Lesson 2: Inventory, asset or liability?

Brightline’s assembly division had been told to cut finished goods. Its manager, Grace, did it: in one year she halved the stock without missing a single customer delivery.

Helen opens the division’s annual results and stares at the bottom line.

A liability in reality

Over the last few decades, managers learned that inventory is not the harmless thing it looks like on a shelf. It:

jeopardises quality, because defects hide in piles of parts;
masks process problems;
limits the ability to respond to changing market requirements;
leads to unreliable due-date performance;
increases lead time.

In short, inventory drastically reduces the company’s ability to compete. It is a liability.

An asset on paper

Yet the financial statements treat it as an asset:

On the balance sheet, inventory sits among the assets.
On the profit and loss statement, the change in inventory is part of calculating the cost of goods sold. If inventory goes up, cost of goods sold goes down, and profit goes up. If inventory goes down, profit goes down.

The conflict this creates

Treating a liability as an asset puts operations in a conflict:

Grace’s results

Here are the division’s numbers. Sales were stable throughout the year; the reduction came from streamlining operations to match sales.

Finished goods at the start of the year: $30 million.
Added value in those finished goods (labour and overhead absorbed into them): 50%.
Net profit in a normal year: $3 million.
Finished goods reduced by half, without hurting customer service.

Grace did exactly the right thing. Will corporate, judging by the financial statements, be pleased?

Yes: she met the target and service didn’t suffer
No

The inventory fell by $15 million. Half of that, $7.5 million, was absorbed cost: added value from previous periods. When those goods are sold without being replaced, that $7.5 million flows into this year’s cost of goods sold. The division swings from a $3 million profit to a $4.5 million loss. Corporate is anything but pleased, and Grace has learned the “appropriate rate” of inventory reduction for next time: slowly.

This is why efforts to reduce inventory move so slowly in so many companies, even when everyone agrees they should. The judgment of the company as a whole punishes the very behaviour the company needs.

Artificial profits work the other way too

The same mechanism rewards building stock. Produce more than you sell, and the extra units absorb overhead; reported profit rises while cash falls. That is how a CEO who keeps the plants producing for stock can be rewarded at year end. (The Throughput Accounting courses work through this effect with numbers in Profits in the warehouse.)

Check your understanding

Answer all five. Get four right to complete the lesson.

1. Why is inventory a liability in reality?

It costs rent
It is taxed
It weakens competitiveness: quality, lead time, due dates, flexibility
It is hard to count accurately, so the reported value is always uncertain

Each effect weakens the company’s offer.

2. On the P&L, an increase in inventory…

Lowers cost of goods sold and raises reported profit
Lowers reported profit, since more money is tied up
Has no effect
Raises taxes only

Overhead is absorbed into the stock.

3. Grace’s division reduced finished goods by $15M with 50% added value. Its reported profit…

Rose by $7.5M
Stayed at $3M
Fell to zero
Fell to a $4.5M loss

$3M − $7.5M = −$4.5M.

4. The conflict operations faces is…

Hire or fire
Reduce inventory to compete, or don’t reduce it to protect reported profit
Make or buy
Raise or cut prices to move the stock that has built up

Created by treating a liability as an asset.

5. Why do inventory reduction programmes often move slowly?

People are lazy
Suppliers resist
The financial statements punish the reduction with an apparent loss
Software can’t handle the new rules for ordering and stock

People learn the “appropriate rate”.