Investment Recovery: Partnering For Profits

Author(s):

Rene A. Yates, C.P.M.
Rene A. Yates, C.P.M., Materials Manager, B. A. Ballou & Company Inc., East Providence, RI 02914, 401/438-7000.

79th Annual International Conference Proceedings - 1994 - Atlanta, GA

INTRODUCTION
Without a doubt, the single largest opportunity for reduction of waste in an organization rests with efficient management of inventory. When considering the potential of this axiom, it is important to define that task in GENERAL terms. "Inventory" - dollars expended that are not adding value to a firm - extends well beyond the asset listed on an organization's balance sheet. There are many other pockets of inventory resting - perhaps hiding - in expense accounts throughout current and past financial statements. It has often been said that the mark of a true manager is the ability to perform in difficult times. Continuing to find opportunities to maximize profitability, through cost reductions -- or cost offsets - is a means toward that end.

Focus on inventory management is an effective way of flushing out many opportunities. For all of the reasons organizations choose to carry inventory, each one, in effect, adds waste to an organization. Invisibly, they allow us longer lead times, slower response, and longer cycle times. Like a drug, the "pain" of these inefficiencies to internal and external customers is dulled by levels of inventory. Many of these considerations are cost justified, or felt necessary to provide adequate levels of customer satisfaction. Care must be taken, however, to ensure that these reasons are not actually rationalizations which avoid the challenges of inventory minimization.

Looking at a simplified Income Statement, Profit from Operations is basically the difference between Sales and "Cost of Goods Sold" (COGS). This "Cost of Goods Sold" is fundamentally the sum of all expenses allocated to the conversion process to finished product. In addition to inventory which is categorized as an asset, then, quantities charged to COGS are, in effect, inventory for which no value has been received. When, along with raw material and component inventory, there is no foreseen use for these items, good business dictates that an organization try to recover as much of that investment as possible. This can occur by putting these idle investments to use, or by converting them to cash which can be reallocated to needed resources.

INVESTMENT RECOVERY
Investment recovery, in the past referred to as the "disposal of surplus, scrap, and waste", is one of the areas least recognized for increasing profitability. Since funds for acquiring of these products has already been expended, they are, in a sense, "free" to the organization when put back into service. Likewise, any sale of these items has a direct impact on profitability. One must remember that the inability to use something does not necessarily mean that it has lost its value.

The responsibility for disposing of surplus, scrap, or waste typically falls under the Purchasing function for a number of reasons. First, familiarity with product and its intended purpose may readily suggest alternate uses. Secondly, purchasing is most aware of current price trends for acquired goods. Thirdly, communication within the supplier base could promote the disposal process. Finally, without a specific department assigned with this responsibility, purchasing is most probably the best logical choice.

THE RECOVERY PROCESS
Assessing the potential of investment recovery can be a difficult process, since many items such as repair parts or supplies are expensed at the time of purchase and not necessarily carried on inventory records. Identification of surplus merchandise should begin with a tour of the facility, noting any large accumulations, items in inaccessible areas, or clutter of any kind. Material identified should then be sorted, segregated, classified, and valued. Sorting and segregating is important, since the difference between value obtained for clean versus mixed scrap, for example, will easily exceed a ratio of ten. Next, a secondary value should be determined. This can be a salvage value pegged to the time of sale, or a value related to an alternate use for the product. Naturally, close attention should be paid to timing where market conditions of supply or demand could significantly affect value received.

DISPOSAL METHODS
The maximum return from investment recovery will come from using the material "as is" in the same facility. This is because no additional expenses are incurred in putting the material to use. In many instances, this may initially meet with little success. Using ingenuity combined with cross functional teaming, however, may provide surprising results. Excesses may provide a new product of a higher or lower quality, which could be a profitable addition to the current product line. This is a common practice, for example, with precious stones in the jewelry industry. Pricing dictates the purchase of parcels which may vary slightly in size, color, and quality. Stones which cannot be used on current line items, are brought to designers who create new styles which will use this surplus inventory.

