Inventory: Taming the Bad Liquid Asset
gtnews recently released a survey on the current state of corporate liquid asset management, ‘Operational Cash 2004 – Insights into Working Capital’. It contains a broad set of findings on treasury operations today.
As a management scientist specializing in liquid asset technologies, I was particularly interested in the ‘Performance’ section of this study. Here, treasury professionals rated the their own companies’ managerial proficiency inside the three primary segments of the Liquid Asset Cycle: Purchase-to-pay, Inventory cycle, and Customer-to-cash. By far, the greatest dissatisfaction was vented over inventory. The portion of respondents characterizing their own inventory performance as poor-to-average was a considerably hefty 64.5 per cent.
I work on the seam between inventory management and treasury, having come to it from the inventory side. My reaction to treasury’s inventory dissatisfaction was surprise – surprise that it is not yet unanimous. Consider this:
Without either metrics or alternatives, treasury’s only inventory control tool is distinctly low-tech – the ‘budget sledgehammer’. Worldwide, inventory’s immaturity as a liquid asset is a multi-trillion dollar problem. In this article, I will address how the corporation arrived at this unacceptable juncture then outline the steps that treasury can take to bring sound investment discipline to inventory.
The modern era of inventory management began in 1913 with the publication of a paper by a Westinghouse engineer, Ford W. Harris, on inventory Optimization. His model is called Economic Order Quantity, or EOQ. It determines how much to make when a production line is set-up. Over the succeeding decades, dozens of new and more elaborate inventory optimization techniques were invented. Suddenly the music stopped. In the early 1980s, Japanese corporations began ‘hollowing out’ industry after industry in the United States and Europe. From analyses of their successes, one factor was obvious – Japan employed far less inventory in proportion to sales than was considered ‘optimal’.
Minimization subsequently superseded optimization as the guiding philosophy of inventory management. Under various names – Kanban, Just-in-Time, and more recently Supply-Chain – the new optimum in inventory management became zero. Minimization dogma says that inventory is the corporate equivalent of ‘fat’ and should therefore be eliminated. Treasury, for its part, was more than happy to endorse this fashionably anorexic philosophy. After all, through the magic of the liquid asset cycle, reductions in inventory wonderfully reappear as cash in treasury’s coffer. Minimization’s siren song was that ‘a corporation can never be too rich or too lean’. This flow of ‘free money’ is likely behind much of the surveyed minority’s sense of self-satisfaction with the status of their inventory control. Ahead, however, we shall see that this money is not at all free. Rather, it can be extremely and increasingly expensive as minimization is pursued.
A second explanation for the minority’s inventory-contentment is almost certainly the misuse of ‘naïve’ ratios. A ratio is said to be naïve when it is completely divorced from true corporate objectives and performance. Most common are ‘inventory-to-sales’ and its reciprocal ‘turns’. These two can provide a comforting but false sense of accomplishment as their numbers ‘improve’. The inherent canard of both is the assumption that less inventory is always better than more. This simply is not true. Anyone who experienced the barren shelves of Moscow’s Soviet-era department stores, or is told by a barista that there are no more coffee-lids, will attest to the obvious fact that inventory shortages are a major source of customer dissatisfaction, lost sales, and lost profit. This truth is finally being voiced publicly by companies as diverse as John Deere and Home Depot.
Just like optimization of old, minimization provides no alternatives, ROIs, maturities, or risks. Treasury’s mounting frustration with inventory and its whole jargon-world is therefore understandable. No other class of corporate asset, especially one as large as inventory, operates without basic investment metrics. Fortunately, I can report that change is in the wind.
The two major failed philosophical opposites – minimization and optimization – happen to nail down the extreme ends of a broad ‘Feasibility Range’ for inventory. By slicing the middle-ground between them into a series of progressive investment options, we can actually calculate the expected returns, maturities, and risks for each incremental step of inventory investment. Some potential placements have extraordinarily high returns. Others are lousy. Most are somewhere in between.
