© 2000 John Petroff

No rated * * * * *

Resize -A   +A

H- Analysis of Inventories

Inventory is held in order to have goods available for sale or raw materials for production. Holding inventory is especially important if sales or production are not stable, continuous and predictable. In well planned and standardized production (such as a Toyota assembly plant), inventory can be reduced to nil with just-in-time deliveries of supplies. Inventory is non-existent in utilities, transportation and services. It is only important in manufacturing, wholesale and retail. Especially in retail companies, it can represent two thirds of the assets of the company (e.g. automobile and motorcycle dealers, jewelers, as well as clothing, shoe and sporting goods stores). In manufacturing, inventory management must deal with scheduling production (especially if only large batches must be produced), as well as holding inventory for sale. But raw materials inventory usually represents a small amount of funds, and work-in-progress inventory is dictated by the need for finished goods. Thus the most important role of inventory is to make immediate sales possible even if the timing of demand is not known.

The optimum level of inventory is determined by minimizing the combined cost of holding inventory and being out of stock. The cost of holding inventory is known as the carrying cost, and consists of warehousing, insurance, funds required, spoilage and obsolescence. The cost of being out of stock divides into reordering cost and cost of lost sales. Ignoring lost sales first, inventory control theory offers a precise derivation of economic order quantity (EOQ) by minimizing total cost TC

TC = Annual ordering cost + Annual carrying cost

TC = (# of orders x cost per order) + (average inventory x unit carrying cost)

TC = ((D/Q) x S) + ((Q/2) x C)

where D = number of units sold, consumed or depleted per year
S = cost per order
C = unit carrying cost
Q = quantity ordered each time
D/Q = number of orders per year
Q/2 = average inventory (i.e. maximum inventory = Q, minimum = 0)

The economic order quantity is obtained by taking the first derivative of TC with respect to Q, and is equal to

EOQ = Square Root ((2 S x D) / C)

Example: A hardware distributor sells 20,000 Makita hand drills per year. The cost of having one drill in inventory for a year is estimated at $5. The cost of ordering and receiving each shipment is $500. The economic order quantity is EOQ = Square Root ((2 x 500 x 20,000)/ 5) EOQ = Square Root (4,000,4000) EOQ = 2,000 drills Observe that there will be 10 orders per year (i.e. 20,000 /2,000). The average inventory is 1,000 (i.e. 2,000/2). Annual inventory carrying cost is $5,000 (1,000x$5) and carrying cost is $5,000 (100x$500). Orders must be place at a reordering point before the inventory is completely depleted, with sufficient time for the ordered quantity to be shipped and delivered by the supplier (i.e. the time it takes to receive the order is called lead time).

Returning to lost sales due to stock outs, to avoid them a company must maintain a safety stock so that it is never completely out of merchandise. This implies ordering ahead of the reordering point. For seasonal sales (as most products have some seasonal pattern), in addition to safety stock it is advisable to adjust EOQ upwards for both anticipated higher demand and longer lead time at season peaks.

Such inventory planning is strictly a managerial task, not even delegated to accountants, but the task is eased by software that computes automatically EOQ and safety stocks for retail store buyers, purchasing agents and production managers. An outside analyst would not have the information needed to judge whether and adequate control of inventory exists in a company. Inefficiency can, however, be detected indirectly by studying the volume and composition of inventory on hand (e.g. with inventory turnover ratios), and observing the impact of inventory management on effectiveness of marketing strategy implementation.

See review questions Q-8H.1 through Q-8H.12.

1)- Inventory turnover

Liquidity of inventory is best assessed with the inventory turnover ratio:

Inventory Turnover = Cost of Goods Sold / Inventory

Let us verify the 1999 value of 4.48 for inventory turnover of Timken shown in Timken_Ratios . Cost of goods sold of $ 2,002.4 millions is taken from Timken Income Statement and inventory of $ 446.6 millions is taken from Timken Balance Sheet for 1999. Timken's inventory turnover is indeed Inventory Turnover = 2,002.4 / 446.6 = 4.48 From Timken_Ratios we observe that inventory turnover was slightly higher the previous year at 4.59. This suggests that Timken's inventory is getting larger for the size of its sales. To reach a more accurate conclusion we compare Timken's inventory turnover to that of the Industry. Steel furnace companies (SIC #3312) is shown to have a 6.2 inventory turnover in 1999 in RMA decreasing from 7.1 two years prior. For automobile parts (SIC #3714) inventory turnover is also exactly 6.2 in 1999, but rising from 5.8 two years prior. For both industries, the lower quartile of inventory turnover is below 4. These numbers indicate that Timken's inventory is clearly larger than most of similar firms, but size is not dramatically out of line.

