The Cash Killer: Excess Inventory

The Census Bureau’s Monthly Report on Manufacturers’ Shipments, Inventories, and Orders for June 2019 showed a 0.3 percent increase in inventories of manufactured durable goods to $425.8 billion. During that same time, shipments were up 1.4 percent to $258.2 billion. The resulting difference between inventories and shipments was $167.6 billion (39% of total inventory).  This, of course, is not all excess inventory, but even if only 10% of the difference was truly excess inventory, that still represents nearly $17 billion in stagnating cash – equivalent to the annual revenues for General Mills or Gap.

 

In addition to constraining cash, excess inventory also accrues other tangible costs as it remains unsold.

  • Cost of Capital - The cost of money tied up in inventory, often expressed as the weighted-average, after-tax cost of a corporation's long-term debt, and the stockholders' equity.
  • Cost of Space - The cost of the physical space occupied by the inventory including rent, utility costs, insurance, and taxes.
  • Cost of Handling - The labor costs associated with receiving, inspecting, storing, retrieving, moving, counting, cleaning, and maintaining inventory.
  • Cost of Deterioration or Obsolescence - Reduced value of inventory as product age decreases shelf-life or usefulness, or the cost of inventory that no longer has customer demand due to long periods of storage.

 

Very few companies operate with an intentional focus on holding excess inventory. If cash were not a constraint for most companies, this practice would no doubt be more popular.  However, since most companies try to maintain “optimal” inventory levels, they are inherently trying to limit excess inventory to the greatest extent possible.  Yet, it still exists.  Why?

 

There are many situations that can create excess inventory, but the five most common causes are the following.

  • Bad Forecasting - Since forecasts typically drive the purchasing process, it is essential that the forecasting process contain checks and balances to ensure that the demand represented has been discussed and agreed upon each month. Relying solely on sales plans to drive demand forecasts, is a common mistake that almost always creates excess inventory.
  • New Products - It is challenging to predict sales volumes for new products.  Optimistic sales targets often result in purchasing too much inventory too early in the product life cycle.  Mitigating this risk requires alignment of new products to the sales history of similar products before initial inventory purchases are executed.
  • Customer Forecasts - Obtaining forecasts from a customer is generally a good method to hold the sales team accountable and gain commitment from the customer.  However, if the forecasts are not contractually binding, they are often overly optimistic, resulting in excess inventory.
  • Supplier Constraints - To keep prices competitive, suppliers often require minimum order quantities or minimum order values. Additionally, lead times often cause planners to factor in “buffer stock” or “safety stock” to avoid supply disruptions.  Both of these situations result in higher purchase quantities than actual demand requires, i.e. excess inventory.
  • Incorrect Levels - The “re-order level” defines when a product should be re-ordered (current stock minus commitments, plus stock on order), and the “order-up-to level” defines the quantity up to which should be reordered (considering buffer stock, safety stock, and lead time).  If any of the inputs driving these two calculations are wrong, the resulting purchases can be greater than demand, creating excess inventory.

 

Recognizing the problem, what are the most effective techniques for controlling inventory?  Below are five practices that we have found to be effective in better controlling inventory and limiting the growth of excess inventory.

  1. Monthly Planning Process - Establish a monthly dialogue between sales, planning, procurement, manufacturing, and finance to confirm what changes to demand are emerging (either up or down), and how those changes will impact the manufacturing plans and purchasing requirements.
  1. Reducing Supplier Lead Times - Negotiate faster supplier lead times or identify additional suppliers that can meet a quicker replenishment model. Faster lead-times give planners more flexibility when reordering inventory and allows for less inventory to be carried reducing the short-term carrying costs and the long-term risk of holding items that become excess or obsolete.
  1. Optimizing Order Size and Purchasing Frequency - Increasing communication with suppliers can help to negotiate reduced Minimum Order Quantities (MOQs), so that smaller, more frequent orders can be placed offsetting long-term risks of holding too much inventory.
  1. Product Lifecycle Management - Establish a formal analytic process to monitor where products are in their lifecycle and apply the analytic process to the following categories: launch, growth, maturity, and decline.  Train planners to refer to the lifecycle stage so that they can apply judgement to recommended purchase quantities, based on where the product is in its lifecycle.
  1. Economic Order Quantity Management - The primary goal of economic order quantity is to determine the optimal number of units to reorder so that the total cost associated with the purchase, delivery, and storage of the product are minimized. Defining a process to review and analyze order quantities, reorder points, pick frequencies, and safety stock levels is critical to establishing appropriate economic order quantities.

 

In summary, having excess inventory can be a luxury, but luxury is expensive.  Managing inventory to minimize the amount of excess inventory is a necessary discipline in today’s business world, especially when balanced against increasing demand by customers to shorten lead time. Focusing on improving inventory management practices, and reducing excess inventory preserve cash and reduce cost.

 

If you have additional inquiries about this article, please contact FGMK.

 

Michael Fenske is a Managing Director at FGMK, who co-leads FGMK's Management Consulting Practice.

 

                Michael Fenske                                                

                Managing Director                                          

                312.638.2941                                                     

                MFenske@fgmk.com                                   

 

 The summary information in this document is being provided for education purposes only.  Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice.  We encourage any recipients to contact FGMK for any inquiries regarding the contents.  FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.

 

About FGMK

FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.

 

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