The most complicated of the “basic” working capital categories involved in the Cash Conversion Cycle is inventory. This is true for a number of reasons.
Inventory is often highly specific to its particular industry. Inventory can take several different forms. Inventory's valuation can vary. In addition, inventory is inextricably entwined with operations, sales and purchasing.
For all these reasons, a careful look at this investment is useful.
The different stages of the production process results in three separate types of inventory. The firm buys “raw materials” that it will use to convert into its products. During the production phase inventory is classified as “work in process”, or WIP. Finally, “finished goods” is the term used to denote inventory that is ready for sale, shipment and delivery.
Depending on the firm, the amount and proportion of inventory comprising these stages will vary. On one end, a firm whose production process requires very little time and its output can be delivered quickly might hold most of its inventory as raw materials.
For example, a bakery does not want to hold a lot of baked bread, which goes stale and moldy as a finished good, so it is far more optimal to keep flour, yeast, butter and the like in its original state until it can all be delivered early in the morning to its customers in just the right amounts.
A long production process, such as a brewery whose product requires fermentation for several weeks, will see a high amount of WIP, as most of its inventory will be in the fermentation vats.
A simple assembly operation, which assembles quickly but batches up units for high volume bulk sales, will hold a higher amount of finished goods.
Inventory and Cost of Capital
Just as we saw when we examined Accounts Receivable, our firm’s inventory policy will carry different implications for its cost of capital. In the case of Accounts Receivable, we could look to a replicating portfolio to arrive at this impact. Unfortunately, it is not as simple as that with inventory.
One factor that makes inventory more or less risky is the level of commoditization. The more inventory we hold in a commodity-like state lowers our risk level vs. the amount held in a non-commodity like state.
If we manufacture a specific part for a specific vehicle, for example, our finished goods are very specialized. We can sell them to only one customer, and then only so long as they continue selling the product for which ours is a part. In other words, our finished goods are not commodities at all.
On the other hand, if our raw material is ingots of iron, these can be sold to a large number of manufacturers making any number of different products in a multitude of industries.
Therefore, a business with a large amount of finished goods in relation to total inventory is more risky than one that holds a larger amount in raw materials.
Each firm must ascertain where in the process this occurs. It is not as simple as saying “raw materials are less risky than finished goods”.
What if we are the firm that receives the vehicle parts manufactured from iron ingots above? Our raw materials are very specific, say part of a car door for a specific model. If the manufacturing process were to shut down permanently, the only use for our raw material is scrap. On the other hand, as a finished good the car can at least be sold, even if it is not for the full list price.
So for the firm in the first example raw materials is the less risky category, while for the firm in the second example finished goods are.
Cost of Capital Worked Example
Let us say that Firm A generates ²1 per year forever, and its cost of capital for this industry is 10%. A perpetuity valuation method then places the value of this firm at ²10. Let’s further say that they paid for their production assets and infrastructure at just this amount, so their Net Present Value was ²0.
In addition, Firm A runs production continuously with a buffer stock of finished goods worth ²2. This is their working capital investment. Since the value of the finished goods in theory revolves around the state of Firm A’s industry, we can say that they should carry the same cost of capital, or 10%.
Just as we did in the last post, we use the Modigliani-Miller assumptions and determine that if we finance the firm with 50% debt at 7%, then our 50% equity is priced at 13%.
For Firm B, we assume all the above assumptions above hold, with the exception that Firm B keeps its inventory as raw material and produces to order only (like the car part manufacturer whose raw material is iron ingots).
In this case, the raw material inventory is more commodity-like. Commodity futures and forward contracts typically use short-term risk-free interest rates to discount their value vs. spot rates, and so for this reason we assign a lower cost of capital (i.e. risk) to this raw material investment, say 5%.
At our 50/50 capital structure, Firm B’s cost of equity is 11.3%, much lower than Firm A’s.
From this example we can see that our inventory and production policy, methods, and practices will have an impact on our firm’s value due to the cost of capital implications.
The Process Matters
As we just noted, the production process, the nature of the input materials and output materials all impact the working capital requirements of our inventory.
We can say, in general, our inventory practices are dependent on the following factors and questions, which need to be optimized for our firm:
· Supply variability – is the supply of raw materials highly variable in terms of either price or quantity?
· Batch supply costs – is there a high “up-front” cost to ordering, receiving, or storing needed raw materials?
· Per unit supply costs – are these costs different depending on the quantity level of the production run?
· Physical per unit inventory storage costs – we need space, insurance, and infrastructure to warehouse inventory in any form.
· Production rates – will manufacturing our product in different amounts affect our productivity?
· Production variability – are there factors that impact our ability to produce?
· Batch sales order costs – are there “up-front” costs on the part of our customers, or batching synergies on our part, to fulfilling sales orders?
· Per unit sales prices – is there variability in what our ultimate realized sales price will be?
· Demand variability – are there factors that can make our sales volumes dramatically different?
· Stock-out impact on sales – if we do not have product in stock, will our customers back-order or will we lose the sale entirely to competitors?
This entire process can be subjected to analytical treatment, which we will investigate in future Treasury Café posts.
Additional Issues With Multi-Product Firms
Our discussion of inventory to this point has been geared to a one-product / one-raw-material type of firm. This is somewhat simplistic. What if we manufacture 100 different items? And utilize 100 different raw materials?
Our analysis then involves the inter-relationship of each product, its manufacturing process, and its sales profile with all the other products in our “portfolio”.
As an example - simplifying the issue to a two product case - what is our optimal production process if product A has very small batch costs, while product B has large ones?
In this instance, we would want to optimize product B’s production schedule and “fill in the holes” with product A’s. Our solution would be entirely different if product A and product B had similar batch and unit costs but faced different variability in either raw material supply or finished good demand, along with different stock-out costs.
The inventory characteristics of our firm will impact our working capital level and the resulting risks undertaken, thereby impacting the cost of the capital required to be deployed.
What inventory peculiarities are present in your industry?
What is the optimal production process given the levels of risk in raw materials, WIP, and finished goods? Why?
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