Inventory is not cash.

EXECUTIVE SUMMARY

Inventor, value and cash flow are inexorably tied in a relationship that is complex and difficult to understand. Mary people assume these values are equal, but the, are not. While reducing inventor, value will not lead to a corresponding improvement in cash flow, the

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Inventory and cash flow. As managers and engineers making improvements to our facilities, as consultants creating plans and value propositions for our clients, and as academics helping to define and explain the nature of this relationship, we have struggled with the relationship between inventory and cash flow.

We may not even be aware of the struggle: There are some assumptions regarding the relationship between inventory and cash flow that are so strong that we rarely, if ever, question them.

We assume, for instance, that values on the balance sheet are cash based or that the process used to assign labor values to work-in-process and finished goods inventories yields correct cash flow-based numbers. However, these and similar assumptions that we make about the relationship between cash flow and inventory are not only invalid, they ultimately lead to yet another equally but more dangerously invalid assumption--that the balance sheet value of inventory represents the same value in tied up cash, and freeing this cash results in an equal amount of money in the bank.

This assumption is often used as the basis for value propositions for projects ranging from product rationalization to lean implementations. The misleading promise of gaining $1 million in cash just by reducing a $10 million inventory by 10 percent results in a fertile field of opportunity for engineers, consultants, and academics looking to make a name or a buck.

It would be easy for a company to consider spending $100,000 in consulting fees if such a project were assumed to bring a 10:l return on investment. Investing in such an inventory reduction may not he the amazing business tactic it appears to be. The fundamental reason, explored and explained in this article, is that most of the costs that go into the $10 million will still exist even with a reduction of inventory levels. Labor costs, which are added to the financial value of the inventory, may not be reduced at the same rate (or at all). Therefore, labor costs are the same or slightly lower. Additionally, if the rate of demand is the same, ultimately, the same cost in materials is required to meet the demand.

The direct benefit of inventory reduction is freeing the amount of cash tied up in materials between the initial inventory level and its reduced level. That is the only pure cash flow opportunity that results from lowering the inventory levels. All others must be achieved through tactical or strategic actions, and the ultimate impact on cash flow is likely to be much less than anticipated when using the values on the balance sheet.

The situation

There is much evidence that would cause one to believe that inventory is, in fact, equal to cash. First, inventory is represented on the balance sheet in all of its forms--raw materials, work-in-process, and finished goods--as a dollar amount, indistinguishable from cash or any other asset or liability Second, inventory is considered working capital along with accounts receivables and accounts payables. Third, the cost of goods sold, which represents the cost of the items that are sold and is used to determine gross income, is often calculated directly from the value of the same item in finished goods inventory

Since all three cases manipulate inventory on an equal basis with cash, it is easy to incorrectly conclude that inventory is, in fact, tied up cash and if one can reduce inventory, one will free up the same amount of cash.

The activities on the balance sheet are represented by an accounting equation:

Assets - Liabilities = Owners' Equity

On the balance sheet, inventory in all its forms is represented as an asset. With work-in-process and finished goods inventory, labor costs are allocated to the value of the inventory, which creates the concept of manufacturing operations and processes adding value to products. In most companies, labor costs are allocated by using labor standards or else actual labor data is used. The approach that uses standards is more common; although with the use of labor and job tracking software, many companies have been able to apply actual direct labor to a job, an order number, or to items of inventory.

From an accounting perspective, calculating direct labor is straightforward: If someone makes $10 per hour and the time standard is 30 minutes, $5 of value is added to the inventory upon completion of the operation. Of course, indirect labor is also added based on predetermined allocation values or burden rates.

If, in the above example, it is assumed that indirect labor costs are five times the burden of direct labor, an additional $25 of indirect labor is applied to the value of the inventory after processing. At that operation, the balance sheet value of the inventory processed increased by $30. If it took two hours of total processing to create a finished part, direct labor would contribute $20 in balance sheet value and indirect labor would create $100, for a total labor contribution of $120. If the materials were $60, in this simple model the value of the inventory would be $180:$120 from labor and $60 from materials. If there were 1,000 pieces in finished goods inventory, the value of the inventory would be $180,000. (There are other values added to inventory costs such as the so-called carrying costs of inventory These are purposely not considered for two reasons: The dominant components of balance sheet inventory value are material and labor costs, and whether these carrying costs behave as suggested is highly questionable. Addressing this in the current article may distract from the message.)

