Let the (Excess) Inventory Flow!
Written By: Predrag Jakovljevic
Published On: January 26 2007
The conundrum of inventory management and the notion of inventory as a "necessary evil" (or the "asset versus liability" dilemma) have long been haunting and bedazzling operations and financial and accounting managers. It is a well-known fact that managing inventory risk is about managing the cost of maintaining unnecessarily high levels of inventory against the risk of running out of stock at a crucial moment of truth (MOT) when a customer actually wants something. In a variety of aspects, inventory management is at the heart of the supply chain management (SCM) realm. Supply chain organizations are responsible for all the processes from sales and operations planning (S&OP) to customer fulfillment, inventory optimization, and new product delivery and introduction (NPDI)—all of which involve the planning and movement of inventory. Profit margins are also directly proportional to operational excellence in each of the above processes.
While cherished by material management folks as supply chain "grease," inventory is not that beloved by financial managers. For one, owing to dreaded inventory costs, start with carrying costs. APICS Dictionary (formerly standing for American Production and Inventory Control Society, but recently renamed the Association for Operations Management) defines carrying cost as follows:
The cost of holding inventory, usually defined as a percentage of the dollar value of inventory per unit of time (generally one year). Carrying cost depends mainly on the cost of capital invested as well as such costs of maintaining the inventory as taxes (based on the value of inventory on hand at a particular time) and insurance, obsolescence, spoilage, and space occupied. Such costs vary from 10 percent to 35 percent annually, depending on type of industry. Carrying cost is ultimately a policy variable reflecting the opportunity cost of alternative uses for funds invested in inventory.
The topic here is not traditional inventory optimization. That issue has already been tackled in previous articles (see Inventory Planning & Optimization: Extending Your ERP System and Lucrative but "Risky" Aftermarket Business—Service and Replacement Parts SCM). It enables clients to reduce investment in stock while at the same time maintain or improve customer service levels. Given that most inventory optimization techniques work on the premise of stock items being in their prime time, the focus here rather is on the tricky effect of product life cycles on inventory.
The motto "time is money" certainly holds true when it comes to inventory valuation. Well, maybe in a reverse (negative) manner, because typically neglected in the continuous battle for executives' focus and priority is the management of at-risk, aging inventory—be it excess active, obsolete, returns, or refurbished inventory. Some refer to these items as "slobs," which stands for "slow moving and obsolete" ones. In other words, most companies in the sectors of high-tech, consumer electronics, retail, and consumer packaged goods (CPG) are focused on new product introductions. Given that everybody is most excited in the early stages of product life cycles (that is, devising and delivering the brand new, "coolest" products), much less attention is paid to the languishing, "totally so not cool" older product lines, with millions of accompanying inventory asset recovery dollars slipping away annually as a consequence.
The S&OP process is chartered with aggregating demand from all sources, translating that demand into a production plan, and ensuring that the sellable product is in the right place at the right time for the duration of its active life (see Sales and Operations Planning Part One: Identifying and Forecasting Demand). In this process too, little time is afforded to the continuous assessment and disposition of excess active inventory, which comes from the ever-quicker pace of new product introduction that drives constant product turnover. Further, the rate of customer returns—reportedly up to 20 percent in consumer electronics—results in returned and refurbished inventory. Industry estimates of inventory excess in the high-tech sector alone reportedly approaches $2 billion (USD) annually, whereby most companies, in the best case scenario, are liquidating that excess "asset" at 20 percent of its original cost. Therefore, possibly the most hated notion for any financial manager is the one of inventory write-off, a deduction of inventory dollars from the financial statement because the inventory is of less value. An inventory write-off may be necessary because the value of the physical inventory is less than its book value or because the items in inventory are no longer usable.
Sure, one has to reckon with inventory shrinkage or losses of inventory resulting from scrap, deterioration (owing to product spoilage or damaged packaging, for example), pilferage, etc., which is one of the considerations included in the above definition of inventory carrying cost. However, what can be particularly annoying and hurtful is the notion of slow-moving items, or those inventory items with a low turnover. Inventory items falling in this category have relatively low rates of usage compared to the normal amount of inventory carried, and eventually become completely obsolete inventory. That is to say, the items have met the obsolescence criteria established by the organization. An example of obsolete inventory would be inventory that has been superseded by a new model or otherwise made obsolescent, and thus will never be used or sold at full value. While on the one hand disposing of such inventory may reduce a company's profit, on the other hand, a company that defers the liquidation process to a once every several months, crisis-like dumping is virtually throwing money away.
