4. Even though inventories are described as the smallest of the three areas of business spending, economists

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4. Even though inventories are described as the smallest of the three areas of business spending, economists tell us that they are extremely important --- why? In theory, what could "go wrong" if a firm's Financial Management team does a poor job?

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INVENTORIES: The category of Business Spending called inventories is often overlooked or misunderstood. Inventories are usually placed in one of three areas: 1. Raw materials 2. ‘work-in-process’------visualize a half-finished car winding its way down an assembly line (in normal times) and 3. ‘finished product’ inventory. Let’s imagine a car manufacturing company that is producing, distributing and selling cars at a profit. Raw material inventories would include steel, glass, tires, aluminum, and hundreds of other parts. A logistical nightmare to manage. “Work in process’ ----“wip’-----inventories include the cars ‘in process’ so to speak: they are halfway down the assembly line. Factory #5 will ‘speed up’ the production line and decrease our ‘w.i.p.’ 3. ‘finished product’ inventories may be the easiest to visualize: cars in transit, being moved, or sitting in the dealership showrooms and back lots that have been BUILT, BUT NOT YET SOLD. The management of inventories may be called part of a larger area we may call ‘Financial Management’--- a woman or man may be a CFO, Treasurer, Controller in an organization—her or his job may consist of managing the flows of funds through various areas: CASH, RECEIVABLES, and INVENTORIES. MANY CEOs have come up through the ranks in Finance. Of course, to manage something well, one must have ACCURATE PICTURES of it. Big companies like SAP and Oracle help Financial Managers with COMPLEX software that is constantly updated. Many of you may have jobs in financial management at some point in your lives... WHAT FORCES OR FACTORS MAY HELP INFLUENCE A RISE OR A FALL IN INVENTORY SPENDING? By looking at a model for one firm, GM in its ‘heyday’, we can in theory extrapolate and say that these factors may affect ALL firms. Let’s say that GM at its peak produced and sold about 400,000 cars a month in this country (on average)---almost 5 million a year. Now, at least up until March 2020, they may have sold about 2 million per year in recent years. In its glory days, this firm, in theory, would produce roughly 400,000 cars a month and sell 400,000 cars a month, while, along with its participating dealerships, decide to “hold” 400,000 cars in ‘finished product’ inventory (GM is the manufacturer and Capitol Chevrolet and many other firms are the dealerships. They are separate entities but they have a symbiotic relationship. GM needs Capitol, and vice versa. In the recession of 2008-2009, and this current one, many dealerships had closed and in this current recession many will close). WHY HOLD 400,000 cars in finished product inventory? It is expensive! Imagine 400,000 cars, built but not yet sold, at a cost of $19,000 per car (it is higher than that). $7.6 Billion! Let’s say that our price per car will be set at $20,000 (just for example) and our cost per car is $19,000 (just for example) for a profit (on average) of $1,000 per car. THIS IS JUST A MODEL!!! In the glory days, before March 2020, a fully loaded SUV or large truck in some cases could bring in a profit of $5,000 or even $10,000 EACH per vehicle---or more! Okay---so why would a rational car company and its dealerships hold a 400,000 car inventory, also known as a ’30 day’ inventory, also known as a $7.6 Billion inventory?

1. A SMOOTH PRODUCTION FLOW: In normal times, the monthly sales volume of cars can VARY WILDLY: let’s say 400,000 in April, 300,000 in May, 500,000 in June. I kid you not. It is incredible. The decision to buy a new car (in normal times) is the largest financial decision a family may make in any year. It is STRESSFUL. It can be EXHILARATING. But it is mainly STRESSFUL. Kind of like romance, in a way... a family can DELAY this decision for a year. Or two. Or three. Imagine how many families were MAYBE thinking about buying a new car... Until March 2020... The drop in car sales this year is going to be just incredible. Remember: it is not just the drop in wage income. It is also the drop in wealth for millions of older Americans. No one in either group is likely to buy a new car in the next year. In ‘normal’ times, a firm (both GM and its dealerships) will want to keep a healthy level of finished product inventories to ensure a SMOOTH PRODUCTION FLOW---even though sales volume is volatile. If sales volume swings from 400,000 to 300,000 to 500,000 from April to May to June, why not just PRODUCE 400,000 then 300,000, then 500,000 from April to May to June? To do so, in theory, we