The denominator is usually the average between ending and beginning inventory, but more understanding is gained if an average of monthly inventory throughout the year is used. One recalls that the inventory at the beginning and end of the year are the lowest because firms chose a fiscal year so that their books are closed during a quiet period when the inventory is at its lowest point. Thus, there is a distortion which is built into the ratio from not using peak inventory. But, when comparing companies in the same industry, the distortion is likely to be of comparable magnitude for all firms, and should not present a serious limitation.

The amount recorded as inventory is significantly affected by the choice of
- standard cost versus full-absorption cost method,
- whether revaluation of inventory for lower of either cost or market was performed, and
- inventory accounting used: LIFO, FIFO or average.
The firms that use standard costs for their inventory allocate a portion of overhead to each item produced. These standard costs also do not change from year to year, whereas in the full-absorption cost method, only direct costs are assigned to produced items, and consequently, unit costs change from year to year. The revaluation of inventory at market price can be based on replacement cost or on salvage value less cost of disposal. A note to financial statements should indicate which method is used. But an outside analyst would have an impossible time trying to modify inventory amounts if the inventory method used by a given firm is known to be different from the method used by other firms in the industry.

The impact of using either LIFO, FIFO or average costs should be familiar to the reader as it is described in most introductory accounting manuals. LIFO increases cost of goods sold and reduces inventory amounts on the balance sheet in periods of inflation. Thus, the turnover ratio can be significantly inflated. When comparing inventory turnover, one must keep in mind that a switch from FIFO to LIFO will automatically increase the ratio, and therefore, when comparing over time, a recalculation may be desirable (if such recalculation is feasible at all).

For manufacturing companies, inventory turnover should be calculated for components (i.e. raw materials, work in progress and finished goods) of inventory rather than for the inventory as a whole. For each of the three types of inventory, the turnover ratio is

- raw materials turnover:

raw materials used in production / average inventory of raw materials

- work in progress turnover:

annual volume of finished goods / average work in progress inventory

- finished goods turnover:

cost of goods sold / average finished goods inventory

It would certainly be desirable to know which portion of inventory is slow moving. Comparing with companies in the industry may be difficult because, while the breakdown of inventory into its elements is common, data on volume of production is managerial information that even corporate accountants may not have.

See review questions Q-8H1.1 through Q-8H1.8.

2)- Additional modification of inventory turnover

Inventory beyond the need for the current operating period should be classified as non-current and included in the fixed asset portion of the balance sheet. The determination of what constitutes the portion of inventory needed for the current operating period is essentially a management decision. Nevertheless, analysts within the firm and even outside analysts can gage the presence of idle inventory stocks on the basis of sales volume over several years. Such break out can be helpful in industries such as metals, construction, precious stones, where turnover can be grossly understated if inventory reserve stocks are considered as current inventory.
Another adjustment that is normally performed after inventory taking at the end of year, is recording losses due to spoilage, obsolescence or theft (also known as shrinkage and/or shortage). When auditors indicate in their opinion that they were unable to attend inventory taking, there is a possibility that inventory is overstated because unsealable inventory may not be written off if the firm wants to improve its profits.

Certain industries have their own methods of inventory accounting. In particular, in American retail stores, inventory is maintained at retail selling price (i.e. not the cost or market as for other industries). At inventory taking, the end-of-year inventory is arrived by dividing inventory at retail by the average mark-up (i.e. profit margin). Comparing that amount to purchases plus beginning inventory, minus sales net of mark up gives the amount of shortage due to theft for the year.

See review questions Q-8H2.1 through Q-8H2.5.

3)- Days sales in inventory

Days sales in inventory (also known as "days to sell inventory") is calculated as

DSI = (Average inventory) / (Cost of Goods Sold/365)

or = 365 / (Inventory Turnover)

See Note N-8G2.1

As an example of calculation, let us verify the value of 81 days, given for 1999 days sales in inventory (DSI) in Timken_Ratios . For the first method of calculation we need the balance of inventory of $ 446.6 millions from Timken Balance Sheet for 1999, and daily sales obtained by dividing 1999 cost of goods sold of $ 2,002.4 millions taken from Timken Income Statement into 365, which gives $ 5.486 millions per day. Days sales in inventory is DSI = 446.6 / 5.486 = 81.40 or 81 days For the second method we just have to divide 365 by the accounts receivable turnover previously calculated as 4.48. Days sales outstanding is then DSI = 365 / 4.48 = 81.47 or 81 days. Timken's DSI was slightly lower the previous year at 79. Looking at Timken's comparable firms we find that their DSI was 59 for steel mills (SIC #3312), as well as 59 for motor vehicle parts (SIC# 3714). This confirms that Timken is carrying a larger inventory than most firms in its industry.

