Treasury vs. Inventory Management: The New Post-War Alliance
“Every year it is worse. Each planning cycle, the Treasury reduces our inventory budget again and again. They have no idea what damage they are doing to our profitability.”
G.C., general manager of the Indian subsidiary of a German industrial equipment company
“Nobody in Treasury understands how different our business is. They are forcing ratios on us that they get from the divisions that deliver parts to the vehicle assembly plants. We can’t serve our customers that way.”
T.M., vice president for the aftermarket division of an American automotive supplier
Over the past decade or so, Treasury departments have tapped a wonderful funding
source discovered in their own backyards: Inventory – massive piles and
vast lakes of it! When inventory is forced down, its value reappears in Treasury’s
cash accounts through the “magic” of the liquid asset cycle. This
is free money. There is no interest to pay. Neither does it involve a dilution
of earnings per share. Reducing inventory has ancillary benefits, too. Because
excess stock conceals off-spec processes, quality improves and scrap costs shrink.
It is all good. Or rather, it was. In many ways inventory containment is not
so different from the various forms of tightening that have already taken place
through Treasury’s efforts. Removing any type of slack produces a nice
one-time windfall, but thereafter requires a firmer grip and closer attention.
Previously buffered variances become truly jarring obstacles, so foresight needs
to be clearer and reaction-times must improve.
The unavoidable upcoming reality is that, as excess inventory is eradicated,
further reductions threaten severe harm to profitability and market shares.
Having taken the lead in setting inventory targets, Treasury needs to be asking
how will it know when the inflection point – where damage eclipses
benefit – has arrived. Managing inventory in this cusp requires more than
just adding some computer programs and specialists. In particular, the long-standing
adversarial relationship between Treasury and Inventory Management must end.
For too long, these two important functional areas have been pulling in different
directions. This is no longer acceptable. Cooperation has become essential.
Unfortunately, Treasury and finance professionals rarely understand inventory
and the nature of the returns this class of investment yields. Likewise, most
Inventory Managers lack background in even basic Treasury operations. Both functional
areas must learn to come to the liquid asset conference table prepared for discussions
that will take place in strategic and financial terms, as described ahead.
When ERP emerged in the 1990s, the three management technologies that had evolved
separately around the perimeter of the corporation’s liquid asset cycle
– cash management, inventory control, and credit management – were
suddenly brought into communion atop a unified database. The immediate discomfort
that came with their new proximity was fairly quickly resolved on the seam between
cash and receivables. Both areas benefited, as did the organization generally.
Inventory, however, did not settle into the new paradigm at all well. At first
one might be tempted to attribute its poor cohabitation skills to the sector’s
non-financial units (gallons, hogsheads, fat-halves, etc.) and/or the variety
of techniques commonly in use to convert them (LIFO, FIFO, Lower of Cost and
Market, etc.). Another fundamental difference is that, by the end of the twentieth
century, cash and receivables had both essentially become disembodied information.
Besides being perfectly clean and instantaneously measurable, these two classes
of liquid assets are now capable of world-travel at relativistic speed. On the
other hand, inventory is bound to the physical realm’s Newtonian velocities,
often uncertain in its quantities, and dirty.
As if these disparities were not enough, inventory is burdened by a deep philosophical
problem, which must be addressed if its integration is to proceed. From an original
charter to minimize costs was born the ultimately destructive guiding-principle
that became the foundation of all of modern Inventory Control theory: Optimization.
While this sounds like a perfect goal, in practice it is anything but. Like
Ice-Nine, the fictitious crystalline form of water in Kurt Vonnegut’s
novel Cat’s Cradle, optimization radiated through inventory –
freezing its liquidity into a solid block. By creating “optimal”
targets and systematically locking onto them, optimization transformed this
entire class of liquid assets into an artificially “fixed” one –
as incapable of flexing with changes in a corporation’s liquidity as Plant
and Equipment.
Besides espousing its own perfection while coagulating what had once been a
free-flowing region of the liquid asset cycle, optimization authorized the bloat
that has been at the center of Treasury’s confrontation with Inventory
Management. A new philosophy, based on inventory’s essential liquidity
and flexibility, is now required that will allow Inventory Management to accept
intelligent direction.
Treasury will be able to provide this, but only if Inventory Management supplies
the necessary information: Alternatives – these need to be listed, with
their projected returns, in a condensed and workable format.
Once a target is chosen, Inventory Management needs to be equipped to explode
its directive into the myriad of necessary item-level details as quickly and
automatically as possible. Finally, actual investment performance must be measured
to enable continuous improvement.
In all likelihood, Treasury will need to lead the way through the transition
from confrontation to cooperation. In order to do so, it must be explicit in
what it expects.
One of the most disorienting characteristics of inventory is the wide variety
of perspectives distributed through the academic literature and inventory’s
various constituencies within the corporation’s community. There are well-established
but distinctly different viewpoints for schedulers, merchandisers, cost accountants,
auditors, theorists, factors, division managers, MIS departments, etc. None
of these, however, is suitable for Treasury.
