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Inventory is not cash.

Article Excerpt
EXECUTIVE SUMMARY

Inventor, value and cash flow are inexorably tied in a relationship that is complex and difficult to understand. Mary people assume these values are equal, but the, are not. While reducing inventor, value will not lead to a corresponding improvement in cash flow, the cash flow improvement opportunity is tied to the approach used to reduce inventory and not the reduction itself.

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Inventory and cash flow. As managers and engineers making improvements to our facilities, as consultants creating plans and value propositions for our clients, and as academics helping to define and explain the nature of this relationship, we have struggled with the relationship between inventory and cash flow.

We may not even be aware of the struggle: There are some assumptions regarding the relationship between inventory and cash flow that are so strong that we rarely, if ever, question them.

We assume, for instance, that values on the balance sheet are cash based or that the process used to assign labor values to work-in-process and finished goods inventories yields correct cash flow-based numbers. However, these and similar assumptions that we make about the relationship between cash flow and inventory are not only invalid, they ultimately lead to yet another equally but more dangerously invalid assumption--that the balance sheet value of inventory represents the same value in tied up cash, and freeing this cash results in an equal amount of money in the bank.

This assumption is often used as the basis for value propositions for projects ranging from product rationalization to lean implementations. The misleading promise of gaining $1 million in cash just by reducing a $10 million inventory by 10 percent results in a fertile field of opportunity for engineers, consultants, and academics looking to make a name or a buck.

It would be easy for a company to consider spending $100,000 in consulting fees if such a project were assumed to bring a 10:l return on investment. Investing in such an inventory reduction may not he the amazing business tactic it appears to be. The fundamental reason, explored and explained in this article, is that most of the costs that go into the $10 million will still exist even with a reduction of inventory levels. Labor costs, which are added to the financial value of the inventory, may not be reduced at the same rate (or at all). Therefore, labor costs are the same or slightly lower. Additionally, if the rate of demand is the same, ultimately, the same cost in materials is required to meet the demand.

The direct benefit of inventory reduction is freeing the amount of cash tied up in materials between the initial inventory level and its reduced level. That is the only pure cash flow opportunity that results from lowering the inventory levels. All others must be achieved through tactical or strategic actions, and the ultimate impact on cash flow is likely to be much less than anticipated when using the values on the balance sheet.

The situation

There is much evidence that would cause one to believe that inventory is, in fact, equal to cash. First, inventory is represented on the balance sheet in all of its forms--raw materials, work-in-process, and finished goods--as a dollar amount, indistinguishable from cash or any other asset or liability Second, inventory is considered working capital along with accounts receivables and accounts payables. Third, the cost of goods sold, which represents the cost of the items that are sold and is used to determine gross income, is often calculated directly from the value of the same item in finished goods...

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