One recalls that combined with the average collection period, it gives the cash or operating cycle of the firm. An aging schedule of inventory, a statement similar to accounts receivables aging schedule, would reveal obsolescence of merchandise on hand and be far more informative, but it is usually not obtainable by outsiders.

See review questions Q-8H3.1 through Q-8H3.2.

4)- Assessment of inventory strategy

The ratio of inventory to total assets indicates a firm's inventory strategy and must be studied in conjunction with the A/R to total assets ratio since increases in sales can be achieved by an increase in either or both. Table T-8.9 presents days sales in inventory and proportion of inventory in total assets of groups of US firms arranged by size in three industries previously studied.

Table T-8.9 shows that smaller firms in the wholesale furniture industry are using inventory much more than larger firms. This seems to be the reverse for the pharmaceutical and machine manufacturers, where larger firms have larger inventory compared to total assets. The strategy for the latter is somewhat unclear. On the contrary, for the furniture wholesalers, it is obvious. Combining the information from this table with Table T-8.8 reveals that large furniture wholesalers rely on credit to promote sales, while small ones rely on inventory.

This means that firms have worked out their competitive advantages. A firm of a given type would be well advised to use a similar strategy (unless it is capable of developing its own niche or competitive advantage). Thus, firms should not just be compared to all others in the industry, but to firms of the same size and type. An analysis of inventory must be conducted in conjunction with a sales analysis which is outlined in Section A of next chapter.

5)- Comparison of use of inventory over time

Table T-8.7 shows the proportion of inventory in total assets for selected years over the past 40 years for corporations in the United States. The data reveals a very significant decrease in size of inventories held by American firms, from close to half the size of A/R (i.e. 0.20 vs. 0.08 in Table T-8.7) to one fifth of A/R (i.e 0.20 vs. 0.04 in Table T-8.7). Many reasons can be offered to explain why this should happen: larger proportion of service companies (which need not carry inventory); purchasing and production scheduling more responsive to sales requirements, better inventory management and more stable economy. For the sectors where inventory is essential, i.e. retail, wholesale and manufacturing, inventory is far from being a negligible investment. Table T-8.4 shows indeed that DSI is larger than DSO for these sectors, which shows that relatively speaking inventories represent a greater investment than accounts receivable. In the manufacturing sector, inventory was reported in Census of Manufacturers and Annual Survey to represent 14.2% of shipments in 1963, 15.7% in 1982, but only 12.5% in 1992, and 11.5% in 1996 (from Annual Survey of Manufactures). This Census data confirms the trend gleaned from IRS data in Table T-8.7, but also that the change is not just attributable to economic sector restructuring but to a fundamental shift in managerial strategy.

See review question Q-8H5.1.

6)- Interpretation of turnover ratios meaning

For both accounts receivable and inventory analysis, it is often necessary to push the analysis beyond the stage of analysis presented so far. A ratio that is high and a ratio that is low can be either better or worse than one in the middle. An adequate interpretation of turnover ratios requires further analysis because a high ratio may indicate either efficient management:
- low cost of inventory
- just in time purchasing and production
- inventory maintained fresh, up-to-date and in demand
or gross mismanagement and other problems:
- delays in shipping and excessive shipping costs
- overtrading
- sales lost because of inadequate assortment on hand
- sales vulnerability (i.e. seasonal or cyclical demand not met)
- inability of the firm to maintain purchasing and/or production in line with
growing demand

Likewise a low turnover may indicate either efficient management
- no sales are lost
- preparedness for expanding sales
- avoidance of raw materials shortages
- potential appreciation of value of precious items on hand
- low risk for lenders
or gross mismanagement
- inefficiency in working capital management (e.g. excessive cost)
- presence of unsealable goods
- ineffective marketing strategy
- poorly performing sales force
- unforeseen decreasing demand

--

The only way of really finding out if inventory is too large is to look at the merchandise in the warehouse, and see if it is old. And the only way of knowing if inventory is too small is to ask sales people if they lost sales because of stock outs. See comments on stock outs in Section A of next chapter.

See review questions Q-8H6.1 through Q-8H6.3.

See research assignments R-8H.1 through R-8H.6.

Previous: Receivables

Last modified: Jun/01/01

Next: Payables