PART I CONTROL CONCEPTS

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1 PART I CONTROL CONCEPTS

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3 CHAPTER I THE FIRST LESSON IN INVENTORY MANAGEMENT By the end of this chapter, the student will be able to: 1. Offer a convincing argument in favor of the position that inventory is money. 2. Point out how inventory affects key financial performance measures. 3. Explain how inventory is valued. LEARNING OBJECTIVES Concern for inventory management and control has always been present to some degree. This concern, coupled with efforts to do something about it, began to peak during the early 1980s. Since that time, and at least through 1988, the United States has sustained one of the longest periods of economic growth and recovery in its history. While the emphasis on inventory management and control cannot claim all the credit, it most certainly has played a leading role in helping U.S. companies obtain a competitive edge in world markets. We won't know for certain what the business and economic annals will have to say about the 1990s until the turn of the century. However, there is one sure bet: the emphasis on inventory management will show no sign of weakening. Too much has been learned about how to improve control over inventory, and how inventory control, in turn, can contribute to the economic health of an organization. While business cycles seem to be inevitable, recessions will likely not reach the depths and duration that they once did. Emphasis on inventory management and control will be one of the leading causes. A REAL EYE OPENER Inventory's significance to the health of the firm is evident throughout it. You need only look around you and ask a few questions to find proof of this: Ask to see the most recent list of corporate directives and objectives. Ask a shop supervisor what his or her major concerns have been lately. Meet with one of the production planners. Visit purchasing. Talk to the

4 warehouse supervisor. See the chief financial officer. If your company is having any problems, your queries will be sure to meet with the words inventory and/or inventory reduction time and time again. If you are still not convinced of inventory's importance, venture onto the production floor. Your experience may follow along the lines of a tale once told by a noted crusader for effective inventory management: The second stop on the required tour is the production line of machinists making part X. We proceed as follows. First look for a 5 by 5 by 3 foot bin of gears or parts that looks like it has been there awhile. Pick up a gear and ask, casually, "How much is this worth?" You then ask, "How many of these are in the bin?" followed by, "How long has this bin been here?" and, "What's your cost of money for this company?" I recall one case in a nameless South American country where the unit cost times the number of parts times the time it had been there times the interest rate resulted in a cost per day figure that would ensure a comfortable retirement for the plant manager on the bank of Rio de la Plata at one of the better resorts to be found there. The plant manager suddenly realized that what he was holding was not just a chunk of high-test steel, but was real money. He then pointed out that he now understood the value of the inventory, but could I suggest a way to drive the point home to upper management? I suggested that he go to the accounting department and borrow enough money to be equal to the bin's value for as long as it had been sitting there, and pile it on the top of the bin. I further suggested that he do that for every bin on the production line. We rapidly figured out that by the time we had the money piled up on the bin, you would not even be able to see the bin. My opinion was that if the upper managers were given a tour of the line with the money piled up, they would never forget it. 1 The difference between surviving and folding for many companies during particularly difficult times has no doubt rested in large part on their ability to reduce unnecessary inventories. Unfortunately, the issues and the answers surrounding inventory management are not so straightforward that one can simply go out and order the wholesale elimination of inventories. Moreover, this course will not advocate so drastic a move, although some Japanese companies seem to have nearly achieved this through their "just in time" philosophy and practices 2. Inventory does have a place, and it can play a very important role in helping a firm run smoothly and efficiently. Chapter 2 addresses this statement by outlining the functions of inventory. In this chapter, we'll spend most of our time looking at the financial implications inventory has for the firm, the various methods of putting a price tag on inventory and the pros and cons of each, and record keeping. As we discuss each of these areas, one fact should become increasingly clear: inventory is an expensive resource; it represents dollars sitting on the floor or on the shelves. That is the important "first lesson" in inventory management. 1Gene W oolsey, "On Doing Good Things and Dumb Things in Production and Inventory Control," Interfaces 5, no. 5 (May 1975), pp Many Americans take an "if they can do it, why can't we?" attitude toward the Japanese. To help clarify your attitude toward the Japanese approach to production and inventory management, both the bibliography and the selected readings provide sources of information regarding this highly publicized topic.