A Treasurer needs to insist that Inventory Management begin by dividing potential
investments into two primary categories, financial and strategic. These require
very different allocation processes that naturally operate at different planning-cycle
frequencies.
A financial inventory is one with a readily calculable return. While one might
balk at the idea that there could be any other kind, some inventory investments
are purely and directly linked to cost reduction or revenue enhancement. It
might be a raw material acquired in bulk to secure a quantity discount. Or a
production run may be lengthened to spread its set-up cost over more items.
The projected savings should be viewed as returns on potential inventory investments.
If Inventory Management would collect these opportunities and arrange them by
ROI, Treasury could intelligently set an affordable target that would not drive
profitability out of the organization.
There are many types of financial inventories. Treasury cannot be required
to be current with the changing micro-economics of each, and certainly cannot
be setting individual targets for the hundreds of thousands to millions of individual
stockable items. The first half of this task should belong to Inventory Management
and be central to its process for developing its list of alternatives. The second
half, generating detailed directives, can be automated. Every candidate investment
with an ROI above the cutoff line is funded; those below are not.
Eventually, financial inventory investments may even be timed in coordination
with cash management. By adding a “maturity” dimension to the investment
options before they are merged into the master list, cash managers could choose
to park excess liquidity in financial inventories, knowing when it will return
to cash-form via the liquid asset cycle’s “magic”. This development
will open a variety of predictable organizational issues – e.g., who gets
credit for these earnings? – that will need to be addressed. If a temporary
inventory investment yielding over 20% can be weighed against a money market
rate in the low single digits, however, these issues will be worked out. (NB:
When Treasury willfully increases the inventory in a item like this, a new era
of liquid asset management and short-term financial maneuverability will have
begun.)
Consider a grocery store with zero inventory; all would agree this is a ludicrous
vision. Nonetheless, when the Treasury of one farm machinery company attempted
a sharp round of inventory reductions at its retail sales outlets, it was genuinely
surprised at the uniform rage the action provoked from its dealers. Some actually
demanded more inventory. At ground level, this rule is obvious: A distribution
system deprived of inventory can kill a business. Clearly, in the Treasury’s
inventory classification system, merchandise must belong to a different order.
A further complication is that many of these inventories defy projected-ROI
calculations. Though they directly support sales, the difficulty they present
is that their most critical cost – of not having an item at the moment
it is asked for by a customer – is very difficult and expensive to quantify.
One customer may simply wait, delaying some revenue. Another will purchase elsewhere,
in which case the revenue is lost. Still another will permanently switch to
an alternative supplier, terminating an entire revenue stream. In real world
cases there are often even more options that need to be considered. Unfortunately,
the market research necessary to quantify a probabilistic “stock-out cost”
would drive many businesses into red ink.
These inventories still need to be controlled, of course, but their intrinsic
difference from financial inventories must be recognized and managed accordingly.
Such holdings are often in place to establish a Customer Service Level, a reputation,
and ultimately market share – one of the primary dimensions,
not coincidentally, in Strategic Planning’s concept-space.
Inventory Management should not be making strategic decisions on its own. Again,
it should be generating alternatives, comparable to those described previously
with financial inventories. This time, however, the “return” that
each layer of investment earns is an increase in the level of Customer Service
(or whatever other conceptual dimension is being quantified).
This time, the options should not be dovetailed together for the entire enterprise,
but instead down at strategic business unit level or even some subassembly thereof.
Expectations vary from market to market, of course. More importantly, strategic
investing dictates that a lower level of inventory and service should be authorized
for an SBU being “milked” than is budgeted for the one that represents
the corporation’s future.
In this sense, strategic inventory investments are actually more closely related
to receivables than they are to financial inventories. Like receivables, strategic
inventories may fluctuate – but their underlying policy should not or the corporation
will appear unsteady. Both are, after all, customer-facing liquid-asset presences.
A company’s image need not be unchanging, of course, but it certainly
should be crafted strategically.
This would suggest that in the future, as liquid asset management evolves into
a more integrated form, that the strategic planning process will continue to
be the locus for strategic inventories and receivables, whereas financial inventories
will migrate to shorter time-spans of control, eventually integrating with cash
management.
Treasury departments are on a collision course with inventory’s inflection
point. Continuing reduction policies will inevitably begin to do more harm than
good. Very likely, many Treasuries are already in this position and do not know
it. To manage inventory in the new era, Treasury must end its antithetical relationship
with Inventory Management, and forge a new one based on cooperation. This will
require Treasury to be explicit in its expectations, and Inventory Management
to facilitate intelligent external direction. Both Treasury and Inventory Management
will need to invest in people and systems, and establish new mechanisms of effective
communication. The end result will be a tight but flexible liquid asset management
process, which will best serve corporate interests generally and the specific
needs of all related departments.