Inventory, Reimagined

Before the pandemic changed organizations’ approach to inventories, conventional wisdom tended toward a just-in-time (JIT) mindset, which enables companies to adjust inventories in real time to accommodate immediate demand. Made possible by predictable supply chains, JIT inventory management optimizes investment in working capital while minimizing cost of carry.

Beginning in the second half of 2020, however, a number of factors began to converge to disrupt this time-tested system. The pandemic caused serious disturbances in the global supply chain, organizations were unprepared to meet new and unprecedented patterns in consumer demand, and shortages became commonplace as producers and shippers struggled to keep up. Further compounding the challenges with using the JIT approach, companies reacted to rising prices starting in the second half of 2021 by stockpiling inventories to hedge against future price increases. And geopolitical turbulence—such as the conflict in Ukraine, beginning in early 2022, and persistent Covid lockdowns across Asia—presented further headaches for corporate treasurers seeking to optimize inventories in pursuit of a strong balance sheet.

Although a number of these factors are still at play, relief may be around the corner for corporate treasurers. Global economies seem to be inching toward a post-pandemic “normal,” which might present new opportunities to normalize inventory levels and optimize working capital.

Companies contending with inflated inventory levels tend to have three primary areas of focus:

1. Trimming current inventory levels, to free up valuable cash in a rising-interest-rate environment;
2. Reverting to a pre-pandemic inventory management strategy without disrupting business operations or sacrificing long-term strategy; and
3. Understanding what an economic slowdown in 2023 would mean for customer demand patterns.

Return to an Old Normal?

Managing inventory, of course, has much to do with predictability and forecasting. Many of the pandemic-related market disruptions appear to be ebbing, while in a number of sectors we are not yet back to pre-pandemic normalcy. The empty shelves that were commonplace as supply-chain bottlenecks met with steep increases in consumer demand for goods have now been replenished, especially as those bottlenecks ease.

Consider the trajectory of container shipping prices, which are down significantly from their record high in September 2021. The Freightos Baltic Index (FBX), for example, reached approximately $11,000 that month. By December 2022, the index had fallen to the $2,500 range—much closer to pre-Covid levels. Declining freight-shipping costs can be a source of relief to companies’ bottom lines, freeing up cash on the balance sheet to offset increased borrowing costs associated with higher interest rates. Less volatility in transportation and logistics pricing can also shore up corporate forecasting and pricing processes.

Still, treasury and finance managers should maintain a strategic and balanced approach to shipping, even as we revert to more familiar market conditions. The pandemic taught us how quickly these conditions can change. Companies might slowly phase in a return to JIT and very lean inventories as the supply chain continues to stabilize.

Similarly, organizations should keep a close eye on demand patterns, as the shift in how and when consumers spend their money may turn out to be semi-permanent. Spending patterns are still being up-ended by hybrid work and, more recently, the uncertain economic outlook for 2023. “Predictable” behaviors may no longer be as predictable as we once thought they were.

The Economic Picture: A Reason to Reduce Inventories

Further complicating things, the economic landscape is much different now than it was a few years ago. The Fed’s aggressive efforts to curb soaring inflation have resulted in a series of rate hikes and a federal funds rate higher than we’ve seen since early 2008.

In addition, there are growing concerns about the health of the global economy. Many experts are forecasting a recession in 2023. As layoffs start to plague broad sectors, economic concerns are mounting. This has led to a decline in factory orders, as organizations prioritize shedding current inventories to maximize working capital and unlock cash to weather a potential downturn.

Given higher borrowing costs and constraints on funding, the strategic liquidation of assets may, in certain circumstances, be a prudent move for treasurers seeking to strengthen the balance sheet, especially since many analysts believe asset prices are unlikely to rise much further and are likely to continue experiencing deteriorations this year.

Prices for January 2023 were up 0.5 percent, and while the inflation rate for the past 12 months fell to 6.4 percent, overall consumer price inflation still remains stubbornly high. The market is predicting continuing tightening by the Federal Reserve and increased uncertainty in the economic outlook for 2023. While consumer prices—and, more particularly, food, energy, shelter, and services prices—remain stubbornly high, inflation is moderating in commodities and possibly industrial products.

We are also seeing evidence of easing inflation among purchasing managers. In December 2021, purchasers were getting calls from their suppliers suggesting that they order more goods in advance, ahead of upcoming price increases. In recent months, for most sectors, the frequency of inventory buildup for that reason appears to have been meaningfully lower.

Working Capital Calculations—Striking the Right Balance

So, what does this all mean? Sitting on excess inventories in the current environment, even as we return to something resembling normalcy, may not be the most effective way to utilize working capital.

Organizations need operational liquidity as much now as they did during the early, uncharted days of the pandemic—and maybe more. Treasurers can take advantage of current conditions to make inventories leaner and garner vital cash that is necessary for future growth. These goals may be crucial, as profit outlooks for 2023 continue to be challenging across a number of sectors.

Managing inventory levels this year may mean striking the right balance between margin preservation and working capital optimization. In many sectors, companies can drive inventory levels lower by sacrificing margin, as in pulling the “pricing lever.” Keep in mind, though, that the calculation might have far more variables than can be counted on one hand. At minimum, it would need to consider:

• Pricing flexibility under contractual arrangements,
• Shelf life,
• Risk of changes in demand preferences,
• Brand dilution,
• Demand outlook for the next quarter,
• Carrying cost, and
• Earnings forecasts.

Higher interest rates and borrowing costs might make it less unattractive to discount prices for customers in order to get inventory off the shelves. However, treasury and finance managers determining the right tipping point between liquidating versus margin preservation must also factor in the reality of market expectations on margins and earnings. Corporations aim to optimize economic outcomes for their stakeholders and communicate certain decisions with investors that, at times, hurt near-term earnings but may nevertheless be necessary.

Every business has its own set of unique facts and circumstances, which determine where it will land on the spectrum of liquidating-vs.-holding inventory. Some companies may have substantially higher holding costs and may attach a high premium to liquidity. Especially if stakeholders have already factored margin pressures into their evaluation of the business, these companies may be more inclined to liquidate and take the margin hit, if necessary. Other organizations, meanwhile, may face the opposite set of circumstances, experiencing predictable and sticky demand, with the resiliency to run down inventories on more typical commercial terms, albeit over a longer timeframe than they would prefer.

One additional consideration in making these decisions is that few businesses are selling solely to end customers. Normalizing inventory levels across the sector supply chain, in its entirety, can take time. For example, one business may have downstream customers that stocked up in anticipation of supply disruptions and rising prices, while another may have downstream customers that did not hoard inventory. For each of these businesses, the circumstances of the downstream customers might affect the working capital and liquidity outcomes for the organization and its treasury team.

All these factors appear to indicate continued volatility and challenges to best practices in inventory management. We could be heading toward a reversion to mean as far as pre-Covid inventory levels are concerned, but that might still be a few quarters away.

Amit Goel is a partner at CrossCountry Consulting in McLean, Virginia. Amit serves private equity clients in the Office of the CFO practice, with an emphasis on financial reporting and technical accounting matters. Goel brings to bear his experience in various roles over the years, ranging from a partner in a Big 4 national accounting office to chief accounting officer and treasurer of a public company.