order parts in line with the forecasts I am given, but I have never had an accurate forecast since I have been with the company."

    Work in Process (WIP): All material between raw material and finished goods. The better the scheduling system, the better control of WIP.

    Although Max isn’t guilty of over using this ploy, this is an area Manufacturing managers can use to make their overall performance look better. If labor and overhead are added to the value of WIP, the ongoing period manufacturing costs are minimized. (See the chapter, Spiral to Oblivion, about really "Dirty Maxes!")

    Finished Goods: This is where products are stationed until sales orders allow them to be shipped.

    Many companies with direct shipping to customer orders can have finished goods in inventory just long enough for a cup of coffee. Poor handling of data entry plagues this category. Products can be shipped physically before they have become Finished Goods on paper. This drives an accounting system crazy.

    Max’s reply to Andy’s complaints: "All data entry is done in a timely fashion because I recognize its importance."

    *Material not on a BOM: The BOM (Bill of Material) includes all the parts and components needed for manufacturing a given product. Engineering is responsible for producing a Bill of Material as part of the product definition provided to Manufacturing for making the product. In heavy engineering oriented companies, the material purchased, but never actually used in the manufacturing, tends to accumulate in inventory.

    This becomes an inventory problem in rapidly growing companies with evolving product lines and companies whose heavy engineering orientation includes a product mix with product development revenue. In developing a product Engineering buys material, and whatever is not used ends up as excess material in inventory. In addition, Engineering departments may make initial material purchases for production, but material intended for manufacturing can be rendered obsolete by design changes before production even begins. Either case creates extra, unusable inventory items.

    This category would allow Max to run a report showing Material not in a BOM. His point, "If it isn’t on a BOM, how can I ever use it in manufacturing the products we are selling?"

    Who can argue with that (see the example on Company E at the end of the chapter).

    *Obsolete Inventory: Everyone is to blame for this category but no one takes responsibility.

    Max says, "Sure we may create some obsolete material at times, but the biggest cause is the discontinuing of products by Marketing. Engineering is a close second, changing part numbers with little concern for good parts that still exist in my inventory, which then become doomed for obsolescence in Inventory Purgatory."

    Then, to get his nails into me, Max asks "Why doesn’t management write off obsolete material when it is identified instead of holding on to it forever?"

    He strengthens his point by showing me components in plastic bags that have turned yellow from aging. My poor defense is, "Because if they throw away the obsolete inventory and take a write down it will hit the bottom line in a negative way. It reduces the asset base, thereby reducing the net worth of the company."

    Max adds, "Management likes to believe the obsolete can eventually be sold at or near costs, Hah, what a pipe dream. In my experience offers of one cent on the dollar are common."

    This is sad, but unfortunately true in many cases.

    *Surplus Material: These are components and parts heading down the path to obsolescence. They accumulate because of overly optimistic forecasting by Marketing or from a company downsizing its product sales.

    Max points out that in order to get a price break, purchasing agents get carried away with over ordering. He got red (or I should say green) in the face when reminded of the 1000 years worth of green paint used for terminals sold to Sears, which ended up in his inventory. It seems that Max’s over zealous purchasing people believed Marketing’s blue sky forecast and got carried away because of a great price break. Low and behold, tons of green paint was purchased for a particular customer who never used it.

    By using a sophisticated computer software system and a reasonable forecast, managers can easily identify surplus inventory. Max may admit that poor planning and purchasing under his control can develop surplus and obsolete items, but still claim the problem occurs more from Engineering and Marketing decisions than his own.

    Max will then ask, "So I’ve identified it, will management write it off or at least set aside the reserve ?"

    Naturally my answer is, "No Comment." As a consultant I have no intention of undermining management’s authority, even though I agree with him.

    *Marketing Samples and Demos: The number of samples and demos held in this category depends on the nature of the product, ranging from a $1.00 floppy disk to an operating system worth tens of thousands of dollars.

    A sloppy Accounting system might keep demos and samples in Manufacturing inventory only to watch the value deteriorate. Even if they are eventually sold, the value of samples and demos will be far less than a product sold new.

    Max, who cannot control the need for demos, is right in demanding, "Don’t use the cost of these in my inventory performance measure."

    Expensive systems dragged around by Sammy Sales from show to show throughout the year, are still considered for sale. A smart Max will serialize all products manufactured. This helps his position when someone decides to analyze the inventory. Then he can demonstrate what has been given to Marketing for their disposition and never returned. Why should he be punished for items still sitting on the books but out of his control?

    *Customer evaluations: Product sent to customers to evaluate can be out of the physical inventory for months at a time and still be counted as available for sale. I have seen a number of policy statements limiting the time product may be held for evaluation at a customer site before obliging them to pay. I have also seen few of these policies fully implemented.

    Aging plays a role here. As deals age, product may be offered at lower prices which the customer can’t refuse. This has an adverse impact on sales expectations and inventory dollars when the cut rate deal is made.

    *Material Returns Authorization (MRA): Rejects do occur and field replacement is necessary. In some business cultures, replacement products are sent to the customer before the unwanted product is returned. The result? The returned unit floats somewhere in limbo, maintaining its inventory value, but without a use to Max. The reality is that once the customer gets the replacement and it works, there is no urgency to send the original back. Max gets hit in a second way by being given the responsibility for getting the product back, even though Marketing and Sales have the customer contact.

