WHEN IS A GOOD DEAL NOT A GOOD DEAL?

by Jim Tarr, CPIM

A distributor of parts to the aircraft industry was growing at 20% per year and very profitable, but had cash flow problems. Their inventory was turning 2 times per year, which they claimed was the industry average. I am always amused when a company justifies their performance by claiming "its the industry average", and yet I’ve never seen a company whose "vision" was "to be the industry average".

An analysis of sales showed that only 60% of sales were supported by inventory. The other 40% were "cross docked", that is, ordered from a vendor in response to a sales order and delivered when received by the distributor. Because the parts were often custom, highly machined parts, lot size pricing was considered important by the company. For example Part A, that cost $90 each in lots of 10 would cost $40 each in lots of 25 because of high cost of setup for the vendor. If a sales order was received for 10 parts, the following scenarios were possible:

The decision is clear, buy 40 Part A, right? Its clearly a better financial statement transaction. But wait, there’s more..... The company may not get an order for Part A for a month, a year or ever. By following this strategy, the distributor ran the risk of having a great deal of slow moving inventory. That’s exactly what happened. The company bought for best price, putting the excess into inventory.

If only 60% of sales were supported by inventory, the actual inventory turns were 1.2, not 2. An analysis of inventory turns per item revealed many items with turns of 0.8, 0.6, 0.2 and even 0.0 (This is referred to as FISH inventory; First In, Still Here).

What are the lessons in this little scenario, which, by the way, is based on an actual consulting assignment:

• Overall inventory turns is a good place to start an inventory analysis, but its important to analyze product family and even individual item inventory turns to get a complete picture of how "necessary" the inventory is to the business.
• Financial statement profitability based on volume purchasing can be deceptive if the purchase creates slow moving inventory. The excess inventory increases holding costs (money tied up, occupancy cost, loss, damage, etc.), and, in extreme cases, can lead to future write offs, effectively deferring the recognition of costs from a current period where they should be recognized to a future period.
• The distributor’s cash flow problems were a direct result of the "buy at the best price" strategy.

How can you identify if these are problems which exist in one of your clients?

• If the company has cash flow problems and slow moving inventory, analyze the inventory in more detail to identify where it is. If the company is a manufacturer, this problem will occur in Raw Material and other purchased items.
• Examine purchasing policies and practices to determine how price and purchasing volume decisions are made.
• If the company is very profitable, its possible that those profits are inflated and the costs are hidden in future write downs of slow moving inventory. If the company is marginally profitable, its possible that the company is actually operating at a loss and may be a candidate for quick remedial action.

The desire to "look good in the short run" can often lead businesses to make decisions that can be disastrous in the long run. I am always happy to discuss your specific client situations in more detail.