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ОглавлениеThe Financial Impact of Inventory
How often have you heard someone say, ‘Without this inventory, production will stop’ or ‘We are merchandisers; we need our inventory or we won’t make sales.’ These statements represent the typical view of inventory—more is better! It is true that without the right inventory some sales may be missed or a production line may stop. Both are outcomes that may result in lost revenue. It is also true that too much inventory costs a business even if it is the right type of inventory. It costs money to buy inventory, it costs money to store inventory, and it costs money to finance inventory.
Often people say that the real issue is one of balance—that is, balancing the cost of inventory investment with the potential gain (or loss) from not making the investment. However, this view is overly simplistic. It can be misleading if applied universally. The goal should be to ensure that you don’t overcompensate for uncertainty by stocking materials that you just won’t need and to avoid overinvesting in the inventory that you do need.
In many cases, the ongoing level of investment that companies make in their inventory just does not make sense. These are the cases where stock minimums are never reached. Perhaps months of supply are held when weeks (or days) will do. Or the inventory is just not needed, but is not sold off or otherwise removed from the system. These are the cases where the ongoing cost of the inventory just cannot be justified.
The Inventory Management Tension
The conflicting needs of meeting demand expectations and minimizing the financial investment in inventory sets up a tension between Operations and Financial Management. This inventory tension is shown in Figure 3-1.
Figure 3-1: The Traditional Inventory Tension
Financial managers such as Chief Financial Officers (CFOs) and accountants will typically seek to minimize the working capital that is tied up in a business. Working capital includes inventory. But if these managers take an approach that is based solely on the dollars invested, it is likely that the investment will end up being made in the wrong inventory. Why? Because the aim is to reduce the dollars invested, not to meet demand expectations.
The accountant’s approach will result in inventory being cut in any way possible to drive a working capital outcome. This approach is most likely going to be the case if the performance of the financial manager is measured solely by financial outcomes such as working capital, not operational or sales outcomes.
Conversely, operations managers typically seek to maintain a high level of investment in inventory. Their goal is to ensure that inventory will be available to meet demand. As a result, there is likely to be an overinvestment in inventory; there may be high levels of obsolescence, and, in some cases, high product spoilage. These outcomes occur because operations managers are typically measured by plant performance or Profit and Loss metrics (P&L — sometimes referred to as the Statement of Financial Performance) such as revenue, cost, and EBIT (Earnings Before Interest and Tax). Inventory is a balance sheet item (see below) and does not impact the P&L. Therefore, minimizing inventory is typically of little concern to operations managers.
Resolving this inventory tension requires an approach to materials and spares inventory management that strips away the excess and ensures that a company only stocks the right amount of the right inventory. The first step to achieving this is to understand the financial aspects of materials and inventory management.
There is an old saying in business that ‘Cash is King.’ What this means is that cash is the lifeblood of all business. No cash, no business. Spending money on materials that end up in inventory ties up cash and diverts it from other potentially revenue-generating or cost-saving uses. The aim, therefore, should be to minimize the inventory investment for a particular level of customer service. The approach taken should ensure that the target level of service is met while also minimizing the cash investment. In turn, this approach will maximize the overall benefit for the company.
A Simple Model of Business Economics
Understanding the importance of cash requires having a basic understanding of business economics. To help explain this, turn to Figure 3-2, which represents a simple cash flow cycle.
(1)Starting at (1), the 12 o’clock position, this business has some ‘Cash on Hand’ with which to operate. The cash might have come from investors or it might have been borrowed from the bank.
(2)In either case, the investors or the bank will want a return for making the money available. The return will be either interest for the bank or dividends for the investor. In a real business, some of this cash would be used for investment in plant, equipment, and buildings. But for simplicity, in this example we will assume that that type of investment is complete and requires no further funding.
(3)The business spends its cash on buying raw materials, spares, labor, and utilities so that it can make products.
(4)Typically the business will need to hold inventory of the raw materials and spares in order to be able to provide a buffer between supply of these materials and the demand from their production department. The buffer is necessary because the rate of demand is usually greater than the ability to supply. In order to accumulate inventory for this buffer, they need to buy more than they will actually need in the short term.
(5)The raw materials are then used to make product. After the product is made, it will be put into inventory, again to act as a buffer between supply and demand. Again, to accumulate the inventory for the buffer, the business must make more than is needed in the short term.
(6)When these products sell, the buyer pays the company; the payment provides an input, or receipt, of cash to enable the company to recommence the cycle.
While the cash flow cycle continues, the company will need to spend cash on overheads, new investment, interest on money borrowed, repayment of money borrowed, and dividends to shareholders.
A company’s cash flow is the difference between all the cash that goes out (buying raw materials, spares, utilities, labor, overheads, investment, dividends, interest, and loan payments) and the money that comes in (receipts from customers).
Figure 3-2: The Cash Flow Cycle
If the cash flow is negative, that is, the ‘cash in’ is less than the ‘cash out’, the company will need to borrow more money or it will be unable to buy supplies, labor, utilities, etc. As mentioned previously, no cash, no business. If the ‘cash in’ is greater than the ‘cash out’ then the cash flow is said to be positive. The business will have excess cash it can then invest or use to repay borrowings.
