In our recent article on Cash Management, we briefly discussed the importance of inventory management in the cash flow cycle. The focus of this article elaborates on the importance of Inventory Management and a number of key issues.
As with many cash flow objectives, there is an art in finding a delicate balance. Inventory management is definitely both an art and a skill that requires the practitioner to sometimes walk a tightrope between minimizing inventory and risking running short. Consider the strategic consequences for a variety of business scenarios:
- A clothing retailer, at the end of a season does not have a particular shirt in stock for a customer;
- An exclusive wholesaler of imported machinery parts does not have the part required to repair a piece of equipment in a customer’s production line;
- A manufacturer does not have the raw materials required for a critical component which has a long lead time for delivery.
From these examples it is obvious that the consequences of not having sufficient inventory can run from pennies to millions and that the ramifications can extend from losing one sale to shutting down a plant for a period of time, or causing the shut-down of a customer’s plant e.g. a supplier of components to a large auto manufacturer.
Similarly, one has to assess the benefits and risks to one’s relationship and reputation if your customer is dependent on your having inventory, especially for long-term contracts and where alternative suppliers are available to your customer. We are all aware of the maxim that the cost of acquiring a new customer far exceeds the cost to maintain a current one. Thus, in assessing the strategic consequences for your business, one must often also assess the strategic consequences for your customer.
As a result, it is critical that you assess your risk and determine how critical that risk is for your business. This will determine how much you are willing to invest in ensuring that you do not have a shortage of inventory. The answer is usually complicated and will apply differently to different products and markets. As this level of complexity increases in a business, it becomes important to assess what processes and areas to invest in, to ensure that inventory shortfalls are minimized.
The most common metric used to measure the effectiveness of inventory management is inventory turns. This is usually calculated as the average cost of inventory on hand divided by the cost of goods sold in the period, stated as the number of turns per annum. There are many variations on this. Acceptable number of turns vary significantly depending on the type of business and the approach taken to inventory management. Manufacturing companies often are in the 6 to 8 turns and low margin retailers can reach in excess of 12 turns per annum.
This metric should be monitored over various periods and significant changes should be investigated to determine the cause. This can be done by determining the inventory turns by inventory type.
The cost of carrying inventory can be very significant and is rarely measured. It is difficult to measure and also to know what costs should be attributed to the cost of carrying inventory. These include:
- Cost price of the inventory on hand, including logistics to get it to the warehouse,
- The costs of warehousing it (e.g. rent, utilities, insurance, taxes, etc.),
- Cost of money,
- Physical handling costs (labour and equipment),
- Clerical and inventory control costs,
- Obsolescence, deterioration costs, shrinkage, and
- The cost of logistics of moving it to the point it is used in manufacturing.
In very efficient warehouses these costs usually exceed 15% of the cost of the materials and most estimates are in the 25% to 35% range.
The delicate balance is best exemplified by the manufacturing industry’s implementation of the “just-in-time” (JIT) approach. This illustrated the importance of minimizing inventory in an effort to have the correct inventory necessary at the right place at the right time. It grew in prevalence as manufacturers recognized the costs of holding and managing inventory.
In recent years there has been more awareness of the consequences of using JIT. This is especially true where there are long supply lines and those that cross borders, or start in volatile parts of the globe (due to political disturbances, natural disasters, transportation issues, etc.). As a result the objective in recent years is to find a balance that meets the strategic needs of the business and all its supply considerations.
Some companies have used JIT systems combined with material planning systems to negotiate inventory replenishment arrangements with suppliers. These suppliers provide production supplies or raw materials on short notice, reducing carrying costs. Some suppliers will provide product based on usage so that title passes during production rather than on receipt. These types of arrangements transfer the financial carrying costs but not the warehousing costs to the supplier.
