This chapter covers these topics:
IN CHAPTER 6, WE NOTED THE MANY issues involved in managing a seemingly simple working capital activity, accounts receivable. As we discussed, the process is far more complicated than sell and wait for payment. Managing inventory is similar, in that finance managers typically do not become involved in inventory decisions, traditionally the responsibility of manufacturing. Furthermore, the concept of “inventory” makes sense on the balance sheet but is too vague in dealing with the realities of working capital issues. There are two aspects of inventory management:
Various economic and financial factors should be considered in managing inventory, including economic order quantity—that is, how much should be ordered at any particular time; price, volume purchasing, and the possibility of pricing concessions; the timing of delivery of material prior to the beginning of manufacturing; and several other considerations that have come to be integrated into the concept of supply chain management (which we will define shortly).
As with receivables, there are important elements in establishing a program to manage inventory, including establishing policies, organizing for policy implementation, and monitoring results.
Inventory policies formalize decisions on the acquisition and use of inventory, and the write-off or scrapping of stale materials. Rules should be established on several issues, based on answers to the following questions:
Policies establish required practice for all parties that cannot be modified except by senior management. This is important when a vendor offers a special accommodation, when POs and/or receiving reports are not prepared, when faulty materials are delivered, and in many other situations directly affecting manufacturing quality and delivery promises. Any violation may trigger appropriate responses by management.
Optimal inventory management requires a dedicated manager, committee, or a task force approach. Unfortunately, most companies defer to purchasing and production managers in making decisions regarding inventory acquisition and use. However, there are large float and cost implications of inventory, and inappropriate decisions or inefficient procedures can add significant costs, adversely impacting working capital. A company might consider appointing a senior inventory manager or a task force composed of manufacturing, marketing, finance, and information technology.
In Chapter 2, we calculated the inventory turnover (Cost of goods sold ÷ Inventory) of the Rengas Company as 6.7 times; its variation inventory turnover (360 days ÷ Inventory turnover) was 54 days. Continuing the actual data for the interquartile range for plastics manufacturing from RMA, we find that the result is 10 (3rd quartile), 7 (median), and 5 (1st quartile) turns, and 35, 52, and 76 days.
Our company (at 6.7 turns and 54 days) is close to the median result for both ratios. This is good news—right? A closer look might be in order, as both of these ratios aggregate considerable data. All of inventory is included, and cost of goods sold—where inventory is placed on the income statement—is the second-largest account after sales.
There are several additional data that should be examined:
We would certainly wonder why we are carrying so much less in inventory than the industry. Are we doing a superior job of managing this asset, or is this an indication that we may have to forgo future sales because we do not have enough to sell? We would want to determine how aggressively we are using our suppliers to deliver materials just prior to the beginning of a production cycle and whether sales are being missed.
Better-managed companies develop internal metrics as a form of control against deterioration in financial and operating performance. Like an aging schedule (discussed in Chapter 6), these measures are used to chart the functioning of relevant activities over time. For inventory, the most important of these metrics are listed in Exhibit 7.1.
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EXHIBIT 7.1 Inventory Metrics
As we noted in our introduction to this chapter, traditional inventory management is controlled by two sets of staff: production managers who focus on securing the necessary materials and components to manufacture goods that can be sold, and purchasing managers who search for the least-cost, highest-quality supplies and equipment. Sounds logical, but who is watching working capital?
The cost of funds is seldom considered when these decisions are made, and few financial managers have ever really reviewed the processes used or the decision rules followed. It is only in recent years that some enlightened manufacturing companies (i.e., United Technologies) are encouraging their production managers and engineers to study financial techniques. Furthermore, staff organizations (e.g., finance, accounting, personnel, law, and information technology) almost always defer to line organizations (sales and manufacturing) in these types of decisions.
Despite years of e-commerce (and its predecessor EDI or electronic data interchange), there continues to be a significant extent of manual activity in purchasing: finding vendors, issuing requests for bids, preparing purchase orders (POs), sending POs, awaiting delivery of materials, preparing reports on items delivered and any defects or shortages (receiving reports), awaiting invoices or statements, matching the PO to the receiver to the bill, reviewing budget codes for payment authorization, preparing vouchers approving payment, and disbursing funds. If payment is by check, bank balances must be reconciled and the clearing debit must be funded.
Whew! It's no wonder that careful analysis of a single purchasing cycle takes weeks, costs $50 to $75 per PO (according to various studies), and appears to be beyond fixing. Let us assume the situation of a large company with significant buying needs, perhaps $200 million a year. If each purchase averages $20,000, this company has 10,000 purchasing cycles a year, costing about $650,000! Even if there are repetitive purchases within a single PO, the cost can still be hundreds of thousands of dollars.
In this cycle, can any element go wrong? Here are some of the problems we've seen at companies:
The extra cost of this behavior has been variously estimated at 15 percent to 25 percent through higher prices, lower order quantity, and tacit acceptance of lessened quality. Reducing or better management of local purchasing can improve the forecasting of future requirements and the determination of economic order quantity (to be discussed later).
