An inventory buildup may mean realization problems. The buildup may be at the plant, wholesaler, or retailer. A sign of a buildup is when inventory increases at a much faster rate than the increase in sales. What ar eimportant concerns when analyzing inventories? What to watch for? This post tries to provide the answer, with easy to follow case examples.
What to watch for is a decline in raw materials coupled with a rise in work-in-process and finished goods pointing to a future production slowdown. If the company is holding excess inventory, there is an opportunity cost of tying up money in inventory. Furthermore, there is a high carrying cost for storing merchandise.
Why aren’t certain types of merchandise selling well? Calculate “turnover rates” for each inventory category and by department. Possible reasons for a low turnover rate are overstocking, obsolescence, product line deficiencies, or poor marketing efforts. There are cases where a low inventory rate is appropriate. Examples: A higher inventory level may arise because of expected future increases in price or when a new product has been introduced for which the advertising efforts have not been felt yet.
NOTE: The turnover rate may be unrepresentatively high when the business uses a ‘‘natural year-end’’ because at that time the inventory balance will be exceptionally low.
What to do?: Compute the number of days inventory is held and compare it to the industry norm and previous years:
Inventory turnover = Cost of goods sold/Average inventory
Age of inventory = 365/Turnover
Also look at the trend in inventory to sales. A high turnover rate may point to inadequate inventory, possibly leading to a loss in business.
Balance Sheet Analysis
When analyzing an inventory on a balance sheet, what to watch for? the answer is: merchandise that is susceptible to price variability, fad, specialized, perishable, technological, and luxurious goods. On the contrary, low realization risk is with standardized, staple, and necessity items.
NOTE: Raw material inventory is safer than finished goods or work-in-process since raw material has more universal and varied uses.
Questions to be asked:
- Is inventory collateralized against a loan? If so, creditors can retain it in the event of nonpayment of the obligation.
- Is there adequate insurance? There is a particular problem when insurance cannot be obtained for the item because of high risk (e.g., geographic location of inventory is in a high-crime area or there is susceptibility to floods).
- Is it subject to political risk (e.g., big cars and an oil crisis)?
Look for inventory that is overstated owing to mistakes in quantities, costing, pricing, and valuation.
Warning: The more technical a product and the more dependent the valuation on internally developed cost records, the more susceptible are cost estimates to error. In gauging manufacturing efficiency, you should look at the relationship between indirect labor and direct labor since a constant level of both are needed to efficiently run the organization.
EXAMPLE: A company presents this makeup of inventory:
Raw materials $89,000 $ 78,000
Work-in-process 67,000 $120,000
Finished goods 16,000 31,000
The Controller’s analysis of inventory shows there was a material divergence in the inventory components between 20X8 and 20X9. There was a reduction in raw material by 12.4 percent ($11,000/ $89,000), while work-in-process rose by 79.1 percent ($53,000/$67,000) and finished goods rose by 93.8 percent ($15,000/$16,000).
The lack of consistency in the trend between raw materials relative to work-in-process and finished goods may imply a forthcoming cutback in production. An obsolescence problem may also exist applicable to work-in-process and finished goods due to the sizable buildup. The company’s operating cycle—which equals the average collection period plus the average age of inventory—should be determined. A short operating cycle is desired so that cash flow is expedited.