    *Material Review Board (MRB): Components or finished products may be rejected for no apparent reason, or because changes or modifications have made the item unacceptable. A component or system can be rejected anywhere along the line, at incoming inspection, while in the production cycle or by customers. The urgency for disposition depends on the need for the item by one department or another, or the customer’s pressure for delivery. Instead of facilitating the disposition of material, the MRB can become a pigeon hole for collecting inventory due to the lack of interest of the parties involved and their failure in making a timely disposition decision. Since all departments in the company have a vested interest in the rejection process, a good MRB should have representatives from Quality Control, Manufacturing, Engineering, Sales, Accounting and Marketing.

    *Inventory in Engineering "being evaluated": Engineering is great for taking parts and systems off the floor for evaluation. Some get returned, but many end up in cabinets and desk drawers or test beds. Engineers are notorious slackers when it comes to paperwork, so nits and bits disappear from Manufacturing inventory without a record. Enterprising engineers, in the desire to resolve issues in off hours, and in need of a component or part, will not be deterred by a lock on a door or cages surrounding inventory.

    Max comments, "Engineers hardly ever put things into inventory, but like to take out with no transaction record." Yet Max gets blamed and is measured by paper dollars on the books and empty slots in inventory.

    *Maintenance Service Spares: In order to make service and repair quickly available in the field, companies often provide spares at field sites or, even better, at the customer’s location. If these are considered as part of the inventory dollars Max is responsible for, he gets hit for things he can’t put his hands on. Accounting can lessen Max’s headache by considering service spares as material to be capitalized, removing it from the active inventory and treating it as a fixed asset to be depreciated.

    *Customer Service Spares: More emphasis is being put on customer relations these days, with Customer Service departments springing up under Marketing divisions and handling customer return problems. This is all well intentioned, but Customer Service has become a graveyard for unused material in manufacturing. This organization may work well, but all the inventory related parts and components should not be carried in the Manufacturing inventory.

    Of course, Max says these people are string savers and will justify holding onto tons of material as long as one of each product from day one is still in the field.

    *Inventory (Equipment) not for manufacturing: This is a technique used by companies in buying capital equipment. The equipment needs a part number before it can be received into the Management Information System. Before being delivered to the department or office that ordered it, equipment is assigned a number and which adds it to the inventory.

    Max says its just another dollar number he doesn’t have access to. Fortunately, if anyone remembers to take it out, it isn’t in inventory for long.

    *Trade-Ins: Companies that take trade-ins from their own products or even at times from competitors products seem to arbitrarily assign them inventory values. Max claims the odds of this stuff being resold out of inventory are between nil and zero, dinging him again for dollars beyond his control.

    The lesson?

    Before knocking around your Manufacturing manager for an apparent inventory disaster, establish the proper categories and do a thorough analysis.

    What I have said all along should be clear by now: The odds of turning all the inventory into product and revenue are very, very low.

    Do not compare the total Accounting Book value to the level of inventory being shipped. It will not give an accurate picture of the performance of inventory usage. There are numerous factors and categories not related to inventory usage in the Cost of Goods Sold. The above breakdown should raise the proper concern to look further into particular circumstances.

    For those companies who do not breakdown the inventory beyond raw material, WIP, and finished goods, I guarantee a big surprise in their future.

    Company S is a start up, high-tech systems company. In one year their total inventory expanded from $450K to $1 million. The cost of goods was running at $150K per month. The Accounting system only accounted for two categories; raw stock (material) and Finished Goods.

    The Manufacturing Manager was called in to explain the growth and the large inventory, seven times the monthly COGS. Thanks to the records kept by Manufacturing, including serial numbers and disposition, it was shown that $450,000 was under the control of Marketing.

    As a result, only $600,000, or four months of inventory, were under the control and utilization of Manufacturing. The calculated Manufacturing turns ratio went from 1.8 to 3.

     Company E is a high technology, engineering driven company with rapid changing products. The total inventory was $500,000 and the Cost of Goods Shipped was $120,000. The President demanded, "Why is the inventory so large, over four months worth, and not even three turns a year?"

    An analysis was done to identify material in inventory that was not on a BOM. The result found $180,000, was essentially non-usable Manufacturing inventory. The Manufacturing inventory exclusive of non-BOM material was $320,000 or 2.66 months of COGS, which yielded a higher turns ratio of 4.5.

    Company D is an aging, high-tech systems company with several changes in products and reduced sales. The total inventory was $1.2 million and the monthly sales required $100,000 per month. The company had been continually downsizing people-wise, but the inventory in place had not been analyzed on a continuing basis.

    A first pass analysis revealed that obsolete inventory—material not used in production for two years—was $200,000. The next pass found material not used for a year and yielded another $150,000. The last pass, based on the level of shipments in the past six months, indicated that $175,000 would be surplus after the next year’s shipments. The total suspect inventory was $525,000, reducing the useful inventory to $675,000.

    This took the turns from one per year to near two turns per year. Worse yet, it reduced the net worth of the company $525,000. In this case, the impact was one third the net worth of the company, a real blow.