Accurate value: finding a place for inventory.

THE THEORY OF CONSTRAINTS (TOC) PROPOSES excess inventory is a liability to a company, yet on a firm's financial statements, inventory is entered as an asset. Inventory-dollar-days, a way to portray the implications of excess inventory on the financial health of a firm, should be used more widely. As with many philosophies emanating from industry, the ideas are sound, but have a difficult time breaking through the web of accounting rules to become part of an organization's financial reporting system. Much like Alex Rogo in The Goal by Eliyahu Goldratt had to prove to his accountants and bosses that inventory is not really an asset, operations managers continue that struggle today because in fact, inventory rests under assets. Assets are something to value.

Did you hear the one about the banker who would not give a loan to a battery distributor because the distributor kept a low inventory of his perishable product? The banker wanted more inventory for collateral. This is just what that business needed: a warehouse full of run-down batteries. At best, inventory could be considered an artificial asset, particularly if it is excess inventory.

Much of the literature about Goldratt's theory of constraints espouses that holding inventory is a liability for an organization. The message from his books is that inventory levels negatively affect quality, new product introduction, overtime, end-of-month processing, equipment, space, investment, and responsiveness to market. This is especially true of excess inventory.

Critics have suggested that inventory is not inherently bad but is a symptom of deeper operational problems and that considering inventory as a liability would help distinguish between a healthy and distressed firm.

Other authors have explored the relationship between TOC and traditional cost accounting. Human Systems Management devoted an entire issue to the topic of TOC reflecting on the practice and research occurring in the area, for example.

In one way or another, TOC does not regard inventory as an asset. So, if it is not an asset, can it be accounted for as a liability? Try to put inventory on the balance sheet in the liability section. It doesn't fit. To balance the Assets - Liabilities = Owner's Equity equation of a balance sheet and increase a liability, you have to decrease an asset or increase owner's equity. Paying cash for the inventory reduces assets and owner's equity decreases when you buy something.

The question is, How do you show the debilitating effect of inventory on a firm's value on a balance sheet while observing the general accounting principles or concepts?

Comparative financial statements

A relatively simple approach is to use the financial statement convention applied to depreciable assets. In a way, inventory is depreciable; the more of it you have and the longer you have it, the more it is going to cost you. There are exceptions, of course (gasoline being one of them, of late). Most technology products, on the other hand, can be obsolete and worthless in a period of months. The approach suggested below can be used for either category of increasing or decreasing inventory value, but is primarily directed at excess inventory that decreases in value over time. For increasing value inventory, add where the models say to subtract.

To consider inventory as a depreciable asset to find its true worth, simply add an inventory contra account to the balance sheet, just as is done for depreciation. As the inventory "depreciates," the contra account is credited. The corresponding debit will be to an additional inventory expense account on the income statement. There is a debit and a credit. No general accounting principles or concepts have been violated.

In Figure 1, financial statement assumptions are shown. The use of the inventory contra account is shown in Figure 2, which depicts traditional and TOC financial statements. Beginning of the period (a fiscal quarter is used here), balance sheets for traditional accounting, and TOC accounting for inventory are at the top of the figure. To isolate the impact of TOC accounting for inventory, only accounts essential to the example are used.

The beginning of period balance sheets are the same for both the traditional and TOC balance sheets. The cash account holds $100,000 and there are 7,000 units of raw material inventory (RMI) on hand for which the company paid $20 each.

Turning to the income statements in Figure 2, both show that during the quarter, no additional units of raw materials were bought, 6,600 units were produced, of which 5,600 were sold at a price of $70. The cost of goods sold section is based on the sale of the 5,600 units at a cost of $32 each. Added to the $20 cost of the raw material for each unit are $2 for labor and $10 for overhead. The TOC defines inventory as "the money that the system invests in purchasing things that it intends to sell." This definition does not include the traditional cost accounting practices of adding labor and overhead. Rather than delve into the implications of the TOC definition of inventory at this time, assume the traditional cost burden is added to cost of goods sold. Keep in mind the purpose of the article is to show a more accurate value of inventory while staying within the bounds of general accounting principles or concepts as much as possible.

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The differences between the two income statements are in the general and administrative expenses section. The traditional income statement has zero expenses. The TOC has expenses of $28,571. This amount reflects the cost of having too much inventory. This amount also appears on the TOC balance sheet, but not the traditional balance sheet.

On the TOC balance sheet, the offsetting expense from the income statement is an entry in the inventory contra account. This account reduces the inventory value by the amount of the expense incurred by having too much inventory. Before discussing the implications of these two entries, consider how the inventory expense is determined.

When TOC accounts for inventory

The TOC literature indicates that too much inventory is a liability. In The Theory of Constraints and Its Implications for Management Accounting, inventory-dollar-days is identified as Goldratt's measure for excess inventories. The concept is that any inventory over what is sufficient to satisfy on-time delivery of product is excess and incurs a cost. Inventory-dollar-days measures this cost by the number of units in excess of what is needed times the number of days the inventory is held times the unit value. For example, if a firm sells one unit a day and has one unit valued at $2 held for one day, that is two-dollar-days.

The example discussed shows this amount being on the financial statements, but could just as easily be calculated and subtracted from the "official" financial statements if one thinks the inventory contra account violates any general accounting principles or concepts.

Figure 3 demonstrates a spreadsheet that inputs readily available information and produces the inventory-dollar-days amount. To calculate inventory-dollar-days, data is entered into the yellow input section. All of this information is usually readily available. Additionally, the green model section of the spreadsheet is based on Goldratt's explanation on calculating finished goods inventory. The spreadsheet extrapolates the FGI calculation to raw materials inventory. The same concept could be used for work-in-progress inventory, but the scenario was omitted to keep the model as simple as possible.

Studies indicate that many companies do not use inventory-dollar-days, perhaps substituting the actual costs of holding excess inventory in lieu of this method. Their reasoning may be that the inventory-dollar-days measure is "often too large to be credible," which could presume the amount of excess inventory lacks credibility. At any rate, the substituted costs could be a compromised way to reduce "book" inventory value to a more realistic inventory value.

Numerical implications

So what does the TOC financial statement tell you? First, looking at the differences in the income statements in Figure 1, the TOC statement shows a net profit being $28,571 less than the traditional income statement. This is the total inventory-dollar-days amount. Income is reduced for the current quarter. At some point in time, excess inventory is written off. Usually with a big write-off in the arbitrary quarter, management believes the write-off will have the least negative impact. The TOC statement shows the cost as it occurs and gives an accurate assessment of inventory value for the quarter.

On the balance sheet, the cost of excess inventory, as measured by inventory-dollar-days, is subtracted from the "book" inventory value. Consequently, the TOC balance sheet shows the inventory asset as being $28,571 less than the traditional balance sheet. Correspondingly, the owner's equity is less on the TOC balance sheet. This shows the business is worth less due to excess inventory. The approach provided gives an up-to-date assessment of the company's worth regarding inventory.

The old axiom, "You get what you measure" applies throughout business--including how managers act upon what is on the firm's financial statements. Measuring the cost of excess inventory as a liability (contra asset) may get the actions desired as managers take action to improve their firm's performance based on more realistic financial statements.