For example, farmers use futures to be guaranteed a price when their produce goes to market, perhaps six months or more after planting. By selling a futures contract in March for delivery in October, they know that adequate revenue will be received at harvest to cover the costs of labor, seed, equipment, and energy, in addition to other expenses. Buyers of futures contracts include speculators and actual users of the asset (such as baking companies for wheat and airlines for aviation fuel).
Purchasing following established rules usually occurs with essential, repetitive buys, such as raw materials, paper, shipping materials, and office supplies. The process is most often incomplete for technical or specialized products, such as technology and engineering instruments. Without proper documentation, the treasurer might as well hand over his or her company's checkbook to its vendors!
While there is no standard method of analysis, a situation encountered at a large manufacturing company may illustrate how to conduct a purchasing cycle review.
The CFO of the company in question discovered that parts were being purchased in anticipation of pricing increases or shortages. This problem surfaced when metrics were developed on materials utilization that showed a significant increase in the days of materials held in inventory. The first step in this effort was to analyze the company's purchasing activities, which were managed at each manufacturing site. Vendor selection was made by the local production managers with advice from his or her supervisors. Maintenance of local vendor relations was considered important to ensure delivery of critical supplies.
The review noted that several appointments with local production decision makers were postponed due to vendor lunches and a few golf games. The CFO requested that any available data on prices paid for the various items purchased be forwarded to his office. However, none of the sites maintained such data, and no statistics could be provided on competitive bids, quantities purchased, pricing discounts, or net prices paid.
As a result, it was decided to pull vendor invoices for a four-month period on 40 significant inventory items, a portion of which appears in Exhibit 7.2. It was discovered that the average price paid was substantially above fair market and that the range of prices was significant. It became quite obvious that local purchasing was redundant, inefficient, and expensive, and that favored vendors regularly entertained the purchasing managers.
Material | Unit | Fair Market Price | Average Price Paid | Number of Purchases |
Steel rods | Ton | $100 | $140 | 50 |
Steel sheets | Unit | $4 | $6 | 700 |
Pig iron | Ton | $70 | $85 | 100 |
Exotic metals | Ounce | $700 | $850 | 85 |
Lumber | 1,000 board feet | $300 | $400 | 60 |
EXHIBIT 7.2 Selected Materials Purchasing Activity
The excess cost above fair market value for the items studied would have amounted to about $100,000. On seeing these results, senior management centralized purchasing, changed procedures for selecting vendors, and established stringent policies on vendor entertainment of the company's purchasing managers.
Here's how to conduct a purchasing cycle review. Hire temps (perhaps college students) to pull three months of paid invoices from the home and branch offices. Have the following data logged onto a spreadsheet:
Have the data summarized. Based on our client experiences, here's what may be discovered:
Supply chain management (SCM) attempts to optimize all of the components of a manufacturing process, including purchasing, inventory management, and transportation-logistics.2 Two key concepts in SCM are EOQ and JIT.
Economic order quantity (EOQ) is a mathematical model that calculates the optimal size of a materials or components purchase. It is also used in making production lot size decisions. Buying decisions may fail to consider the cost of carrying inventory, the real value of volume discounts offered, or the potential loss from stale inventory. For example, one large manufacturing company frequently acquired materials and components far in advance of the start of its production cycle, resulting in excessive carrying costs and some unusable materials due to changes in production requirements and the natural decay of inventory.
The average holding period for this company was 70 days, which reduced the realized gross margin (sales less cost of goods sold) by 1.5 percent, from 10 percent to 8.5 percent. The impact on the company's return on equity (ROE) was 2 percent, with the target ROE of 16 percent declining to 14 percent.3 The role of finance in this situation is to determine the EOQ, calculate the value and costs of volume discounts based on recent experience, and support decisions that optimize results.
The optimal order quantity can be determined from the following calculation:
where
Assume that we expect 5,000 units in sales, a purchase order cost of $50, a price per unit of $10, and a carrying cost per unit of $1.4 The resulting EOQ is calculated as about 700 units, with an average inventory on hand of 350 units (or one-half). Few companies actually do these calculations, and, in fact, do not know their PO costs or the carrying cost of inventory. Instead, orders are either based on sales forecasts, which are usually optimistic, or the inventory carried is minimized, following the Japanese concept of just-in-time.
Just-in-time (JIT) attempts to set the minimum required inventory of materials through careful planning and management of production cycles. JIT means having the right materials, parts, and products in the right place at the right time, on the theory that excess inventory means waste and cost. Successful JIT programs rely on the ability of vendors to meet tight delivery schedules and a high level of quality control. The example of Dell Computer from Chapter 2 should be reread as an application of JIT.
However, if a disaster affects a vendor, such as a weather situation or a fire, a company's activities may be adversely affected. Even a delay in transporting materials, a frequent event in winter months, can be a problem. In the current economic environment, companies have failed, and a JIT supplier may have been forced into bankruptcy. In that situation, the economics of JIT may look fairly insignificant when there are no materials or components for production lines.