Ingenuity through the marketing organization can sometimes lead to successful new products. Ivory Soap is a testimonial to that fact. A batch of soap was inadvertently left mixing while the operator went to lunch. Rather than discard the batch, the product was sold to stores and became an instant success. People loved the soap that would float to the top of wash water and be easily found. Similar thinking very probably resulted in Munchkins, and pieces of candy bars which are now mixed with ice cream.

Should using the material "as is" within the same facility not be an option, perhaps the material might be used in another division . This would only add handling and transportation costs. Another option might be to rework or convert the material. This might only add nominal expense and still provide a good opportunity to recover costs and improve profitability.

When considering all elements of the disposal process, the single most important part of the procedure is to identify the reason for accumulation. As with any part of a management control process, reasons for variance must be identified and corrected. Without this, the recovery process becomes an increasingly constant problem to be dealt with. Just as the goal of Total Quality Management is to eliminate the inspection process, the ultimate goal of the disposal process should be the elimination of that function. As with any inventory, one should seek to address the reasons for accumulation in an effort to minimize future surpluses that must be dealt with. Just as any inventory, these excesses have covered problems and inefficiencies within the organization, and addressing them will lead to reductions in waste, inventory, and cost.

OUTSOURCING
When using the product within the firm is not an option, the disposal issue becomes one of outsourcing -- or perhaps its reciprocal -- which would amount to a "reversed marketing" situation. Although the term here is not used in the traditional context of convincing a source to make product for which there are no suppliers, the role of the purchaser is quite similar. Here, the task of purchasing becomes one of selling; where the goal of negotiations becomes maximizing price rather than minimizing the terms of sale! Traditional methods often lead to modest results: donating product to non profit or educational institutions for a tax deduction; sale to employees; or sales to a dealer or broker. Even suppliers are often resistant to purchase materials that were once sold. For obvious reasons, most of these methods provide minimal returns on the original investment.

TRADE CREDITS
Two effective methods that help regain a significant portion of an original investment -- and, hence, profit are bartering and exchange of material for credit.

The first instance involves trading the product for merchandise or services that can be used in the future. Although no cash is seen immediately as a result of the "sale", cash is conserved when future purchases are made. This provides a return to the company for the inventory that was transferred. Bartering companies typically offer a variety of products and services acting as a clearing house, matching needs of various companies with products available for trade. A particular advantage of these arrangements is that credit is often given for the full book value of inventory. This saves the need for write-offs and their negative effect on an income statement. The value of goods transferred is shown as a receivable on the organization's books which is satisfied by future purchases from the bartering company. The disadvantage of this type of arrangement is that the bartering firm must be able to provide products and services that are needed, at an acceptable price and quality. The risk, however, can be minimized by choosing trading companies which allow the products, quantities purchased, and price to be determined before the transfer of surplus material takes place. In this manner, risk and exposure is minimized since one knows in advance what will be purchased to recoup credits extended for excess inventory.

The following example will illustrate the situation:
Neil Industries has a surplus of commercial grade diamonds which are no longer useful for any applications within their facility. This excess inventory accounts for $100,000 at book value. The Purchasing Manager contacts Alpha Trading which specializes in the purchase of surplus inventories. Alpha agrees to allow Neil purchase credit for the full book value of the diamonds. These purchase credits can be used according to an agreed formula toward future purchases. Alpha, through their network, then finds a buyer for the diamonds, and instructs Neil as to where shipment should be made. Alpha never takes possession of the surplus inventory, and therefore does not have to provide storage facilities for it. Neil Industries can immediately begin sourcing products or services needed through Alpha Trading. Depending upon requirements, purchases could represent physical products such as raw material, hotel rooms, air travel, advertising, or even long distance telephone service. For each purchase, a portion of trade credits is deducted from the payment sent to Alpha. In this method the company receives value for the surplus inventory "sold."