Here is where materials and inventory management comes in: if a company is able to reduce its level of inventory, it can free up the cash that is invested in the buffers between suppliers, production, and customers. This improvement then reduces the ‘cash out’ and helps provide a positive cash flow. The extra cash can then be used to pay back borrowings and reduce interest bills or it can be used for further capital investment, without borrowing more money. This is the most effective way for a company to manage its cash — free up the cash that it has already invested in itself.
Minimizing the investment in inventory is good business practice for all companies as they improve cash flow. It produces both an increase in cash and an ongoing reduction in costs. Table 3-1 shows how reducing inventory has a positive impact on the key business measures of cash flow, ROFE (Return on Funds Employed), and EBIT.
There are a number of actions that can be taken to reduce inventory; these are discussed in detail in Chapter 8. However, to demonstrate the cash effect, Table 3-2 shows some of the generic actions that can be taken and their specific business impact. The key point to remember is that ‘cash is king’ and that excessive inventories are an unproductive use of cash.
| Business Measure | Impact of Reduced Inventory |
| Cash Flow | • Reduces the outflow of cash because items are not purchased for restocking• Delays expenditure until an item is more likely to be needed• Frees up cash for other uses such as capital upgrades or repaying borrowings |
| ROFE | • By reducing the investment base, the return on funds employed (ROFE) increases• By increasing ROFE, the company becomes a more attractive investment• The impact of this change is likely to be an increase in share price |
| EBIT | • By freeing up cash to pay back borrowings and/or minimizing the amount of borrowings, the company saves on interest payments and holding costs. This adds directly to the company’s earnings |
Table 3-1: The Impact of Reduced Inventory
| Example Actions | Impact |
| Remove obsolete stock | • Scrapping stock will provide a tax benefit in most countries.• Sale of items will provide an inflow of cash (and may produce a profit). |
| Reduce reorder stock | • A delay in spending cash retains cash in the business (improving cash flow).• Lower reorder quantities reduce the stock held value and associated costs. |
| Reduce maximum holdings | • Reduces the stock held value and associated holding costs. |
| Remove overstocked items | • If removed by natural attrition, the impact is to reduce the stock held value and associated costs.• If written off, the impact is the difference between held value and revenue if sold. |
| Reduce quantity held | • In addition to the obvious reduction in inventory, the impact will be to reduce the costs of counting, maintaining, moving, storing, etc. |
Table 3-2: Examples of Actions and Their Impact
The Four Financial Reports that You Absolutely Must Understand
Now that you understand the business impact that inventory has on an organization, it is important to understand the financial reporting that relates to inventory. There are four levels of reporting that you absolutely must understand:
1.The Cash Flow Statement
2.The Balance Sheet
3.The Profit and Loss Statement
4.The Operating Statement
Each of these reports relates to financial outcomes. However, the type of expenditure and the time frame that they address vary. Understanding these distinctions is crucial to appropriate materials and spares inventory management.
1.The Cash Flow Statement
As described in the Cash Flow Cycle (see Figure 3-2), businesses have cash that comes in (capital raising, loans, revenue from sales, etc.) and cash that goes out (capital purchases, payments to suppliers, wages and salaries, dividends, etc.). The Cash Flow Statement is simply an accounting of each of these inputs and outputs so that we can readily see where money came from and where it was spent. The Cash Flow Statement typically classifies the transactions in cash flows relating to operating activities, financing activities, and investment activities. Money that is spent on materials and spares will appear on the cash flow statement as an outflow of cash in the ‘operating activities’ section under a title such as Payments to Suppliers.
2.The Balance Sheet
The Balance Sheet is sometimes now referred to as the Statement of Financial Position because it is a snapshot of the financial assets and liabilities of a company. As a snapshot, it describes the state of the business on the day that the report represents. The content of the balance sheet, or at least the items represented and their meaning, is standardized through international accounting standards that form the legal reporting requirements for all companies (although the requirements may vary slightly from country to country).
Materials purchased as inventory will appear on the Balance Sheet as an asset because, in theory, they have a financial value (see Figure 3-3). They could be sold to raise cash (which of course is what happens with raw materials, WIP, and finished goods inventory). When the inventory materials are purchased, their cost is recorded against a ‘capital account’ which is like a cost center or cost code for balance sheet items.
Figure 3-3: Example of the Asset Section of a Balance Sheet
Although companies can generate a balance sheet at any time, they are typically produced (or published) twice a year: the fiscal midyear and fiscal year end reporting. From this we can see that, if the inventory on the balance sheet is only reported twice a year, it may only get highlighted and receive attention twice a year. Is it any wonder then that it becomes the forgotten investment! When accountants comment that a company holds too much inventory, they are typically referring to the value on the balance sheet rather than the physical holdings of any specific item.