would have to layoff many of our workers on April 30 – not nice---- and then hire them all back on June 1 WHILE PUTTING ALL OF OUR WORKERS ON MANDATORY OVERTIME for June—not nice and not smart! If we did so, in May we do NOT cut our costs by 25% by cutting back on our workforce. These workers who just ‘lost their jobs’ for a month may be paid for medical costs, Unemployment insurance, workers comp and other costs AND THEY ARE NOT EVEN PRODUCING CARS FOR US THAT MONTH! OUR COSTS DO NOT DROP MUCH IN MAY! But in June, our costs SKYROCKET----we have to put most or all of our workers on overtime---at let’s say ‘time and a half”---say $45 an hour instead of $30 an hour. Workers at a GM transmission plant were once put on mandatory OT (overtime) for 18 hours a week over 11 weeks. They worked 58 hours a week AT A TIME THEY WERE USED TO WORKING 40. Let’s say they got tired. Started making mistakes. Let’s say some of those cars had to be recalled. GM had to fix the cars for free, and customers were INCONVENIENCED to say the least! Let me ask you: you just bought a BRAND NEW CAR (in the old days). It has 8 miles on the odometer. They contact you: “Uh..... sir ... there’s a DEFECT... you have to bring in back in for repair...” ARE YOU EVER BUYING ANOTHER CAR FROM THEM AGAIN? A SMOOTH PRODUCTION FLOW allows us to minimize our labor costs while in theory maximizing the quality of the cars produced. Oh: managers and supervisors are people too. THEY do not want to work 58 hours a week either. (Guys, you are young, and many of you work 58 hours a week RIGHT NOW... but imagine being OLD---like 40 or 45 or oh-my-GOD 50 or 55 years old. Your body is breaking down. You do NOT want to work 18 hours a week of mandatory OT. And your employer should not, either)...

REASON #2: MAXIMIZE SALES VOLUME AT THE RETAIL LEVEL:

In the old days, a customer might walk into a dealership ----(she or he would have to be in a pretty good mood) and she tells the salesperson: “I want a car of this make and this model, with this options package... in the color black” The dealership either has the car or it does not. I know, the internet has changed this somewhat..... but to this day, sometimes the transaction works out this way. Maybe the dealership says ‘we have it in blue’ or they say ‘we can get one here in 24 hours..” “okay, okay... I’ll be back in 24 hours..”.................. and they never come back. Life intervened. Often, YOU HAVE ONE CHANCE TO SELL THAT CAR TO THAT CUSTOMER. Maybe they went home and got into an argument with their partner: “ NEW CAR? YOU are not getting a NEW CAR!!!!” Do couples argue over money? It’s the NUMBER ONE subject, according to many studies. As a car dealership, we MAXIMIZE OUR CHANCE of selling you a car TODAY by holding MORE cars than maybe ‘necessary’, not fewer (in theory)---obviously, these cars cost a lot of money to hold ---carrying costs are discussed in many Finance classes. (More on this later)

REASON #3:

THE ULTIMATE ‘INSURANCE POLICY’ AGAINST ANYTHING THAT MAY ‘GO WRONG’”--- what may ‘go wrong’ for us as we mass-produce cars? Our workers may go on strike. Workers at any one of our 500 parts suppliers may go on strike. Obviously, we will have MORE THAN ONE parts supplier to deal with, but still... what else can go wrong? A PANDEMIC DISRUPTS OUR SUPPLY CHAIN.... We still have one month’s worth of sales (in theory) ALREADY SITTING IN OUR DEALERSHIPS----thus, as we keep advertising our product on the Internet, radio, tv, billboards (display ads), and other areas, we may, in theory, draw in customers and SELL THEM A CAR! CAN YOU IMAGINE ADVERTISING YOU PRODUCT, THE CUSTOMER WALKS IN --- YOU HAVE A LIVE ONE! ------ and there are no cars to sell? You won’t be in business for long. I remember walking into a Saturn dealership, asking about this car---the Vue---that was profiled in the paper... and they said “Sir, we don’t have any HERE,..... but... would you like to see a pretty picture of one?”-------------------------oh..... you’ve never heard of a Saturn?I’m not surprised. Saturn is not around anymore. What else? ONE OF OUR PARTS SUPPLIERS MAY JUST VIOLATE OUR CONTRACT AND NOT DELIVER THE PARTS AS PROMISED. Maybe their costs went up. We

can sue them.. But this is a civil case, not a criminal. It would take years to resolve in court. The civil courts are backed up (in normal times---now, much worse)... what WE NEED is to sell those 400,000 cars every month. (IN THEORY) IT MAY TAKE TIME to line up another parts supplier, or to negotiate with other suppliers to sell us more parts. FINISHED PRODUCT INVENTORIES BUY US SOME TIME---IN THEORY, WE DO NOT HAVE TO LOSE ANY SALES DUE TO THIS DISRUPTION that was beyond our control (I realize that right NOW, in 2020, sales volume is dropping -----to put it MILDly, but please imagine we are selling about 400,000 cars a month and expect to keep selling 400,000 cars each month when this supply disruption occurs). There are MANY reasons to hold finished product inventories!!! But what if interest rates rise, and the supply of debt financing AND equity financing decreases?