Reliant Products Inc. manufactures electric space heaters. While the CEO, Lynn J
ID: 2462427 • Letter: R
Question
Reliant Products Inc. manufactures electric space heaters. While the CEO, Lynn Jennings, is visiting the production facility, the following conversation takes place with the plant manager, Aaron Clark:
Lynn: As I walk around the facility, I can’t help noticing all the materials inventories. What’s going on?
Aaron: I have found our suppliers to be very unreliable in meeting their delivery commitments. Thus, I keep a lot of materials on hand so as to not risk running out and shutting down production.
Lynn: Not only do I see a lot of materials inventory, but there also seems to be a lot of finished goods inventory on hand. Why is this?
Aaron: As you know, I am evaluated on maintaining a low cost per unit. The one way that I am able to reduce my unit costs is by producing as many space heaters as possible. This allows me to spread my fixed costs over a larger base. When orders are down, the excess production builds up as inventory, as we are seeing now. But don’t worry—I’m really keeping our unit costs down this way.
Lynn: I’m not so sure. It seems that this inventory must cost us something.
Aaron: Not really. I’ll eventually use the materials and we’ll eventually sell the finished goods. By keeping the plant busy, I’m using our plant assets wisely. This is reflected in the low unit costs that I’m able to maintain.
If you were Lynn Jennings, how would you respond to Aaron Clark? What recommendations would you provide Aaron Clark?
Explanation / Answer
If I were Lynn Jennings , i would respond by ths way;
Look Aaron , I understand that you are trying to produce on a non stop basis without lloking at the demand schedule, this keeps your machines and factory workers busy throughout the year and you are maintaining low unit cost by spreading the Fixed costs over huge no of produced units , but the cost of carrying inventory is phenomenal for a company and perhaps you do not have any idea how it affects our company both ways.
Lest us take the case of excess raw material inventory. As the supplier is ineffecient , we are purchasing extra raw materials and keeping in stock. But we need to pay the supplier for supply of materials which will not be converted to cash generating finished goods. So factually we are paying without earning revenue and also encouraging suppliers'inefficiency.Also the extra purchase draining out cash and working capital which has huge interest cost.
Now come to huge Finished goods stock without immediate demand. For the company fixed costs are sunk cost, those do not change if you produce more or less. By producing more Finished goods than required , you are unnecessarily incurring extra Direct Labor and other direct Overheads which could have been avoided. So you are incurring extra cost and producing finished goods which are not earning revenue. Again there is huge amount of working capital blocked as costly inventory of finished goods.
Now I believe you understand that your decision of extra raw material and finished goods inventory carrying is a double edged sword which incurs more cost without any additional revenue.
I would suggest Finance department to revise the performance parameter from low unit cost to higher contribution per product to pre empt such mistakes.