Cost Accounting Chokes, Part 2: Inventory

Volume 135, No. 18  - Friday, October 29, 2010

Cost Accounting Is Choking Your Business, Part 1

Skypeing with Louis Schultz the other day, he said: “Inventory is evil.” I couldn’t agree more. Inventory is evil. But can it sometimes be a necessary evil?

In fact, the larger than usual response to my last column included some interesting questions about inventory that came from all over the globe, from the Midwest, Northern California, and even South Africa. I will share some of them with you, and my answers.

Q—“When you discuss inventory, and see it as a liability, are you just talking about finished goods and/or work in progress and/or procured items (material stock)?”
A— All three. One makes money by investing a dollar in raw materials, and turning it into a product, then selling it for more than a dollar,. (You can see a slick YouTube summarizing the process on my website and blog at www.managenaturally.com.)

The faster you turn your dollar invested the smoother the flow, the more money you make. I call it the Repeater Effect. Inventory diverts the flow into stagnant pools so your money isn’t working for you. Any kind of inventory.

Q—In the tooling industry (especially aerospace), for example, they often manufacture for “inventory” as a specific strategy to optimize plant and labor utilization, minimizing the peaks and troughs of the industry product-cycle. This minimizes the need for overtime, casual labor and outsourcing. So they keep manufacturing going, bringing orders forward for “stock” to streamline operations and also to maximize the time and cost incurred in machine set-up. In these instances, isn’t the “inventory” an asset, as it has been ordered – just later down the line?
A— Well, I have never worked in the aerospace industry, but I am familiar with building inventory buffers to level production. Though evil, some in-process inventory may be a necessary evil, but it is still a liability. From when it is made to when it sells, it can only lose value, through damage or loss, tying up dollars that could be used to offset borrowing, pay salaries, or make other products that sell. Seen as a liability, you will be sure to manage it more closely than thinking it is money in the bank.

By all means maintain a buffer stock, if you need to. But not with finished goods. The more upstream your buffer, the less money is frozen. And be sure it is needed by doing due diligence. If you calculate wrong, or shoot from the hip, you risk your business.

Q—One person wrote asking, “There can be good reasons to keep raw material stock as inventory, with ‘bulk’ discounts, exchange rates, and logistics (time-lines).
A— I have rarely seen an example that held water under careful analysis. A bargain is tangible, and therefore seductive, but did you make money overall? Show me when it entered bank account. Profit on paper is shadow profit, the proof is in the pudding. I am always suspicious of having to spend money to save money.

When I was in supermarkets, I made more money than you can imagine by doing the opposite: paying more.
Allowing my cheese suppliers a bit more profit guaranteed their quality, got me the lion’s share of promotional monies, and made sure I rarely ran out of a hot-selling product on the shelf, even if they had to go to the warehouse on a Sunday to get it for me.

Q—Another reader commented: “Reminds me of my first business... industrial safety distribution– part of my success was attributable to stellar service involving the willingness to stock inventory needed for toxic spills or refinery fires. Unlike cheese, spills & fires are accidental, unplanned, and unwanted – that I could deliver what was needed when it was most needed led to some exclusive, and hefty contract agreements. Although the money in inventory might sit for months, the higher markup and delivery profits compensated for the “dead weight inventory.”
A—Bless you for charging extra to assume their risk. In our industry supermarkets force distributors, then distributors force producers to take all the risk, but they still want the lowest price. What is it that rolls down hill? Why play a game you can never win? Better to run out of a product than be run out of business.

Q—She went on, alas, “Purely coincidental or intuitive - Sitting on specific stock also worked to my advantage when there was a global shortage of latex (gloves & monkey suits) due to a sudden upturn in the manufacture of disposable diapers.”

My question, if she didn’t have to due to her business, would keeping lots of inventory to avoid unforseeable special circumstances have paid off in the long run? Wouldn’t the money lost over the long term through missing, stolen or damaged inventory, plus the cost of funds to buy it, and the slowing of dollars turned back into the system, have added up to more than what was gained in this one, rare, special circumstance?