5 THE FINANCIAL IMPLICATIONS OF INVENTORY MANAGEMENT The financial implications of carrying inventory can be demonstrated clearly by examining the direct impact inventory has on the company's financial statements. Of particular importance are the balance sheet and the income statement. The balance sheet describes the general financial health of the company at a given point in time, usually the end of the last fiscal year. The income statement, or profit and loss statement, describes how well the company performed over a period of time, usually the past year. The information contained in both statements is generally combined to form the key indicators of how well the company is being managed. To illustrate the points to be made, abbreviated samples of a balance sheet and income statement are provided in Exhibits I -1 and 1-2, respectively. Since the data in these tables represent a hypothetical company, you might like to follow along using data from your own company's income statement and balance sheet, making the same calculations about to be made here. In addition, you may want to compare your company's status with that of one of your competitors. Our first step is to find the company's net earnings for the year before federal income tax (the total revenue from sales less all expenses associated with being in business) on the income statement. In our example, this figure is $200,000, as shown in Exhibit 1-2. Now, from the balance sheet, look for the company's total assets. This figure represents the total investment in the company, or the resources, including cash, equipment, and material, that presumably had to be available in order to generate the sales realized. The appropriate figure from Exhibit 1- I is $1 million. Since this is actually an end of the year figure, we assume that it also represents an average investment throughout the year. The measure we are looking for, however, is what kind of return, expressed as a percentage, the company was able to generate on its investment. Our case yields the following: THE INCOME STATEMENT AND BALANCE SHEET $200,000 Net income before taxes = 20% Return on assets $1,000,000 Total assets It is this measure, admittedly along with others, that will attract future investment interest in the company and affect the company's ability to raise cash when it is needed. The point, insofar as inventory is concerned, is that the company's inventories figure twice in this measure. First, the cost of goods sold, which represents the value placed on the inventory used in the manufacturing process, influences net income. Second, part of the asset base is the average inventory level purportedly required to support the manufacturing function. We will investigate this area first. If less inventory was required, on the average, the denominator would be TOO MUCH, TOO LITTLE, smaller, and the return on assets much greater-obviously a desirable OR JUST ENOUGH?

6 result, as long as the same level of sales could be sustained. Whether it can be sustained is another question, which can be partially answered by a further examination of the financial reports. We begin with the cost of goods sold, as measured by the value of inventory consumed during the year. This is shown as "materials used" in the income statement, and amounts to $300,000. The balance sheet, however, shows that the average amount in inventory throughout the year was $200,000. These two figures reveal that the company holds inventory for two thirds of the year on the average ($200,000 / $300,000). One must wonder what could have been done with the cash that would have been available if this investment in inventory had been reduced. A possible flaw in the foregoing analysis is that we are assuming the two values being compared (materials used and average inventory) are for inventories used in the manufacturing process-namely, work-in-process or raw material inventories. This may not in fact be the case, and it is important to compare like values in terms of the inventory being represented. If the great majority of inventory reported in the balance sheet was finished goods waiting to be sold, then a more accurate assessment would compare the total sales of $1 million to the average inventory balance of $200,000. This implies that inventory is held for an average of only one fifth of the year, meaning that the total investment in inventory flows through the company at a rate of five times a year. This is obviously a much better rate than one and a half times a year, which is the case in the first analysis ($300,000 / $200,000). In this condensed example, we don't know where our inventory money is tied up-whether it is in raw materials, work-in-process (which would also have some labor and overhead value added to it), or finished goods. The example illustrates a simple although admittedly broad way to gauge

