Inventory: Asset or Evil for Financial Performance in S&OP/ IBP?
Tim Cook—Apple’s CEO, former COO under Steve Jobs—considers inventory “fundamentally evil”. In Accounting, inventory is an asset.
This means a resource that the company expects to generate future benefits. It seems that Cook and Accounting views are in conflict. Who’s right: Apple’s CEO or Accounting?
To answer this question, let’s look at the impact of inventory in the financial statements. The financial statements of public companies like Apple are available in the 10-K.
This is an annual report that the US Securities and Exchange Commission (SEC) requires from public companies to show their financial performance. There are three core financial statements:
- Cash Flow Statement
- Profit and Loss Statement (P&L) or Income Statement
- Balance Sheet
Inventory on Cash Flow Statement
Inventory is present in the cash flow statement. It is in the cash from operating activities. The logic is like that in the balance sheet.
If inventory goes up, the cash from operating activities goes down; if inventory goes down, the cash from operating activities goes up. Cash is tied in inventory that the company could use in a different way.
An important metric related to inventory and cash is the cash conversion cycle. Inventory management has a significant impact on this metric.
It shows how many days it takes a company to turn inventory into cash. This metric has three factors:
- Days of inventory outstanding (DIO)
- Days of sales outstanding (DSO)
- Days of payables outstanding (DPO)
The calculation is the addition of days of inventory and sales outstanding, deducted the days of payables outstanding. The shorter the cash conversion cycle, the better.
For example, if the cash conversion cycle is 6 days at Walmart, it means that it takes 6 days to get cash from the investment in inventory.
There are companies, like Coca-Cola, with negative cash conversion cycle. This means that such companies receive payments before having to make payments to suppliers and other third parties.
Inventory on the Profit and Loss Statement (P&L)
Where’s inventory in the P&L? Different from the balance sheet, the inventory word is nowhere in the P&L. However, inventory transformation is there.
When inventory does generate benefit, it transforms into revenue, the top line in the P&L. This is the demand plan in S&OP/ IBP.
Inventory is also present in the second line with cost of goods sold (COGS). COGS is all costs related to getting the products ready to sell to the customers.
It includes the raw materials, the packaging, freight-in cost, plant labor, and factory overhead. Bills of materials (BOMs) and production routings are critical to estimate and track production cost.
The difference between revenue and COGS is the gross profit. Companies also calculate the gross margin that is the percentage of gross profit over revenue (gross profit divided by revenue).
This is when inventory brings profits to the organization, but inventory can also mutate into losses, to Apple’s CEO viewpoint. Inventory write-offs are also in the P&L.
They can be because of changes in the market demand, obsolescence, damage, theft, among other factors. If write-offs are not significant, they are part of COGS.
If they are significant, companies record the expense in a separate loss line item to track inventory write-offs properly without distorting gross margins.
Inventory is on the P&L in the operating expenses (OpEx) as well. For example, warehousing costs to keep the inventory in good condition and R&D expenses incurred for new product introductions.
Although R&D is designed for future growth, per GAAP, companies must expense (not capitalize) R&D. As we can see, inventory is in multiple lines in the P&L. It is also in the Cash Flow Statement.
Inventory on the Balance Sheet
As Accounting regards inventory as an asset, inventory is on the balance sheet. In supply chain terms, this is the inventory on hand that the company owns.
It includes raw materials, WIP (work in process), and finished goods. Examples of raw material inventory are ingredients, packaging, and components.
A company may also work with co-manufacturers and co-packers. Sure, the S&OP/ IBP team accounts for all inventory—no matter the ownership—in the plan.
However, the inventory treatment on the balance sheet is different. If the company owns the inventory, it will be listed as such within assets. If the company doesn’t own the inventory like when the contract manufacturer does, this inventory is off the balance sheet.
This is how the inventory information displays on the balance sheet. About the mechanics, the balance sheet attempts at reaching the equilibrium (aka balance) between assets on one side of the equation and liabilities and shareholders’ equity on the other side.
If inventory goes up, another asset(s) goes down in the same amount, for example, cash. The other option is that if inventory goes up, liabilities or equity goes up as well.
These changes in inventory can be because of new purchases and production as well as customer sales. There can also be inventory losses including obsolescence or aged material.
This happens with seasonal products, for example. All these inventory changes—positive or negative—show that inventory does transform.
It doesn’t stay the same. It can generate revenue or loss. The Profit and Loss Statement (P&L) shows how inventory transforms.
Conclusion
Accounting is right when inventory transforms positively in gross profit in the P&L. This is the difference between revenue and COGS in the P&L. In this case, inventory is an asset as it generates a benefit to the company.
Apple’s CEO is right when inventory transforms negatively in losses including inventory write-offs in the P&L. Inventory ties cash— as conveyed in the cash flow statement and balance sheet— that could be used for other pursuits or further growth.
How fast inventory turns into cash as measured by the cash conversion cycle has a significant impact on whether inventory is an asset or evil. Inventory management is key in defining how inventory will transform—in a positive or negative way— being an asset or evil.
