Inventory Costs (part II on Cost Accounting)

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Inventory is evil.

Louis Schultz

Another problem with cost accounting is that it treats inventory as an asset. From an operational point of view, inventory is a liability, not an asset. Inventory is evil! But, sometimes it can be a necessary evil. Any amount of inventory more than what you need to keep production flowing to meet demand, freezes money.

 Money frozen is money you can’t use, is money you don’t have; money that is losing value; money that could be making you more money.

Cost accounting leads companies, and their banks, to think it a good idea to arrange financing based on inventory for instance. What security is there in frozen money, evaporating value every minute.

With cost accounting there is no simple way to add up the losses because it treats the losses as if they don’t exist; it’s an asset, remember? And by the time the difference between the expected inventory and the calculated value from the new physical inventory takes place, it is too late in the game to find out what happened, what really caused it and why. So we blame the people.

How many dollars are tied up in inventory in products that don’t sell? How many hours of work that went into processing them? How many “specials” will need to be done to try and move product people don’t want? How many products will break, lose flavor or rust, or disappear over time? How many potential customers lost because they associate your company with the less than optimal product they bought on deep “inventory reduction” discount. How many customers come back asking for the same discounts on the rest of your products, erodig your margins? How much of your time cost is spent working to make products that lose money by sitting in inventory? How many resources wasted maintaining and counting it.

Lost in the Dark

Hiding losses is not a way to survive, but a way to lose your business. The more efficient and timely conversion of raw materials to sales, the less time your money is tied up, the more turns your dollars can make and the more profit you can make. I call this the repeater effect.

What is needed is an accounting system that provides information for those who create, build and deliver the product or service you sell, that is useful, actionable, clear, simple and accurately models what is happening in the business in the moment, so they stand a chance to find the cause if something unexpected or unwanted happens. The products they make or provide are the only thing that generates income for your company. The people that sit in the accounting offices are important, but generate no income: they count it..

Some interesting inventory questions from my network

Q- “When you discuss inventory, and see it as a liability, are you just talking about finished goods and/or work in progress and/or procured items (material stock)?”
A- All three. Inventory diverts the flow of value into stagnant pools so your money so it isn’t working for you. Any kind of inventory, even necessary inventory.

Q -In the tooling industry (especially aerospace), for example, they often manufacture for ‘inventory’ as a specific strategy to optimize plant and labour utilization, minimizing the peaks and valleys of the industry product-cycle. This minimizes the need for overtime, casual labour and outsourcing. So they keep manufacturing going, bringing orders forward for ‘stock’ to streamline operations and also to maximize the time and cost incurred in machine set-up. In these instances, isn’t the ‘inventory’ an asset, as it has been ordered – just later down the line?
A- Well, I have never worked in the aerospace industry, but I am familiar with inventory buffers. some inventory may be a necessary evil, but it is still a liability, not an asset. Seen as a liability, you will be sure to manage it more closely than thinking it is money in the bank.

Q- One person wrote asking, “there can be good reasons to keep raw material stock as inventory, with ‘bulk’ discounts, exchange rates, and logistics (time-lines).
A- I have  seen examples that held water, and examples that did not, when given careful analysis. Mostly examples that did not. A bargain is tangible, and therefore seductive, but did it make money overall? Show me when it entered the bank account, not when you see the supposed savings on your spreadsheet..

I have made money by paying more. Allowing suppliers a bit more profit made sure I rarely ran out of a hot selling product, even if they had to go to the warehouse on a Sunday to get it for me.

Q- Another reader commented: “Reminds me of my first business... Industrial Safety Distribution– part of my success was attributable to stellar service involving the willingness to stock inventory needed for toxic spills or refinery fires. Spills & fires are accidental, unplanned, and unwanted – that I could deliver what was needed when it was most needed led to some exclusive, and hefty contract agreements. Although the money in inventory might sit for months, the higher markup and delivery profits compensated for the “dead weight inventory”.“
A: Bless you for charging extra to assume their risk.

Q- She went on, alas, “Purely coincidental or intuitive - Sitting on specific stock also worked to my advantage when there was a global shortage of latex (gloves & monkey suits) due to a sudden upturn in the manufacture of disposable diapers.”
A: My question, in another business, would keeping inventory to avoid rare, chance and unforeseeable circumstances have paid off in the long run? Would this event make up for the missing, stolen or damaged, the cost of funds to buy it, and the slowing of dollars turned back into the system? And what if it never happens?

The point is, how you see things can help you ask questions that can help you make better decisions. Does cost accounting help you ask the right questions? If your goal is to hold large amounts of your precious dollars where you can’t touch them to watch them lose value, fine, it’s an asset.

Next Column: Capital Expense.

About the Author

Dan Strongin works with medium to small companies, helping them master the art and science of managing.

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