7 the potential for inventory reductions. Many financial statements will sort out the different components of inventory investment. Let us now look at the implications of inventory investment from another angle. Financial analysts and investors are very much interested in a company's ability to meet its current obligations. They want to know how liquid the firm is and if it can pay its bills, because a firm that can't pay its bills won't stay in business. An indication of liquidity is typically derived from the balance sheet by calculating the ratio of current assets to current liabilities. Taking figures from Exhibit 1-1, we can calculate the following ratio: CAN THE BILLS BE PAID? $350,000 Current assets = 2.0 Current ratio $175,000 Current liabilities A 2.0 current ratio implies that the company can pay its current bills two times over, which would generally be considered a fairly healthy ratio, depending on the seasonality of the business and any other causes for fluctuation in cash flow. However, this ratio can be misleading and create a false sense of security. Therefore, we must examine what constitutes current assets more closely. Turning again to Exhibit 1-1, we find that inventory makes up more than 57 percent of current assets ($200,000 $350,000). Because inventory is not highly liquid, particularly if the firm wants to avoid much of a loss, a better indicator of liquidity would exclude inventory from the equation. This indicator, sometimes referred to as the "acid test," is the ratio of current assets minus inventories to current liabilities: $350,000 - $200,000 =.857 $175,000 It now appears that our sample company doesn't even have enough cash, or the ability to generate ready cash, to pay its current bills. It is probably an understatement to say that the company is in a very precarious position

8 regarding its cash flow and that its relatively high investment in inventory may be forcing rather heavy short-term borrowing just to make ends meet. During periods when money is in short supply, as was experienced in the early 1980s, this situation could be disastrous. HOW INVENTORY IS VALUED Refer back to the line item "materials used" in the income statement. How the company chooses to value its inventory, and therefore how it translates that value into the cost of production, can greatly influence the net income after taxes. Four methods of valuation found in practice are first in, first out (FIFO), last in, first out (LIFO), and, to a lesser extent, average cost and specific cost. Managers practicing FIFO assume that the first material received into FIFO ACCOUNTING i nventory will be the first issued to production, or the first sold. During PRACTICES periods of increasing prices, FIFO allows lower-cost material to be charged to the cost of goods currently being manufactured and sold, ultimately resulting in higher profits and greater tax liability. To a certain extent, FIFO distorts the income statement. On the other hand, the last items received into inventory are still there at the end of the year, resulting in a balance sheet that displays a very current inventory value. Of all four valuation methods, FIFO coincides most closely with the actual physical flow of inventory from storage to production to customer. However, with the exception of highly perishable inventory, such as food products and some chemicals, no specific attempt is made to match a given unit cost to the actual item purchased or produced at that cost, nor is it necessary to do so. FIFO was long the most common accounting practice employed. In recent years, however, more and more firms have shifted to LIFO, and this trend accelerated with the passage of the 1981 Economic Recovery Tax Act. The reason is that since LIFO assumes the last items received by inventory are the first to be assigned to production, the costs charged against goods produced are the most current and therefore higher. This results in smaller profits and reduced tax liability. LIFO ACCOUNTING PRACTICES A comparison of FIFO and LIFO methods, as shown in Exhibit 1-3, nicely illustrates the impact of both methods on the income statement. The example assumes the consumption of 30,000 units of inventory, which were purchased at $10 apiece at the beginning of the year but cost $12 apiece at the end of the year. In the FIFO method, the items are charged against production based on their cost when they first enter inventory at the beginning of the year. In the LIFO method, the price of the last items purchased is charged against production. This is obviously a simplistic example, but it does point out the tax advantage of the LIFO method, which offers a $37,200 tax savings in this example. However, while FIFO FIFO VERSUS LIFO