To sort these out, alternatives must initially be created down at the individual item-level. Numbers needed to do this are normally already available in ERP’s item-master table. Once born, the little options then flow through a fairly straight-forward aggregation process that involves prioritization, summarization, presentation, and ultimately top-level ‘point-and-click’ investment authorization – just like normal liquid assets on a Bloomberg terminal.
After the ‘click’, the top-level authorization is automatically disaggregated into all of the item-level controls necessary for its implementation, which are loaded into the appropriate item-master fields in ERP. The process does not stop here, however. Actual returns are measured. This too initiates at the detail level as each micro-investment closes out. Consolidated variances are used for continuous process improvement and to quantify inventory investment risk.
A new set of techniques is emerging to create and manage the lists of inventory investment options. Collectively, they take their ‘Third Way’ name from the group of British politicians who positioned themselves philosophically between conservatives and liberals. To illustrate how Third Way inventory management works, I will use the total cost curve optimized by Ford W. Harris with his EOQ methodology nearly a century ago. The same can be done with any existing inventory control technique, a process called ‘activation’. Incidentally, this term is also applied to a specific inventory when Third Way tools bring out its investment alternatives
EOQ’s classic total cost curve is a combination of two opposing cost-forces. One is the ‘set-up cost’, which pressures for longer runs and more inventory. The other is a ‘holding cost’, reflecting the fact that the more you run the longer the average item sits waiting for its consumption. The graphical sum is the leaning U-shaped curve in Figure 1. The lowest total cost, at the bottom of the curve, almost shouts “Optimization!”
At a relative minimum, the slope is zero. Notably, this curve’s slope happens to be ROI. (To be exact, it is marginal-ROI with a sign change and cost-of money extracted from holding-cost.) At EOQ, both the slope and the ROI are zero. Obviously, this is no place to operate if you are among those who consider zero-returns to be inadequate. It is typical of Optimization, however, and illustrates how that philosophy unintentionally came to authorize far too much inventory.
Clearly, no one should ever consider operating anywhere on the right-arm of the total cost curve either. Inventory ROIs are actually negative there, which is why it is dimmed out in the illustration.
This leaves us with the left-arm upon which to search for a new ideal operating plan. The top-point is the zero inventory scenario, i.e., true minimization. Here, each item is made-to-order and shipped as soon as it is produced. Depending on the microeconomics in play, the costs can be very high and the cost-slope so steep that initial ROIs are frequently over 1,000 per cent. Minimization dogma holds that you should never take advantage of these enormous returns. This is clearly and completely crazy. Moreover, when treasury orders the liquidation of these investments, the so-called ‘free money’ squeezed out can actually cost the corporation far more in lost profitability than if it had borrowed the sum from a gangland usurer.
Sometimes make-to-order is sensible, of course. These are typically either low-volume/high-craft or high-volume/dedicated-equipment business units. More often, at least some inventory is appropriate. How much? You may notice that no visually intuitive solution jumps out from the total cost curve’s left-arm once its extremes are eliminated.
Enter the feasibility range, the greatest thing sliced since bread. Here we see the alternatives, each with an operating cost and inventory investment. The way the ROIs are applied is to start at zero inventory, step to the right, calculate the cost reduction and divide it by the increment in inventory. You now have the return on your first inventory investment option. Step again and you have another. Continue to EOQ, stop, and toss your options – with their respective returns – into the ‘aggregation process’ described previously in this section.
At the detail level, the important difference of the Third Way is that inventory decisions are not made here. The two primary factors that determine an item’s best investment level are: a) the range of returns on all inventory alternatives throughout the company and b) the amount of cash available. With the Third Way, investing in inventory is just like managing your own portfolio.
To treasury professionals, the preceding paragraph is not exactly rocket science. Over in inventory management, however, the idea of a corporation’s inventory as an investment portfolio is truly foreign. The story I am about to relate is true. It is about a difference of opinion between divisional management and treasury over how much inventory to budget. The twist here is who wanted more.
