Introduction to Corporate Finance

ONLINE CHAPTERS

18-3a INVESTING IN INVENTORY

A company must evaluate its inventory investment in terms of associated revenues and costs. Simply

stated, additional investment must be justified by additional returns. From a financial point of view,

constraining inventory levels improves returns by releasing funds that the company can use for more

profitable investments. In contrast, the production and marketing perspectives are that expanding

inventories provides for uninterrupted production runs, good product selection and prompt delivery

schedules. The company needs to balance the conflicting preferences of finance, production and

marketing managers in order to manage inventory effectively.

The financial manager should consider several specific factors when evaluating an inventory system.

On the asset side of the balance sheet, inventories represent an important short-term investment. The

smaller the level of inventory needed to support the company’s sales, the faster the total asset turnover

and the higher the return on total assets. (This is consistent with the DuPont system, discussed in

Chapter 2.) More rapid inventory turnover also reduces the potential for obsolescence and resulting

price concessions. On the liability side, smaller inventories reduce the company’s short-term financing

requirements and thereby lower financing costs and improve profits. The following example illustrates

the key financial trade-off associated with inventory investment.

example

Duntago Manufacturing, in New Zealand, is contemplating larger production runs to reduce the high setup

costs associated with a major product. The company estimates the total annual savings in setup costs to be

$120,000. It currently turns this product’s inventory six times a year; with the proposed larger production runs,

this turnover should drop to five times a year. If the company’s $30 million cost of goods sold for this product is

unaffected by the proposal, assuming the company’s required return on investments of similar risk is 15%, then

the analysis would proceed as follows:

Average investment in inventory = cost of goods sold ÷ inventory turnover

Proposed system = $30.0 million ÷ 5 = $6.0 million

Less: Present system = $30.0 million ÷ 6 = 5.0 million

Increased inventory investment $1.0 million

× required return × 0.15

Annual cost of increased inventory investment $150,000

Less: Annual savings in setup costs 120,000

Net loss from proposed plan $ 30,000

Decision: Don’t do it; an annual loss of $30,000 will result from the proposed plan.

18-3b TECHNIQUES FOR CONTROLLING INVENTORY

Although inventory control is an operations/production management task, the financial manager serves

as a watchdog over this activity. This monitoring role is important, given the company’s typically sizeable

investment in inventory. Companies commonly use a variety of techniques, discussed below, to control

inventory. Although these techniques are typically used by operations and production managers, a good

financial manager should understand them.

LO18.3

thinking cap

question

Why are financial managers

in manufacturing companies

concerned about inventory?