Working capital represents a company's ability to handle short term debt. Net working capital is defined as the difference between current assets and current liabilities. The idea is that if assets outweigh liabilities, the company is in good shape. The company can collect that which is owed by others and can sell inventory to pay off its liabilities if it were to experience trouble.

Many manufacturing companies have defined their working capital similarly by considering accounts receivables and inventory as assets from the balance sheet and accounts payable as the liability' from the balance sheet. This would create an equation for net working capital in receivables, payables, and inventory:

Net working capital = Receivables + Inventory - Payables

As stated, the equation suggests that the dollar unit for receivables and payables, both exact amounts of money or cash, are the same measure as the dollar unit for inventory. If they were different units, one may argue, they could not be added together just like apples and oranges cannot be added together. Since receivables and payables reflect cash, it is assumed that inventory, too, must be cash-based.

The cost of goods sold, or COGS, is the value on the income statement that is subtracted from revenue to determine gross profit. Items in finished goods inventory have a balance sheet value assigned to them, including all of the labor and burden from the manufacturing process as well as management. In this form, finished goods inventory is considered to be an asset to the company.

However, when an item is sold, it is no longer an asset to the company, so it is transferred, on an accounting basis, from being an asset to being a cost--the cost of the good that was sold. This value shows up directly on the financial statement that determines profitability, and, ultimately, cash flow--the income statement. If the value of finished goods inventory is directly transferred to the income statement to determine gross profit, it again is incorrectly assumed to be cash-based.

With all of this evidence, we assume that inventory and cash flow are the same, and that by reducing inventory, the cash flow will increase by the same amount of the reduced value. This is how the calculations suggest that a reduction of 10 percent on inventories of $10 million would yield $1 million in cash flow. This is not true.

There are one or two steps between inventory and cash flow. Performing these steps, one finds that there are benefits to reducing inventory and acting on the opportunities, but the true cash flow savings as realized by the company are much lower.

Ultimately, three things can improve cash flow. First, sell more products. This clearly has a direct impact on the revenue component of the income statement. Second, reduce costs. Spending less (or the same amount of revenue will improve margins and, therefore, cash flow. Third, flee up cash that is tied up in assets. If a company keeps buying assets that are not converted to cash, it will have lots of assets hut may not have much cash. The idea is to buy the assets that are necessary for operating the company, to do so at the cheapest price, and to convert current assets as quickly as possible.

To understand why inventory and cash flow are not the same, we should first begin with how inventory influences cash flow. As mentioned earlier, COGS, calculated from finished goods inventory value, is used to determine gross profit. Consider the following two issues.

First, the amount or volume of inventory represented in raw materials, work-in-process, and finished goods are not a part of the COGS calculation. Only the inventory sold is included. Second, gross margin is not a cash flow value because it has not been subjected to taxes or any other influences that occur lower in the income statement yet lead to cash flow. Influences such as taxes and other expenses will also affect cash flow.

Ultimately, cash flow is determined when all revenues, (operating and non-operating) are considered along with all expenses (operating and non). Taxes and depreciation also come into play, suggesting that gross margin is a long way from being true cash flow.

The effect is similar to considering a mortgage. A mortgage payment may be $1,000 per month, but the impact of taxes and other deductible and nondeductible expenses must be considered to see the overall cash position over the course of a year. The overall impact of $12,000 spent annually on mortgage payments may be much less based on the improvements created to taxable income associated with mortgage tax laws. A similar concept holds true for companies, suggesting that to determine cash flow for a period, all money factors that show up on the income statement must be considered.

If a company has constant demand for its products, a couple of issues will be applicable. First, the rate at which inventory is converted from finished goods to COGS will be constant. As a product is sold and its value is transferred from finished goods to COGS, if the rate of demand is steady, the COGS would seem not to change (barring improvements to the process that will reduce this value). Therefore, the cost component of the gross margin will be the same. Second, the capacity in labor, equipment, materials, and space required to meet the demand will be the same. Therefore, the amount being allocated to determine the value of the inventory is the same. Note that the rate at which costs are identified in gross margin are the same, and the costs of running the plant are the same. In both cases, the costs are independent of the level of inventory in the system, suggesting that the level of inventory itself has little impact on costs and, therefore, cash flow generated from operations.