The first time I assembled an Option List was over twenty years ago. I must admit, I was not thinking about inventory as a liquid asset at the time – or about treasury at all. After having discovered the relationship between inventory investments and their declining ROIs, and then figuring out how to dovetail the option lists of many different items together into a single master, an opportunity for in situ experimentation arose.
I collected data, created item-level lists, and assembled the ‘top-level option-list’ shown in Figure 2. Then I needed someone to look it over and pick an option, one that would then break back down into item-level inventory controls that we could use to run the factory. I went to divisional management. This turned out to be an interesting mistake.
My primitive option list had no maturity or risk calculations or any other modern functions yet, of course, which is fine because it makes the telling of this story easier. Divisional management, chronic complainers about treasury’s inventory parsimony, chose the option with a marginal ROI of 31 per cent (D). Their handy rule-of-thumb was to cut-off investment at 30 per cent, I was told. I accepted this choice uncritically. Lab space for experimental management science is exceptionally rare, so making waves is inadvisable. Also, I just needed any decision. What I had to know before going further with the development of this technology was whether inventory’s ROIs could in fact be reliably forecasted and measured at all. On that level, the experiment was a success.
Inventory experiments are slow, allowing time for reflection while they run. During this interlude, I realized that Divisional management’s 30 per cent rule was used to budget fixed asset investments, like a conveyor system that might yield some labor-savings. Inventory, however, is a liquid asset – at least, it should be – and the concept of liquidity premium states that higher liquidity justifies lower yield. Inventory was not really liquid any more, though. Optimization and minimization establish rigid targets that rob its intrinsic flexibility. Inventory had become a faux-fixed asset.
With an option list an inventory can flex, however, because the selected option can be changed from time-to-time depending on the company’s changing cash situation. Inventory thus becomes a true liquid asset again – not as liquid as cash, of course, which can fly around the world at the speed of light. Inventory is naturally viscous, but – when activated – it is far more fluid than buildings and equipment.
The people who know best how to manage a corporation’s liquid assets would be found in treasury, I figured. So I walked this little option list over – not knowing these strange people at all – and asked what they would have authorized. Interestingly, though none was what I would call an inventory aficionado, each understood the option list instantly, much faster than the divisional people. The kicker was that they would have taken the 15 per cent marginal-ROI option (T).
In other words, when inventory presents itself as a proper liquid asset, treasury professionals will tend to invest more than a divisional manager because they understand liquidity management. This is the exact opposite dynamic of the one that is in play in today’s dysfunctional inventory environment.
Any treasury finding itself in the dissatisfied majority can choose to be the agent for change within its home corporation. The following is the set of steps that I advise.
gtnews quantified the immense aggregate dissatisfaction rate that corporate treasuries have with the current management of inventory. The history, from optimization through minimization, that brought about this unacceptable and enormous problem is over ninety years old. Fortunately, a Third Way for managing inventory is emerging that will allow treasury departments to lead this entire class of liquid assets into a new era characterized by sound investment discipline. In the future, inventory placements will be based on returns, maturities, and risks – like other liquid assets. Inventory will no longer be a faux-fixed asset, either, but rather a truly flexible and responsive liquid asset. A corporation’s inventory is a portfolio of investments that can be managed dynamically. Some of the requisite technology is internally complex, but Third Way controls are deliberately similar to those for cash-based investments. Some inventories are in place for strategic reasons, others are purely financial. These controls need to be separated and integrated with existing corporate asset management processes. An ordinary cross-functional team, lead by treasury, can activate a corporation’s inventory if given the support and resources. Finally, as the Third Way propagates, I predict that the measurement of inventory dissatisfaction-rate will exhibit a wonderfully precipitous decline.
For more information on this topic please see the book “The Liquid Corporation”, written by George H Brown, President of EweLamb Technologies.