9 results in a somewhat distorted income statement, as was pointed out earlier, LIFO results in a distorted balance sheet. This is because items left in inventory are valued at older prices, not current costs. EXHIBIT 1-3 A COMPARISON OF FIFO AND LIFO INVENTORY VALUATION METHODS Before concluding our discussion of inventory valuation, we should address the lesser-used methods of average cost and specific cost. OTHER VALUATION METHODS THE AVERAGE COST METHOD This method attempts to achieve exactly what its name implies. The best way to explain it is by example. Two ways of implementing average costing are illustrated in Exhibit 1-4, employing a simple average in one case and a weighted average in the other. The weighted average attempts to correct any bias that could be caused by unequal lot sizes. THE SPECIFIC COST METHOD This method charges the actual cost of a given item to production or sales. It assumes the firm has the ability to track each item perfectly and to match it with its original cost. Of course, this can only be achieved by literally tagging the item when it comes in, before it goes to inventory. The costs to implement and maintain such a system are generally prohibitive. Therefore, specific costing, if used at all, is employed by companies with highly efficient computer-controlled systems or reserved for high-value items and low-volume custom items. The point of discussing these valuation practices has not been to persuade you to alter your firm's current method of inventory valuation. The method used in your firm was probably chosen with great care and in the firm's best interest. The point is that the correct interpretation of your company's inventory policies depends on your knowledge of how inventory is being valued and charged against production and sales. If, however, you or others in your firm do contemplate changing the existing valuation THE POINT

10 method, you should consult applicable tax laws. They dictate in detail how a conversion should be made. HOW RECORDS ARE KEPT By this time you may have questioned the practicality of one or more of the foregoing valuation methods in light of the way that inventory transactions are recorded. Inventory record-keeping systems are generally classified as either perpetual systems or periodic systems. Both are important to understand and will be discussed again later in the course, particularly in Chapters 6 and 9, where order sizes, reorder points, and safety stock levels will be introduced. The purpose here is simply to give you a working definition of each system. In a perpetual system, all transactions are posted when they occur, whether they are additions to or depletions of stock. In a computer-integrated THE PERPETUAL SYSTEM

11 inventory system, transactions are generally assumed to occur in real time, with very little or no lag between the actual entry of the transaction and the posting of inventory balances. Hence, balances are always current. FIFO, LIFO, and specific costing can be implemented very easily within a perpetual system. However, since average costing cannot be applied until all costs are known, and they will not be known until the end of the current period, it is not very well suited to a perpetual system without some adjustment. One approach to resolving this problem is to employ a moving average cost. In a periodic system, all records are updated only periodically. Although additions to stock are usually made when they occur or soon thereafter, a check on stock balances is not made until the end of each period. Each period is generally of equal length. Any of the four costing methods can be implemented in this environment. THE PERIODIC SYSTEM SUMMARY This chapter has not been as concerned with introducing you to the entire subject of inventory planning and control as it has been with laying a few relatively simple foundations, supplying "the first lesson in inventory management," as the chapter title suggests. Again, that lesson is that inventory is an expensive resource, representing real dollars. The most important first step in understanding inventory management is understanding that inventory is money. No one would put their personal money in a savings account that pays no interest. Yet plenty of companies surround themselves with inventory that sits, and sits, and sits.

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13 INSTRUCTIONAL PROGRAMMING 1 l. From an accounting point of view, inventory is: 1. (a) (a) an asset. (b) a liability. (c) a necessity. 2. What is the inventory turnover ratio for a company showing an average inventory value of $1.6 million and an annual cost of goods sold totaling $2.4 million? 3. is affected when a company switches from FIFO inven- 3. (d) tory valuation to LIFO valuation. (a) Net income (b) Total assets (c) Neither a nor b (d) Both a and b 4. A current asset can be readily converted to cash. 4. True ( ) True ( ) False 5. Computer-integrated inventory systems use a method 5. (b) of record keeping. (a) periodic (b) perpetual (c) simple average (d) weighted average

14 6. FIFO inventory valuation most closely resembles the actual physical 6. True flow of inventory through a manufacturing operation. ( ) True ( ) False 7. Inventory is not considered to have real monetary value until it 7. False. Inventory has value reaches the finished goods state. in all states, beginning with ( ) True raw material. ( ) False