As noted at the start of this chapter, the work-in-process (WIP) cycle involves the second component of inventory, and includes the management of materials and components as they are retrieved and used to produce goods for sale. From an accounting perspective, the costing of WIP requires an inspection of inventory as it progresses through a manufacturing cycle and an estimate of the approximate stage (or percent) of completion.
It is important to analyze WIP because of the inherent inefficiencies in many manufacturing situations. According to various observers, only a small portion of manufacturing cycle time is actually spent in the production of a good, with considerable delays for queuing, inspection of physical movement to the next production activity, temporary packaging and storage, and similar activities.5 These delays are aggravated by changes due to customer requirements, engineering specifications, maintenance, and manufacturing processes.
Long WIP cycles contribute to rigidity in manufacturing and reduce a company's flexibility to alter production routines to meet unique customer demands. While consumer products are usually not subject to unusual requirements, large systems and some business products nearly always have a particular configuration. This problem indirectly affects a company's capability to respond to the pressure from global competitors and likely raises delivered prices.
In most companies, it is extremely costly to institute a manufacturing change. The strategy traditionally considered to be the most economical is mass production and long production runs. As an alternative approach, some producers acquire equipment that can produce different products by simply changing fabrication tools and manufacturing configurations. The strategy should be to foster flexible and customized production with decentralized control, with the goals of reducing setup time and smoothing the production schedule on the basis of customer demands.
A manufacturer of consumer electrics confronted variations in demand and inefficiencies in SCM that strained resources, delayed time-to-market, and increased supply chain costs. The company decided to outsource to a SCM software vendor, enabling it to focus its scarce internal resources on furthering its core competencies of research and the development of innovative products. Several elements were required for a workable solution:
Results included the following:
Global competition has forced companies to deemphasize the management of physical inventory and to focus on information about the supply chain. This problem is compounded when there are hundreds of items in various locations organized by different identifiers, such as serial numbers, container or bin numbers, and unique product codes. Various SCM systems have been developed to integrate data on inventory quantity, location, status of WIP, expectation of delivery from suppliers, promises of delivery to customers, costs incurred, likely sales price, forecasting of future demand, and other functions. See Exhibit 7.3 for a representative listing of SCM capabilities.
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EXHIBIT 7.3 Typical SCM Functions
The complexity of these analyses forces companies to use SCM systems provided by specialized software vendors. The demand for these products has created an $8.5 billion a year business, with leading vendors of these systems including SAP, Oracle, JDA Software, and Manhattan Associates.6 For a listing, see Exhibit 7.4; the largest companies have grown significantly, while those below the top three have experienced a decline in revenues.
Rank | Company Name | 2012 Revenue | Website |
1 | SAP | $1.721 billion | www.sap.com |
2 | Oracle | $1.453 billion | www.oracle.com |
3 | JDA Software | $ 426 million | www.jda.com |
4 | Manhattan Associates | $ 160 million | www.manh.com |
5 | Epicor | $ 138 million | www.epicor.com |
6 | IBM | $ 112 million | www.ibm.com |
7 | Infor Global Solutions | $ 111 million | www.infor.com |
EXHIBIT 7.4 SCM Software Vendors
There are versions of these systems now available for nearly any size company. Although specific quantitative savings vary, reported benefits include reductions in working capital requirements, increased customer satisfaction, and improved integration with corporate strategic initiatives.
Asset-based financing, discussed in Chapter 6 regarding accounts receivable, is used for working capital with a company's inventory functioning as the collateral for the loan. Lenders typically use a conservative valuation of inventory and a loan somewhat less than the valuation figure, with the key factor being marketability of that collateral. Interest rates charged on inventory financing are similar to those for receivables lending. The interest cost is typically the prime rate plus 2 percent.
Typical lender discounting allows a loan of 60 to 80 percent of the value of a retail inventory. A manufacturer's inventory, consisting of parts and other unfinished materials, might be only 40 percent. Inventory that is financed through ABF programs typically is industrial and consumer durables that can be readily identified by a serial number or other tag. Some lenders specialize by line of business. For example, Textron Financial lends to aviation and golf course customers, while ORIX lends on technology purchases. Selected industries that could consider ABF are noted in Exhibit 7.5.
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EXHIBIT 7.5 Industries That Use Inventory as Collateral in ABF
Working with ABF lenders that accept inventory as collateral requires different skills from borrowing from a bank through a line of credit. For a list of inventory lenders, see Exhibit 7.6.
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EXHIBIT 7.6 Selected Inventory Lenders
Companies considering using inventory as collateral in an arrangement with an asset-based lender should consider the following:
These restrictions may be onerous, so any ABF decision should be carefully considered.
The two aspects of inventory management are (1) purchasing of materials and components and (2) management of those materials and components as they are retrieved and used to produce goods for sale (work-in-process). Several economic and financial factors are relevant in managing inventory, including price, volume purchasing, pricing concessions, and the timing of delivery of material prior to the beginning of manufacturing. The integration of these concepts through supply chain management involves economic order quantity (EOQ) and just-in-time (JIT) delivery. As with receivables, asset-based financing using inventory has become an important source of working capital financing.