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
- Bankester, Rebecca R., "Obsolete By Nature: How To Cash In Inventory",
EBN Purchasing Issues, March 1993, 10-13.
- Murphree, Julie, "One Purchaser's Trash Is Another's Treasure",
NAPM Insights, August 1993, 24-26.
- Panati, Charles, Extraordinary Origins of Everyday Things,
New York: Harper & Row, 1987, P. 218.
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