Managing cash flow in a manufacturing business is complex. There are an amazing number of interconnected processes and decisions that impact revenues, profitability, and whether you have the cash you’ll need to survive and thrive (in good times and in bad times).
One of the larger drivers of that complexity in a manufacturing business is inventory.
I look at inventory as a necessary evil. Necessary in that you need inventory on hand to manufacture your product and sell it to customers. Evil in that it’s a huge cost driver… and holding inventory can be a big drain on your cash flow.
As a result, I’m a big believer in minimizing the amount of cash (or debt) tied up in inventory.
A Tip for CFOs
If you are the CFO of a manufacturing business, and you want to begin reducing inventory, you will be tempted to get right to the heart of the matter. The message to managers might be, “We need to free up some of the cash tied up in inventory… and this is how we need to do it.”
But don’t do that… yet.
Don’t start talking about the benefits of reducing inventory until you first demonstrate to management that you understand and support their fears about what might happen if inventory goes down too low.
Lost Sales is a True Risk
A manager’s number one fear when reducing inventory is lost sales. A lost sale is the sale you didn’t make because your finished product was not available when your customer wanted to buy. You never see a lost sale in your income statement. You can’t see what’s not there! It’s an invisible enemy (at least in your financial statements).
Managers are right to be worried about missing a sale.
When they voice that concern to you, acknowledge it. Show them you understand their concern. Talk about ways you can help them better evaluate and minimize lost sales. Provide the information and reporting they need to ensure they have the right product, at the right time, in the right place. That will open the door to your discussions about the benefits of reducing inventory levels.
The Benefits of Reducing Inventory
The primary objective/goal in reducing inventory is to reduce cost of goods sold (in addition to freeing up cash). Inventory affects your cost of goods sold in a number of different ways.
Here’s a small list of examples.
- Cost of the material itself
- Inventory spoilage, obsolescence, etc.
- Whether you buy in small or large quantities affects the cost of the material (and your inventory levels)
- The cost of the space donated to holding the inventory
- The cost of moving the inventory to where it is needed in the manufacturing process
- Interest expense if you use a line of credit to finance inventory
Buying in large quantities can reduce per unit costs… and drive inventory levels up. But maintain higher than necessary inventory levels and you end up eating a lot of that inventory in the form of spoilage, obsolescence, etc.
In many manufacturing businesses, reducing cost of goods sold by even two points (and therefore increasing your gross profit margin by two points), can be the difference between making money and losing money.
Reducing inventory in a manufacturing business isn’t easy. You have to deal with the uncertainties inherent in demand forecasts, lead times, scheduling and a host of other complicating factors.
But it is becoming more and more important to proactively manage (and reduce) inventory as you deal with economic uncertainty and the ever-increasing demands of prospects and customers.
Reduce Inventory… Wisely
In order to free up cash that is tied up in inventory, first let your managers know that you understand the risks associated with lost sales. Then talk about the benefits of lowering cost of goods sold by reining in inventory levels.
Then the last step is to demonstrate for managers in very clear terms how the cash freed up by reducing inventory levels can be used to increase sales and grow the company.
That approach will help you minimize inventory the right way.