It is easy to see a supposed benefit when there is a shortage of latex, not so easy to see what you are losingwhen there is no shortage. But they are real, and which happens more often?

The point is, how you see things can help you ask questions that can help you make better decisions. Are you asking the right questions to help you achieve your goal? Do your financial reports based on cost accounting help make it easier, or harder to see? If your goal is to hold large amounts of your precious dollars frozen out of reach, losing value all the time, fine, it’s an asset. Otherwise, think like me, it’s a liability, and handle with care!

Q—One reader asked, “How can you apply your ideas to aging cheese?”
A— It is a reasonable question. If you are making for sales months and even years in down the road, and you don’t have confirmed orders:
• Make better projections. If you don’t know how, get some training in simple statistics and making projections. Learn the difference between common and special causes. Work to reduce the range between over and underproduction, bringing both closer to the middle through process control and control charts.
• Offer incentives for people to place advance orders. If you subtract the true cost of excess inventory, you may find you can offer a hefty discount, especially if you have already paid your monthly bills, (see last column, available through the cheese reporter.com website). In spite of the discount, you may end up making more, not less money. For a YouTube video of how this works, go to my website and click on the link “Flow: How Money Really Moves Through your Business.”
• Adapt your product line. Balance your long hold with some shorter hold products.
• Add more value to your long hold items, in other words, great flavor, and make less. What happens to prices when demand overtakes supply?
• Make some products you only sell to advance order.
• Think! Think! Think! There is always a way to improve!

The first clients I worked with, when I began consulting in 1996, were mostly start-up artisan and farmhouse cheese makers, some now national brands. In the first few years of production, they all had problems with cash flow due to excess inventory until I was able to get them to see that production needs to be market, not supply, driven.

Two former CEO’s I know, of large midwestern cheese plants, had to sell their companies after years of struggling under the weight of excess inventory. Both saw it as a sales, and not a production problem, (aka excess inventory.)

They were blinded by their accounting department, and their financial reports, which showed the inventory as an asset, a fatal flaw. If inventory had been counted as a liability, they would have reacted sooner. There would be a painful month when they would have to take a write off for the “assets” turned into liabilities, but they would have stopped making cheese until they sold down their liability, and survived.

Maintain only the minimum amount of in process, finished or raw materials inventory needed, and keep the amount of money frozen in it about the same, month to month, and a simple purchase to sales report combined with knowing when you break even, can give you a powerful tool for understanding and growing your profit.

Dan Strongin is managing partner and owner of Edible Solutions, a consulting company focused on helping companies making great food make a profit. He will be writing a monthly column in Cheese Reporter. Strongin can be reached via phone at (510) 224-0493, or via e-mail at dan@danstrongin.com. You can visit and blog with Dan at www.managenaturally.com.

 

Other Strongin Articles written for Cheese Reporter

dot Cost Accounting Is Choking Your Business, Part 1
dot It Ain’t Over ‘til It’s Over
dot Raw Reason
dot A Story For The Holiday Season, Part II
dot A Story For The Holiday Season
dot Truth In Labeling
dot This Too Shall Pass or "What were we thinking?"
dot Marketing Language That Resonates
dot When Will We Ever Learn?
dot Cheese Competitions In The Context Of Marketing

dot Economy
dot Even The Best Laid Plans Go Astray
dot Root Causes: Communication
dot Partners
dot Diamond Cutting:
dot
It's What You Don't Know That Can Hurt You
dot Integrity and Ethics
dot Pricing:  The Perceived Value
Designing the Effective Sell Sheet
Common Sense
It All Begins in The Mouth
Of Cars...

The Gathering Storm
As Our Industry Evolves, So Should Our Terminology:

Other Cheese Reporter Guest Columnists
Visit John Umhoefer
Visit Neville McNaughton

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