Supply Chain Pressures Keep Inventories High in Q2

Inconsistent lead times and shipping delays force companies to maintain inventory buffers.

Efficient handling of working capital frees up cash that can be used to replace the forms of capital getting more expensive as interest rates climb.

The Hackett Group’s Working Capital Survey, updated for the second quarter of 2022, showed the 1,000 companies studied did fairly well at managing receivables, inventory, and payables. (See chart.) The slight degradation in days payables outstanding (companies paid their invoices faster) might have been due to the leverage suppliers now hold over buyers due to parts shortages.

Though days inventory outstanding (DIO) was steady with the year-ago second quarter at 46.5 days, inventory balances for the nonfinancial publicly held companies rose to $1.44 trillion from $1.19 trillion the year before.

Some of the inventory increase was due to price inflation. But as supply chains continue to experience dysfunction, companies also have had to build up stocks to keep production lines running and avoid disappointing customers.

“Many, many companies are struggling to find the right balance in terms of inventory performance,” said Shawn Townsend, a director at The Hackett Group, “What is the right inventory level, what is the right inventory mix, versus what is the demand going to be in the next few months? That’s a very hard question to answer.”

Last week, CFO reported nearly half (45%) of the 1,064 global CFOs, vice presidents, directors, and managers of finance surveyed by Protiviti planned to ditch the just-in-time supply chain model (focused on efficiency and low costs) for a revenue assurance model (emphasizing flexibility and resilience).

The depth and duration of supply chain inefficiencies over the past two years leave organizations little choice but to construct supply chains that are more reliable and diversified.

In the meantime, second-quarter balance sheets were still laden with inventories, mostly due to unpredictable lead times and the need to build safety stocks:

  • Costco reported total inventory up 26% year-over-year in its fiscal fourth quarter. About 10% of that was due to inflation, said CFO Richard Galanti, according to S&P Capital IQ’s transcript of the company’s earnings call last week. But Costco said it consciously bought some products a little early based on the length of supply chain delays. Supply chains are improving, Galanti said, but in the past fiscal year the big box chain had some seasonal goods — like Christmas trees and air conditioners — arrive after their selling seasons. Overall, Costco won’t have to resort to large markdowns to move the merchandise, said Galanti. For example, Costco will be able to sell last year’s artificial Christmas trees this year, he added, “and if you add in the cost of holding them and a little cost of interest, I think they’re still a little cheaper than the ones we added to the inventory this year.”
  • Outdoor equipment and clothing company KMD Brands, based in New Zealand, saw a year-over-year inventory increase of 36% (U.S. dollars) in its fiscal year ending July. It was part of “a strategic decision to temporarily build stock positions to meet forward wholesale orders, expected retail demand, and to mitigate increased production lead times and international shipping delays,” said Group CFO Chris Kinraid on KMD’s September earnings call. That decision, of course, impacted the company’s operating cash flow. KMD expects careful management of stock in the fiscal year 2023 will allow the “unwinded inventory to underpin increased operating cash flow generation.”
  • Medical device company Dynatronics had double-digit sales increases during the fiscal year 2022. Longer lead times for raw materials and other supplies forced it to place additional orders in each quarter. Although lead times are getting more consistent, said CEO John Krier, “we’re still having to carry much more safety stock or plan for longer lead times due to the environment that’s out there. … It’s hard to tell exactly what [the company’s steady-state] inventory level will be, along with our growth. … We’re having to modulate what is that inventory level we need to support that [double-digit] growth.”

Overstocking can hurt operating cash flow, inflate payables, and erode gross margin performance. In addition, a product or part can become obsolete before it’s used or shipped. “Many companies have built additional buffers, but that doesn’t mean overstocking inventory is the answer, either,” said Townsend.

Many companies still don’t have visibility into key indicators of inventory performance, said Hackett’s Townsend. Sharing information and automating processes boosts agility. Changing demand signals need to be rapidly recognized, captured, and disseminated across the organization, Townsend said.

“CFOs need to understand the supply chains and inventory processes from end to end, Townsend said. “What is your lead time? What is your customer service level? Where are you picking up order quantities? How is your inventory stocking strategy impacting inventory levels and demand?”

The alternative to building inventory buffers or stocking goods much earlier than they are needed would be to draw down inventory and potentially miss or delay a sale because a product isn’t available.

With inventory balances having grown substantially over the last two years, some companies are making the decision to start running them down because they’re consuming too much working capital.

“We’re going to err to inventory depletion [in industrial goods and finished products] early on” in 2023, said Richard Joseph Tobin, CEO of industrial products company Dover at the September Morgan Stanley Laguna conference.

Tobin said, “If we get caught out a little bit in Q1 by not having the product available, then that’s a risk that we’re willing to take because we believe that we can catch up,” according to the S&P Capital IQ transcript.

Because Dover operates in “very concentrated niche markets,” said Tobin, “there’s not a lot of optionalities for customers to go somewhere else. Unfortunately, we’ve trained our customers to be late on a lot of deliveries …” he said. “We’re just pretty much going to have to continue that by willfully drawing down working capital.”

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