Developing Inventory Policies

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:

• Who is managing our purchasing? Should this function be handled on a decentralized or centralized basis?
• How strictly do we require adherence to inventory and purchasing cycle documentation such as purchase orders (POs) and receiving reports?
• How aggressively should inventory be managed? That is, should we consider a just-in-time (JIT) approach or is it more prudent to maintain a reasonable amount of inventory of raw materials, work-in-process (WIP), and/or finished goods?
• How forcefully will we address vendor errors? Should we demand some control and/or access to our vendors' sites and procedures, or simply request replacements and/or billing credit?
• Should we allow vendors to buy lunches, drinks, or similar entertainment for our purchasing staff? If this is allowed, what limits are appropriate?
• Should we attempt to forecast our inventory requirements, or is purchasing as our needs are determined adequate to deal with possible price increases or shortages in the future?
• Would using a supply chain management system enhance our ability to compete and satisfy our customers?

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.

Organizing for Inventory 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.

Supplemental Data

There are several additional data that should be examined:

• Common-size financial statement data. RMA (and some other sources like Troy's Almanac) publish data by industry that set total assets (and total liabilities and owners' equity) equal to 100 percent, allowing the calculation of the percentage for each significant account. Inventory is 24.9 percent of total assets for this industry, while our company has 12.0 percent in inventory ($15 million ÷ $125 million).
• Additional ratio data. As noted in Chapter 2, Troy's Almanac publishes ratios that support additional analysis of the basic ratios. For inventory, an inventory-to-working capital ratio is provided, which is 1.0 times for the industry. Our company has a ratio of 0.353 times ($15 million ÷ [$65 million − $22.5 million]).

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.

The Purchasing Cycle

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.

Purchasing Cycle Problems

In this cycle, can any element go wrong? Here are some of the problems we've seen at companies:

• High vendor prices and too much expended on inventory. There are various sources of these situations:
  • Suppliers could simply be charging too much. This could be due to sweetheart arrangements between the vendor and a company's managers, or because services have not been recently rebid to more competitive vendors; see the appendix to Chapter 5.
  • Local buying, often permitted to empower branch managers, to meet unexpected needs, and to maintain goodwill with the local business community. A centralized purchasing function may be perceived as unresponsive and bureaucratic, and local purchasing managers may be rewarded with lunches, golf games, and baseball tickets.

    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).

  • Manufacturing processes are inefficient. A company may be using production techniques that have not been reengineered or reconfigured. Making products the same way as in 1980 may be forcing the company to spend too much.
  • Swings in the price of materials. Certain purchases can be traded as commodities futures contracts, and it is possible to hedge¹—a form of risk management—by buying these contracts to lock in a price for later delivery. Futures are derivative contracts that give the buyer the right but not the obligation to buy or sell specified amounts of commodities, interest rates, and other physical or financial assets.

    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).

• POs and receiving reports may not be issued. In our experience, about one-third of all buying does not conform to these procedures. If there is no PO, unauthorized company employees can make and approve a purchase. If there is no receiving report (sometimes referred to as a receiver), defects and missing items may be overlooked.

  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!

• Bills may not be reviewed for authorization or matched to POs and receivers. The accounts payable department receives an invoice or a statement and verifies that appropriate approvals have been attached. But where are the PO and/or the receiver? We'll discuss payables in Chapter 8. For the present discussion, note that most payables functions go ahead and pay the vendor even if the PO and/or receiver are missing.

A Situation of Decentralized Purchasing

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.

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.

Investigating a Company's Payables History

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:

• Dollar amount
• Whether the cash discount was taken
• Invoice date and date of payment
• Vendor's name including address and tax identification number
• Items purchased, by budget code or category
• Authorized approver's name

Have the data summarized. Based on our client experiences, here's what may be discovered:

• Dollars spent exceed budget authorization.
• Multiple vendors were used for the same type of item or service.
• Invoices lacked appropriate approvals.
• Some vendors are phony (although we hope not, as this indicates fraud).
• Some purchases were for questionable services (fancy meals, trips to Las Vegas, etc.).
• Some cash discounts were missed (discussed in Chapter 8).
• Some invoices were paid early (discussed in Chapter 8).

Economic Order Quantity

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.

Calculation of EOQ

The optimal order quantity can be determined from the following ­calculation:

where

• Q*= EOQ
• T= total sales in units
• F= fixed purchase order (PO) cost
• CC= carrying cost of inventory per unit

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

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.

WIP Cycle Management

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.

Benefits of Supply Chain Management

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:

• Implementation of a flexible supply chain capable of meeting peak demand spikes without service disruption or other delays.
• Initiation of efficient logistics programs to improve repair cycle times and customer satisfaction.
• Creation of an infrastructure that accommodated anticipated distributor and consumer sales growth of more than 300 percent in the next two years with minimal risk and capital expenditure by the company.

Results included the following:

• Improvement in production efficiencies with close to 100 percent of orders shipped on time to end users.
• Consistent achievement of 99 percent order accuracy.
• Reduction in sales returns program cycle time, achieving a 36-hour turnaround, thereby strengthening customer loyalty.
• Improvement in customer service by maintaining high service levels during peak demand cycles where demand increases from an average of 30,000 products to more than 80,000 in a single month.
• Reduction in the time required to bring products to market, improvements in efficiency, and reductions in total costs.

Supply Chain Management Systems

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.

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.

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 Lenders: Inventory

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.

Companies considering using inventory as collateral in an arrangement with an asset-based lender should consider the following:

• Typically, the business experiences rapid growth, is highly leveraged, and is undercapitalized.
• Inventory turns several times a year, and there is some seasonality.
• Borrowing requirements are substantial (above $500,000) to justify the lender's cost to monitor the loan.
• A good inventory tracking system is required, with tags, labels, bar codes, or other unique identifiers.
• Daily communications between borrowing companies and lenders on the sale of specific inventory items.
• Lenders designate a bank account for deposits of collections.
• Companies can use other banking services of the lender if available; e.g., for disbursements to other vendors and for payroll.
• Strict loan covenants are limited on other borrowing arrangements, and on the payment of salaries and dividends.
• Periodic visits by the lender to ascertain adherence to the loan agreement.
• Lender expectation that stale inventory will be periodically purged.

These restrictions may be onerous, so any ABF decision should be carefully considered.