What happens when inventory is reduced? When the value of inventory is reduced, the amount of time between paying for raw materials and receiving revenue from the sold products is reduced. Unlike labor as capacity, materials come into manufacturing, are processed, and become finished sold products.

If a company buys a week's worth of production inventory on Jan. 1 and it remains as inventory until sold on June 30, the investment in inventory does not pay off until six months later. If a company buys the same inventory on June 1, the investment takes one month to pay off. If one week of production uses $100,000 in materials and the practice of buying one week of materials continues, over any six-month period, the company has $26 million in materials waiting to become revenues.

If, however, the company has only four week's worth of inventory, on hand, it has only $400,000 tied up in materials waiting to be converted to revenues. It is important to note that this difference of more than $25 million is not a cost reduction because ultimately the same amount of materials will make up the inventory that will become finished products if assuming constant demand (Figure 1).

[FIGURE 1 OMITTED]

It takes four tires to make each car, so the ultimate amount invested in tires for a one-year supply of automobiles is the same whether the company has one month of tire inventory or six months. But the transaction frees the cash that was tied up in materials and makes it available tot other revenue-generating opportunities such as investments elsewhere that may yield equal, higher, or faster returns.

Concerning labor, the story is different. With labor as with materials, the company buys capacity: But this is where the similarity ends.

The labor component

When a company buys labor capacity, it is buying the knowledge and time to perform work, some of which involves converting materials into salable products. Knowledge is a reusable resource, but time, once passed, is gone forever. Neither, however, is a specific item that can be physically tied to that purchased by the customer and transformed into revenue. Because time and knowledge exist independently of the inventory that is produced, their value can be only arbitrarily assigned to the value of a product. Inventory, in other words, is a byproduct of time and knowledge.

An hourly worker is paid based on the hours worked, not the amount of material processed. And although the time spent processing an item can be measured and monitored, the fact still remains that there are forced and unnatural mathematical and logical relationships that exist when applying a fixed salary to work performed.

Additionally, the labor component of inventory will be the same whether there is six months of inventory or one month (assuming constant demand). The workers, direct and indirect, will generally work 50 weeks out of the year. The output of this investment is the work performed by the employees which, in large part, created the inventory. If the inventory levels remain constant, the labor to create the inventory remains constant (Figure 2). The level of production determines labor capacity required and the static labor capacity determines the cost of direct labor. With constant demand will come constant labor costs, regardless of inventory level.

[FIGURE 2 OMITTED]

Summarizing to this point, the cash flow freed from inventory reduction, independent of all other factors, is influenced by materials, not by labor. Whether there is six months of inventory or one, the rate of consumption of materials will be constant with constant demand, so lower inventories will tie up less cash for a shorter period of time. With regard to labor, as long as labor capacity remains the same, the cost for the labor will remain constant regardless of inventory levels.

How to influence cash flow

There are two issues to consider when creating a cash flow-based improvement by reducing inventory. The first issue involves strategies that will allow for the inventory to be reduced. The second issue involves calculating the financial impact of the transaction. The company will need to get rid of the inventory, and the cash flow impact of this action must be determined. Note that this is the process of reducing the inventory and not the inventory reduction itself. Cost reduction and cash flow enhancement are not functions of reduced levels of inventory.

With the reduced inventory level being the independent variable and cash being the dependent variable, one value that represents a difference in inventory levels can yield multiple cash flow differences. By definition, an independent variable in a function can yield only one dependent value. This suggests that it is the process of reducing inventory that yields financial improvements, not the difference in the inventory value itself. That is one important reason why one cannot look at a balance sheet, select a percent reduction off this value, and based on that information alone determine the financial impact of reducing inventory When determining the value of cash flow improvements, the critical component is bow the inventory will be reduced.

There are really only three ways to get rid of inventory: Sell it at a faster rate, produce it at a slower rate, or eliminate it through non-operating options such as declaring the inventory obsolete and disposing of it. The approach and the timing of the activities will have varying impact on the size of the cash flow improvement opportunity. Before identifying a strategy, consider which option works best given the company's financial position, the options for disposing of the inventory, and the dynamics in the market. The arbitrarily selected approach may not be one that delivers the most value.