Figure 1: Time-based product price erosion, FreeFlow
Obsolete inventory is the inevitable result of new product introduction, whose ever more hectic pace nowadays ensures that price erosion starts just months or even weeks after the product launch (sometimes even by a minute following rumors or speculations of a newer line coming). Inventory in the channel loses value in direct relation to the cycle of new product introduction, whereby competitors' product introductions immediately impact the market value of inventory at any stage in its life cycle. An enterprise can either firmly manage the NPDI phase-in/phase-out processes resulting in low levels of residual inventory or, conversely, it can face large volumes of obsolete product. Whichever the case, the same market pressure applies to both, as prices continue to drop steeply with each month of product obsolescence (see figure 1). In this illustration, the time axis consists of the following phases from left to right: new product introduction, excess active inventory, end of manufacturing, end-of-life (EOL), and obsolete inventory. Market pricing on rapidly evolving high-tech products can erode at an incredible rate of 15 percent per month. A broad average across the consumer electronics category is between 2 percent and 8 percent (according to the private marketplace auction services provider FreeFlow [http://www.freeflow.com]). As a good illustration of the "time is (negative) money" mantra in inventory management, this cumulative price erosion can have a considerable impact on potential recovery. At 15 percent per month degradation, within six months the cumulative price erosion on $1 million becomes almost $500,000 (USD)—close to half price.
Further, the above mentioned inventory carrying costs invisibly yet measurably add to the financial exposure of excess and obsolete (E&O) inventory (see figure 2). As indicated earlier, carrying costs consist of warehouse costs (the direct cost per pallet of storage) as well as period costs, which typically include standard revision, excess and obsolete inventory reserve, and cost of capital. Figure 2 illustrates the cumulative effect of period costs, which, when combined with price erosion effects from figure 1, points out the double whammy of inventory procrastination. According to AMR Research, approximately $150 billion (USD) of supply chain is wasted across all types of global industries, for which the electronics industry (with ever-shorter product times-to-market) represents 15 percent of the global economy. Proportionately, this translates to over $22 billion (USD) in supply chain inefficiencies in the electronics industry alone.
Figure 2: Cumulative effect of period costs, FreeFlow
Newsflash—Excess Active and Obsolete Inventory Is a Money Drain
Excess inventory, which ties up working capital and whose value is declining by the day, does not necessarily come from new product introductions only. Namely, nowadays the manufacture of most goods is largely carried out in the Far East, which comes with a nominal item price advantage, but also with many potential downsides (see The Gain and Pain of Global Retail Sourcing). In addition to the inevitable quality, communication, and cultural issues, manufacturing product in such lower cost, remote locations means a sizeable lead time increase, as the goods will need to be transported from the Far East back to the company's warehouse. This in turn means that a planner will have to forecast the demand before placing an order with a remote supplier far away. In the high-tech and electronics world today, it is a common industry fact that forecast accuracy is at about 80 percent. This means that often 20 percent of everything that is manufactured is deemed to be "at risk" immediately and may never sell. In other words, potentially 80 percent of a company's inventory is active product that is currently selling. The remaining 20 percent is either slow-moving or will never sell simply because of the inevitably inaccurate forecast. Also, excess inventory scenarios often exist within worldwide services and warranty repair organizations. This can mean one of two things: One can have excess spares inventory that another service organization within the company or the distributor channel needs, but hardly anyone has any way of knowing about it; or there is excess stock of the product throughout the company and one must go to the open market to dispose of it. Other sources of excess inventory come from safety stocks, inventory buildups for seasonal and promotional items, bigger order sizes due to volume-based discounts, consignment inventories, returned goods, and so on.
To rub salt into the wound, excess active inventory is arguably the most difficult life cycle category to get rid of. If it is still on the original equipment manufacturing (OEM) company's price list, it is often contractually price-protected, and creating channel conflict by selling off discounted inventory to competing wholesalers is categorically not an option. In addition to the price protection that precludes the use of any form of broker liquidation, potential channel conflict restricts wholesale and retail options. Companies may sometimes resort to ineffective, high-overhead marketing promotions to move this inventory, but more often than not, significant quantities remain in the warehouse until eventually the product is rendered obsolete. Then it is eventually liquidated for several pennies on the dollar. While such marketing programs as promotions and rebates may move some excess inventory, profitability analysis reflects not only the margin impact of discounting, but the significant overhead costs of program management to develop, launch, and manage each distinct program as well. Hidden are the costs of claims matching, invoice reconciliation, credit resolution, and write-offs. Creating hefty financial reserves against product obsolescence, writing off the inventory, and ultimately recovering only a small fraction of the original value is the inevitable result of most companies' inventory asset management processes. Their focus, naturally, is on new product introduction.
There must be a smarter, more cost-efficient way for a company to increase its inventory asset recovery dollars. And there is. FreeFlow, a provider of business services, offers a way for businesses to off-load their inventory in the form of an online auction portal.
Part One of the series Let the (Excess) Inventory Flow!