The major disadvantage of this type of arrangement is that value is not immediately received for the merchandise, but only as trade credits are used. Value received, then, is a function of Neil's ability to buy product through the trading company. Naturally, the higher the volume, the more quickly the trade credit can be used up. It should also be understood that the trading company usually does not provide product directly, but acts as an agent -- in fact, an extension of Neil's purchasing department. Purchases may be arranged through some of Neil's traditional sources, or new sources. Other disadvantages include the fact that Neil is now dependent upon a single source for a number of future purchases. This source could use this leverage to advantage by increasing prices over time, or decreasing quality of product shipped. In addition, returns could be a greater problem than normal, since the supplier's customer is actually the trading company, and not Neil Industries.

There are two major benefits from this type of transaction. First, the company does not incur any book loss for disposing of surplus merchandise. Second, full book value is actually received for inventory that was inactive. Also, the trading company very probably has access to an extensive supplier base. This could add perspective on sourcing and pricing which otherwise they were not be aware.

Risk can be minimized in this type of transaction by thorough planning prior to contract formation. Many trading companies allow - and even encourage - purchase commitments tied to trade credit usage consecutively. In this way, the seller knows what items and time frame will satisfy the trade credit and value to be received for surplus inventory. Quality concerns can also be put to rest quite easily by choosing purchases of generic, standardized products or services such as air travel with a major carrier, hotel rooms with a major chain, or even long distance telephone service with a major carrier.

PARTNERING FOR PROFITS
A variation on this theme that also works quite well, is to offer the exchange of inventory for trade credits with current suppliers, or other suppliers who would be interested in acquiring new business.

The following variation on Neil Industries illustrates how the plan would work:
Neil Industries, in this case, would contact the supplier from whom the inventory was actually purchased, and ask that they consider purchasing the surplus inventory from Neil at the original price paid. Rather than cash, however, Neil would expect only a credit on the supplier's books. This credit would be applied to future purchases that Neil would make. If the supplier is unwilling, or hesitant, Neil might offer to use only a portion of the credit toward future purchases. For example, both parties might agree that an offset applicable to credits might be 50% of future purchases. From Neil's point of view, the surplus material has been moved at a level well above distressed prices, and value will be received from a known source. From the supplier's point of view, they have been guaranteed future business, and depending upon the arrangement reached, may even be guaranteed revenues two or three times the value of the credit they have extended. When negotiating this kind of arrangement, the word CREDIT is an important one. The supplier has not expended any cash and yet has been guaranteed future business. When considering the typical cost structure, future payments by Neil will naturally include the supplier's profit on future shipments.

When the traditional supplier is not interested in this arrangement, negotiations are still possible with other suppliers. This provides Neil with considerable leverage with others who have solicited their business. They are now offered a chance for guaranteed future sales in exchange for surplus inventory for which they do not expend cash. They may have an opportunity to resell that product at a profit as well. When Neil's traditional supplier realizes that they will lose future business until the inventory credit is used up with the new source, they may reconsider their interest as well.

SUMMARY
Overall, trade credits are a very effective way to provide value for idle assets. Involving suppliers in the process can lead to a very effective partnership arrangement that is beneficial to both parties. Buyers receive higher than normal value for surplus inventory, and suppliers receive assurance of future business. The process provides a continuing relationship with both parties, fostering mutual trust resulting in mutual advantage. In short, a partnership leading to higher "profits" for both parties.

REFERENCES

  1. Bankester, Rebecca R., "Obsolete By Nature: How To Cash In Inventory", EBN Purchasing Issues, March 1993, 10-13.

  2. Murphree, Julie, "One Purchaser's Trash Is Another's Treasure", NAPM Insights, August 1993, 24-26.

  3. Panati, Charles, Extraordinary Origins of Everyday Things, New York: Harper & Row, 1987, P. 218.

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