Sell more. When the rate of sales is greater than the rate of inventory creation, the amount and, therefore, the value of the inventory goes down. When sales increase, they take along with them the cost of goods sold, so from a cash flow perspective, the first value to consider is the gross margin Improvement. In addition, one must consider the tax impact of the transaction before beginning to consider the cash flow improvement of reducing inventory this way. As a result, only a percentage of the gross margin created will find its way to cash.

Another factor to consider is the timing of the benefits and what is necessary to create the improvement. When looking at a return on investment of increasing sales, the approach used to create the improvement may significantly affect the magnitude of the returns. For example, did sales costs--a component of sales, general, and administrative (SG&A) costs on the income statement--increase? SG&A is the cost component that, when subtracted from gross margin, determines net income. If SG&A costs have increased due to hiring more people, increasing the pay incentive to sell slow-moving products, or added training, this will reduce the net margin, further reducing the cash flow impact of tire inventory reduction.

Also, when calculating a cash flow-based Net present value, larger numbers earlier have a bigger impact than larger numbers later because of the impact of discounting. However, sales activities often require time to increase the productivity and the output of those doing the selling. Therefore, the sales approach may inherently reduce the net present value of the cash flow even further.

To achieve the maximum impact on cash flow from increasing sales, minimize whatever reduces cash flow. First, focus on speed. Salespeople must be aware of item inventories and pricing options for the inventory as quickly as possible. Any training or hiring that must occur should happen quickly to move the materials. Second, when increasing sales output, companies must manage SG&A costs because although they are not a part of the gross margin on the income statement, they have the same impact as gross margin when calculating net margins. If sales increases gross margins positively but the increase in sales costs offsets the efforts, the company is none the better.

Reduce production. When building inventory, a company is basically paying its labor to create assets for itself, hoping to sell them one day at a profit. Managers must manage the cost to create assets and the value of the assets themselves. The objective is to reduce the value of the inventory without increasing COGS. By using the wrong approach, companies may find themselves having a negative impact on gross margins by actually increasing COGS.

One way companies reduce inventory is to reduce production rates. Another way is to cut shifts. When reducing production rates, the company spends the same money on labor but produces fewer assets. The result is a negative variance, and the inventory has a higher relative value because from a financial accounting perspective, the same costs are spread over fewer assets. When converted into sold products, the inventory carries a higher COGS. With higher COGS and constant sales come reduced gross margin.

Although cutting shifts is not the most desirable option from a human resources perspective, the company will spend less money to create fewer assets. Relatively speaking, the COGS will be the same for the same sales volume, but the company spent less money creating the assets necessary to achieve the sales. The time that the company does not pay salaries will allow inventory to be depleted to a more desirable level. When the desired level has been achieved, production can continue generating inventory at its regular rate.

As with sales, the tinting of the benefits is important. To the extent possible, benefits should be achieved earlier rather than later to increase the net present value of the activity.

Obsolete inventory. When a company wants to get rid of inventory by making it obsolete, there is an impact on cash flow. Companies are able to write off the inventory being disposed. The company spent money generating assets that were not sold. The government allows a company to acknowledge these expenses, as the items never reached the point of becoming COGS. The write-off is a percentage of the value of the inventory being disposed, and it is represented on the income statement as an expense. Since it is an expense, it will reduce profit and, therefore, taxable income. So the transaction itself does not create the same benefit in cash as the book value on the balance sheet or as the calculated expense item, but it will affect cash flow. The expense cannot show up until the inventory is physically disposed of, so the company should waste no time in performing this transaction.

As with increased sales rates and reduced production rates, the net present value of the activity increases the sooner larger transactions occur.

Summary

It is possible to achieve cash flow improvements to inventory reductions, but be careful identifying the source and the magnitude of the cash flow improvements. The process of reducing inventory frees cash that would normally be tied up in inventory and therefore is not available to the organization for other investments. The impact that can be made on the income statement, which is directly tied to cash flow, is a function o[ how the organization chooses to reduce the excess inventory.

Some policies are much more effective at creating a positive cash flow position for a company than others. If finished goods are rapidly and easily salable, consider maintaining production rates but achieve the sales at the lowest possible cost. Consider the financial impact of the whole transaction rather than the transaction at the gross profit level. If sales are moderate, perhaps a reduction or cut in production makes the most sense, especially if operations are fairly flexible with regard to volume changes. If slow moving, and if the financial impact is deemed to be positive, make the assessment and dispose of the inventory so that the impact on cash is immediately realized.