The boom-and-bust cycle of the recent past filled high-tech manufacturers’ supply chains with excess materials, prompting them to collectively write off billions in inventory and hundreds of millions in purchase commitments. Yet a potentially greater problem still lurks in the form of off-balance-sheet inventory: goods ordered but no longer needed in the face of the global slowdown.
Suppliers possess contracts, orders, and even materials requested by the manufacturers but no longer needed. Traditional inventory metrics capture only goods on the balance sheet. As a result, excess off-balance-sheet commitments and materials — billions of dollars of supplier commitments — often are invisible to management and shareholders. The problem demands attention, as strapped suppliers and contract manufacturers want buyers to make good on their promises.
It is, therefore, critical to manage potential off-balance-sheet liabilities early and proactively. Recent events have shown that failure to disclose off-balance-sheet liabilities can be disastrous. Furthermore, once a supplier makes an actual claim, a manufacturer’s options are extremely limited, and the likelihood of a cash payout is quite high, so getting in front of them is critical.
Purchasing organizations traditionally attempt to resolve such claims. But these efforts often are inadequate because they fail to take advantage of corporate leverage and potential “tradeables.” Supply chain organizations don’t always pay enough attention to looming unfulfilled forecasts and orders until they become real claims. Managing commitments earlier and proactively can help to reduce cash impacts.
Booz Allen Hamilton has identified a five-step process that makes off-balance-sheet inventories visible and allows manufacturers to deal with potential liabilities in an effective manner. Although this approach is designed for the proactive management of potential liabilities, it can also be used to develop a balance-sheet entry for supplier commitments. The steps are:
- Use a company-wide “radar screen” to make off-balance-sheet inventory visible; segment each item by risk of cash impact.
- Manage exposure, with different strategies for each type of potential liability.
- Negotiate at the corporate level with vendors to aggregate all potential liabilities.
- Leverage tradeables to defer cash outlay.
- Establish processes to monitor potential off-balance-sheet liabilities and to respond to problems as they arise.
To deal with off-balance-sheet inventory liabilities, companies must understand their magnitude and risk. Inventory liabilities that could require cash outlay range from “hard” to “soft.” “Harder” liabilities pose higher risk, are more difficult to negotiate, and generally have a shorter term than “softer” liabilities. In brief, harder liabilities cost more; softer liabilities can be negotiated down and possibly away.
Potential liabilities tend to move from soft to hard. If obsolescence and forecast reductions are not dealt with in a timely fashion, they can turn into claims. Still, it doesn’t make sense to go out and settle every potential liability claim.
The trick is to understand the threat and deal with it appropriately. Many potential liabilities will not turn into hard claims or may take a long time to do so. In those cases, it may be worth taking some risk to keep the cash. In some cases, the supplier doesn’t even realize that a liability exists.
Knowing and acting upon the aggregate liabilities from a supplier is critical. Otherwise, you are at risk of getting picked apart by the supplier through many claims spread over time and across your facilities. Although minimizing the payout is one objective of resolving potential liabilities, it should not be the overriding one. Gauge the balance between the health of your balance sheet and the health of the supplier and incorporate it into the negotiation. Look for “win–wins” that will preserve a positive relationship.
In high-tech manufacturing, conserving cash is a high priority. Heavy debt loads, stingy capital markets, and reluctant customers have made cash king. Paying out cash to settle contingent liabilities, even for a fraction of the original promise, could threaten your existence. Since your suppliers want you to continue to be a customer, they may be willing to entertain compensation other than cash.
Managing off-balance-sheet inventory liabilities should not be a one-time event. The tech bust created excess inventory as demand fell off faster and farther than ever experienced previously. However, more than ever before, the tech world has to pay close attention to managing supply chains to optimize inventory levels. Supply chain management is more critical in technology manufacturing for several reasons:
- The popularity of high-tech products and specific configurations has become increasingly unpredictable. Bigger bets are required to capture the upside.
- Outsourcing manufacturing to contract manufacturers and consignment programs shifts on-balance-sheet inventory to off-balance-sheet inventory.
- Traditional buyer–supplier agreements can create conflicting objectives and incentives that result in financial liabilities between layers in the value chain.
The best way to avoid off-balance-sheet inventory liability is to prevent it. Focus supply chain and product management processes on running lean rather than on scaling up. The recent past rewarded manufacturers with supply chains that could scale up and phase in new products quickly. The near future will reward those who run lean supply chains that are as flexible scaling down as up.
Ed Frey, [email protected]
Ed Frey is a vice president with Booz Allen Hamilton in San Francisco. He focuses on operations strategy, manufacturing, and supply chain transformation.
Steve Nied, [email protected]
Steve Nied is a principal with Booz Allen Hamilton in Chicago. He specializes in operations and performance improvement in the telecommunications and electronics industries.
Barry Jaruzelski, [email protected]
Barry Jaruzelski is a vice president with Booz Allen Hamilton in New York. He concentrates on corporate strategy and organizational transformation for companies in the high-tech industry.