Let’s review some more common approaches to investing in reducing inventory levels:
For many small businesses the first step is to ensure that staff are aware of the importance and costs of not holding an absolute minimum of inventory. Where production or operations staff are responsible for ordering, their emphasis is often a sense of security – that they never run out of stock and therefore they build in unnecessary stockpiles. This is an area where it is very easy and common for the employee’s personal motivation (possibly due to fear) to exceed the needs of the business.
The second step is to measure the inventory and report on it. One cannot manage what one does not measure. The complexity and comprehensiveness of this depends on some of the steps below. However, it is critical that inventory measurement is implemented and reported with appropriate key performance indicators (KPIs) to alert executive management that appropriate questions are necessary. Examples of relevant KPIs are inventory turns, out-of-stock, wait time metrics, shrinkage rates, order lead times, etc. Be aware that most ERPs will easily produce these KPIs at the detail level of each SKU, which is great for the staff managing inventory at that level. However for management, summarized KPIs by geographic area or product line, can be more meaningful as they do not have the ability to spot trends in the details.
Most good accounting packages (even the basic ones provide some features for inventory management and reporting) and ERP systems have a range of features that enable management to track inventory on hand, usage-over-time and forecasts. For many businesses the big challenges are implementing the features that are relevant to their needs and maintaining the discipline to ensure that all the necessary data is maintained as a priority. Part of the success of a good system is the ability to integrate different systems in a seamless way, so that all the relevant data can be utilized effectively. Too often we see systems that are incompletely implemented or not properly maintained, which results in inaccurate data. It takes time and a lot of effort to implement and maintain reliable data. When this doesn’t happen, the cost of recovery usually exceeds considerably the cost that would have been required to maintain it. Of course, the worst scenario is where the system loses credibility and the staff does not rely on it.
This emphasizes the importance of having adequate staffing to manage the inventory, i.e. the number of people with the requisite skills. Where they are not dedicated to inventory management, they also need the management support for ensuing that this critical role is maintained. Also, it is very important that the processes and systems are not regarded as static and that the staff strives for continuous improvement. It is also really important that the staff have a reporting relationship to a supportive senior manager who sees the importance and benefits of inventory management.
In too many businesses the management fails to clear out slow moving inventory on the basis that it will be useful or sold one day. This philosophy is dangerous as it detracts from all the concepts of minimizing inventory and creates a cost of holding it that is financial, inefficient and potentially demotivating to the staff (who see selected items sitting idle while being pressured to minimize inventory in other areas).
There are times where minimizing inventory levels may not be the best strategy for the business, as long as the business has the working capital resources to afford it, such as:
- Strategic considerations regarding supply lines, as discussed above;
- There is an expected price increase for either the product or the costs of acquiring it (e.g. shipping costs);
- There is a low cost and strategic advantage to assuring, maybe even guaranteeing, your customer that you will have the inventory when they need it;
- Efficiency can be enhanced by having longer production runs;
- Cost of shipping/delivery can be reduced by doing so in larger volumes; etc.
Minimizing inventory results in an increase in the cash flow and the focus on some of the practices above will reduce the inventory and therefore the cash that is tied up in it. The art or trick is to find the right balance for your business.
If you found this article valuable, you may want to refer to previous articles in this series:
In the next article in this series on Cash Management, we will discuss accounts payable policies and practices to improve cash flow.
David Balmer is a Chartered Accountant with over twenty years of Treasury experience with companies such as RJR Nabisco, Cott Corporation and Maple Leaf Foods Inc. He has presented at treasury conferences in Canada and the United States. He has also earned treasury designations from treasury organizations in both the United States and United Kingdom. Contact David at dbalmer@sympatico.ca .
James Phillipson is a Chartered Accountant and a Principal of Mastermind Solutions Inc. www.mastermindsolutions.ca , with over twenty years experience in large and small businesses. He has provided financial counseling to his clients since 1996, often in the role of or as a coach to a Controller or Chief Financial Officer. James has experience in financial roles in a wide variety of businesses and industries. Contact James: james@mastermindsolutions.ca
