For many manufacturers, inventory may be the most significant current asset on the balance sheet; but is it really an asset at all? As anyone who has worked in the field can attest, the costs of maintaining inventory can often feel much more like a liability than an asset.
The accounting equation to calculate cost of goods sold (COGS) is beginning inventory, plus purchases, minus ending inventory. Thus, if you have a higher ending inventory than a beginning inventory, you have a lower COGS and a higher gross profit. The problem with this thinking is that the gross profit generated is only on paper and the inventory on the balance sheet costs actual hard cash. It is difficult to pay employees or vendors with paper profits.
Large manufacturers use “just in time” accounting to move the burden of carrying inventory from themselves to their smaller vendors, thereby increasing the turns of their inventory without any significant risk of stock shortage. Large manufacturers generally have more than one supplier for individual raw materials. For smaller manufacturers, this is often not practical because of limited supplier options and reliance on a smaller base of customers who require materials in stock at their suppliers or else they just move to the next name on their list. Due to the issues facing smaller manufacturers, keeping inventory at “just in time” levels may not be feasible; but there are still ways to reduce inventory on hand. Consider asking suppliers if they are willing to provide inventory on a consignment basis. You physically hold inventory, but will not own it, and therefore do not have to pay for it, until you use it. Perform a study to determine realistic minimums and maximums for raw material stock. Update overhead rates at least annually. Often, at smaller manufacturers, these rates remain unchanged for several years, but the costs that go into calculating these rates change frequently. Determine that the overhead driver that you are using to add overhead costs to inventory is still an accurate method of assigning those costs. Man hours may have been an appropriate driver in the past, but has a significant investment in new machinery caused machine hours to be a more accurate driver currently?
Other ways to reduce inventory include selling old obsolete inventory for scrap value. No one likes to admit they made a mistake, but pride should not get in the way of converting an asset into cash. To reduce excess inventory consider a reduction in price or other sales incentive, although this can be a perilous method to reduce inventory.
Reducing inventory may generate more available cash, but keep in mind that many bank loans are asset based with the two most common current assets borrowed against being accounts receivable and inventory. As inventory is reduced your borrowing capacity may be reduced, but hopefully the lower inventory will allow you to borrow less because you do not need to finance all that inventory.
Finally, from a tax perspective, if your business has less than $25 million in average annual gross receipts for the last three years, you may be able to eliminate all but your raw material inventory for tax purposes. This would help lower your taxable income.
Please reach out to The Bonadio Group if you would like to further discuss any of the ideas above or need to tap into our extensive expertise in the field of manufacturing.
Jon Herdlein is a principal based out of our Buffalo, NY office.