Inventory – asset or liability or both

Even though inventory is a financial asset, having to maintain it has some liabilities. These also have financial consequences.

1. Inventory – Asset or Liability? Or both?

In financial terms inventory is an asset, and is recorded as an asset on the
balance sheet. It has value for financial strength. It can be used as collateral to
borrow against so you can grow your business. So why worry about it?

The true cost of inventory includes “carrying costs” which are operational and
financing costs. Estimates of carrying costs range from 20% to as much as 40%
of the material value. We will discuss some of these in a minute.

First, let’s consider why a business needs inventory. All product-oriented
companies have and need some whether they are a producer, distributor or
retailer. Why? Inventory is needed to fill customer orders and availability is critical
to be able to provide good customer service. Manufacturers need inventory to
make or assemble the product that is eventually to be sold whether they are a
build to stock or build to order company.

But if inventory is an asset, why is it also a cause for concern?

Can you spend that inventory?
Inventory ties up money that could be put to better use. While a product is sitting
on a shelf, it is not producing any revenue until it is shipped, invoiced and cash is
received. It costs money to finance inventory, whether that is borrowed money or
what might be considered opportunity cost.

Accidents happen
Material has to be handled and moved. It has to be picked for sale or use in
production. It is received into and out of storage, sometimes multiple times.
Damage can occur in the process – it may be dropped and damaged, a lift truck
may hit a container, etc.

Do you really need that addition?
Inventory takes space to house it. While there and inactive it may become
obsolete. The thicker the level of dust, the greater the risk of this happening.
Material generally has to be inspected, almost always as it is received from a
supplier. Sometimes it is inspected again as it completes a production operation.
There may be additional counting activities such as in “cycle counting” to verify
the accuracy of records that are maintained. Knowing what is on-hand is
essential to know what can be shipped to customers or put into additional
processing, so a record keeping system is needed. Inventory often follows a
variation of Parkinson’s law. That is, it expands to fill the space available, so be
careful to control it.

With this list, each of which has a cost associated, it seems to be a valid question
to ask if inventory is really a liability as well.

2. Higher turns mitigate inventory’s liability
Perhaps it is appropriate to consider a reduction of inventory. Or viewed in
another way, “Is the profit being earned what is expected or desired”. If some of
the costs associated with items on the list above did not exist, wouldn’t your profit
increase?

Several indicators point to a need for reduction. A high absolute level, whether
measured in dollars or as a percentage of total assets, is one red flag. What is
that percentage? There is no recognized rule of thumb, but another way to view
inventory is to look at “turns”. This means the number of times inventory turns
over, usually measured as turns per year.

Back in the 1970’s and 1980’s Toyota as an automobile manufacturer was
considered the leader with 60 or more turns per year. The auto industry today is
probably closer to 10 turns. Today Toyota in a forklift plant experiences over 30
turns, not per year, but per month. Think about that.

Another indicator of need is high “days worth” as measured against use in
production or sales. What is considered is dependent on replenishment time. If
that time, often called lead-time, is long, the “days worth” of inventory will be
higher. However, if the “days worth” is a multiple of that needed for the lead time,
it would have to be considered to be excessive.

Remember the dust level mentioned earlier. If there is a situation of actually
having dust on inventory, aisles cluttered with inventory, there is likely a need to
reduce. Common inventory valuation mechanisms for accounting purposes are
FIFO (first in first out) and LIFO (last in first out). However, there is one unofficial
valuation mechanism referred to as FISH. This stands for “first in still here”. That
certainly says it is time to reduce!

Too much of a good thing is not a good thing
A couple of other factors frequently indicate there may be a higher inventory level
than necessary. People usually don’t get fired for having too much inventory, but
they may for having too many stock-outs. However, if there is a strong fear about
avoiding stock-outs, there probably is more inventory than there should be.
Secondly, a procurement philosophy of always buying at the lowest price may be
an indicator of building inventory. Looking for the next price break is only one
side of the equation, and ignores the high costs of carrying the inventory.

Apply the 80/20 rule
There are several examples of how the Pareto principle applies related to
inventory. 20% of items take 80% of the space. 20% of items represent 80% of
the value. 20% of the items account for 80% of the sales. So what is the
significance of this with regard to inventory reduction? Focus only on the highest
value 20% of the items.

3. Continuous attention nets increased profitability
If you want to reduce inventory, how can it be done? First, recognize that you
have more inventory than desirable. Take advantage of the fact that Pareto’s law
is in play and focus on a relatively small percentage of the items.

Most importantly, believe it can be done. Mount a focused and sustained effort to
make it happen. Anticipate reluctance and resistance because it has become
comfortable to operate at the higher levels that have existed. Find champions
who will help execute the strategy. Challenging goals must be set, but they must
also be realistic. For example, a 10% to 20% reduction will not be achieved in a
month, but it might be in a year. Then monitor performance of the effort against
the goals to assure the effort stays on track. Recognize employee contributions
to achieving results. Then “rinse and repeat”. That is, do it again, and again, and
again.

(If you see a need to reduce inventory or address other process problems getting
in the way of your business' productivity and profitability, please contact me at
[email protected])