3.The Profit and Loss Statement
The Profit & Loss (P&L) Statement is sometimes now referred to as the Statement of Financial Performance. Although the Balance Sheet shows the state of affairs at a particular point in time, the P&L compares income with expenses over a period of time. This could be a month, quarter, or year.
The P&L does not include Balance Sheet items such as property, plant and equipment, and other assets, such as inventory. This is because the money spent on capital items and inventory is expected to be consumed over several (or many) reporting periods, rather than in one period. The attribute that it is not used in the same period in which it is purchased is an important factor for identifying inventory. Thus, the P&L does not record the level of inventory held or, overtly, the change in the level of inventory.
Because most operational personnel are concerned with operational expenses and generating company profit, they may be familiar with the P&L but many do not realize that it does not help with inventory management.
4.The Operating Statement
The typical operating statement details only the expenses over a period of time. This statement might also be referred to as a Cost Center Report, Expenditure Report, or Departmental Report. The Operating Statement does not include revenue; it only includes costs and might be issued weekly, monthly, quarterly, or annually (or all four!). The statement includes items such as labor costs, overtime, and material costs, by department.
Engineering materials and spares are only included if their purchase cost is recorded against one of the cost centers included in the report. This means that they are purchased directly against an operating cost center or are ‘booked out’ or ‘issued’ from the storeroom against that cost center. This action moves the cost of the item from the capital account on the balance sheet to the P&L and Operating Statement.
How Much Cash Can You Generate?
Now let’s try and put some numbers together to get an understanding of the magnitude of the benefits that you might realize by implementing an appropriate inventory review. This is important for two reasons. First, goal setting is an important element of any improvement program. An appropriate goal provides direction and motivation—a ‘yard stick’ for measuring progress. Second, goal setting can assist in justifying an investment in the resources required to achieve the benefits. There are few things more frustrating than seeing value-adding opportunities and not being able to justify the investment required to achieve them because the benefits are difficult to quantify.
On page 47 there is a calculation sheet for you to use to calculate the benefits you could realize from a well-implemented program. However, before you complete that form, work through the example on page 46; it will help explain the elements of the calculation. Turning to Figure 3-4 you will see that the sheet is divided into two sections, Inventory Costs and Potential Savings.
Step 1: Let’s first look at the Inventory Costs. The topmost number on Figure 3-4 is the current inventory value. In this example it is $5,000,000. For your organization, this number might be more or it might be less. The important thing is that you record the value as reported by your Finance Department—don’t guess.
Step 2: The next line down reads Estimated WACC. The cost of financing working capital is much more than just the interest rate that businesses pay on borrowings. In business finance, there is a term called the Weighted Average Cost of Capital (or WACC, pronounced wack). The WACC will be different for every company because it is based on the sources of capital, such as shareholder funds, borrowings from banks, bond issues, and so on. Because this book isn’t a business finance text, I won’t be explaining this concept further except to say that for most companies the WACC generally ranges from 10–15%. To be conservative, the calculation in the example will use 10%. You should ask your Chief Financial Officer (CFO) what WACC to use for your company.
Step 3: The next line is for estimating the value of obsolescence and spoilage as well as the costs of managing and storing your inventory, as a percentage of the total inventory value. It is fair to say that this is usually the most difficult number to estimate. Some companies estimate that this cost could be as much as 25% of the total investment in inventory per year. However, for general use, a value of 10% is recommended as a suitable rule of thumb.
Step 4: Now by adding together the values from Steps 2 and 3, you get what I call the Inventory Cost Ratio. This ratio represents the annual percentage cost for just having the inventory available. This does not include the cost of actually purchasing the materials. In this example, the Inventory Cost Ratio is 20%.
Step 5: Multiply the Value of Inventory by the Inventory Cost Ratio to determine the Total Annual Cost of Inventory. In this case, $5,000,000 × 20% = $1,000,000. This is the annual dollar cost just for having the inventory available. It does not include the cost of actually purchasing the materials. Instead, this is how much it costs simply to hold this inventory each and every year.
Now calculate the benefits of an inventory reduction program.
Step 6: To calculate the benefit, the first thing to do is to estimate a target. Elsewhere in this book you will find case studies where companies have achieved results as high as nearly a 50% reduction. However, in my experience, the average is somewhere around 25%, so let’s use that value.
Step 7: To calculate how much cash you can potentially realize, multiply the Inventory Value by the Reduction Target. In this example, this is $5,000,000 × 25% = $1,250,000 and is shown as the Potential Cash Release. This calculation indicates that a program of inventory reduction with these values could realize a cash benefit of $1,250,000. That’s a lot of capital!
Step 8: In addition to the cash savings, you can also generate an ongoing saving because the cash generated in Step 7 no longer needs financing or will result in obsolescence. This means that you generate annual savings equal to the Potential Cash Release multiplied by the Inventory Cost Ratio. In this example, this is $1,250,000 × 20% = $250,000. This amount is in addition to the Potential Cash Release and will be saved each and every year.
Figure 3-4: Example of a Calculation Sheet
Figure 3-5 Blank Calculation Sheet
