Inventory is an asset on your balance sheet. Finished goods can be converted to cash relatively easily. Raw materials end up becoming finished goods, thereby completing that part of the cash cycle. But excess raw materials may be difficult to dispose of if no longer needed. Not only that, but raw materials need to be available in the proper proportions or the money invested just sits there, waiting on the shelf.
Not all manufacturing uses stock materials. Sometimes specialized raw materials are purchased to produce product for one individual customer. Even though this is common practice for some companies, it can create additional risk for the manufacturer, because it can only be used for one customer, one product. As long as the delivery follows in due course, it’s not a problem. But it can become a major issue if things change. Then, who is left holding the bag?
The bank insisted that the company get some help. They were bumping up against the top of their credit line constantly. Their inventory control was manual and therefore questionable. Plus, specialized inventory raised questions on their borrowing base. They had been profitable until recently, but their record keeping was inconsistent. The bank had already determined they would not allow an over-advance of the company’s line of credit, and the company had to get expenditures approved daily.
Because the company produces custom seating for franchises, particular components could only be used for that individual brand. As a result, significant inventory just sits, waiting for the next order. The company maintains a manual inventory system, which is updated monthly by full inventory counts. The concern about running out of components results in more inventory on the floor than is needed.
Because of lackluster company performance over the past two years, the bank has tightened borrowing availability. As a result, the company supplies daily information to the bank to release payments.
The company’s ERP system is only partially utilized. They receive the standard Income Statement, Balance Sheet and Statement of Cash Flows monthly, but there are no subsidiary reports. Those reports would help identify issues for management to address.
Any money a company spends should ultimately drive profitability. But when inventory is purchased specifically for an individual customer, cash commitments and risks are increased. Not only are you dependent on sales of your products for your company to survive, but now you’re dependent on a customer to complete their sales order, so you can use the raw materials you purchased for them.
Being able to control your company’s assets is key to your independence. If you are totally dependent on the purchases, sales or payments from any single customer, you are beholden to them more than you may think. This is another aspect of customer concentration. Too often, specialized inventory can become a write-off when the customer goes out of business or makes changes in their business. And, if buying specialized inventory is for a large customer, rather than a general company practice, the risks – especially in an economic downturn – can spell danger for any company.
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