When valuing inventory under any failure concept, there are specific areas considered ineligible by the appraiser. These areas are classified as such due to their proprietary nature, lack of compatibility and/or alternative use and factors related to all forms of depreciation, e.g., physical deterioration, functional and economic obsolescence. The starting point of consideration between the appraiser and the lender is equal. However, if the lender advances against each of the ineligible areas defined by the appraiser, the exposure between that advance and the appraiser's opinion of value becomes extreme.
There are valid reasons for classifying areas of inventory such as printed or special packaging, work-in-process, slow-moving and obsolete as ineligible or exempt. Conversely, there are instances within each of these areas where value consideration can be given. Examples of this would be:
1. Packaging materials tend to be proprietary in nature concerning name identification and designs specific to a product. However, there are items within this area of most inventories that are not proprietary in nature or subject of factors of depreciation. These areas include off-the-shelf packaging materials such as standard size boxes, containers, protective wrapping, and filler.
2. Work-in-process within each company's inventory is typically assigned as ineligible due to that product being in an unfinished stage of completion within its manufacturing process. This, by definition, would exempt classification of these products from finished goods. However, it is likely, there would be items contained within this area that could be anything, at one time, or another has been inventory. Therefore, what is considered work-in-process to one company could be considered a finished good to another. This would relate to purchased parts that are not designed for a specific use and are standard to the industry. Though there are many examples, a few could be burners for oil and/or gas fired boilers, lawn mower engines and standard wired motors.
3. Slow-moving inventory as it relates to a specific company is any inventory that cannot be disposed of by that company within a period of one year. This measurement is made by the appraiser through an analysis of the company's past sales history and its respective industry. However, slow-moving inventory is not always such due to limited market acceptance, demand or some form of depreciation, but rather due to factors related to bad management or lack of operating capital. Also within one company, slow-moving inventory may move better in another where the product or area has greater demand.
4. Depreciation:
a. Physical deterioration is an element that has an impact on value to certain types of inventory. An example of this could be inventories that are subject to a limited shelf life such as film paper, chemicals, liquids, pharmaceuticals, and perishables. In addition, the storage may cause inventory to age faster, rust, or oxidize.
b. Functional obsolescence is relative to factors that are inherent to an item such as inadequate design and construction, size, lack of compatibility and/or alternative use (is it standard to the industry), and changes in technology. This is especially prevalent in high tech areas such as computer.
c. Economic obsolescence is relative to factors that are external to an item such as imposed governmental regulations, industry swings, and reputation. Within economic obsolescence, there are three areas of consideration. These areas are item specific, business specific, and industry specific.
Concerning the manufacturing of inventory, it is not always smart to be clever. There are instances where extreme efforts to stay ahead of competition can cause a company to lose its competitive edge due to changes in acceptance. This is best demonstrated in the apparel industry as it relates to what would be considered faddish clothing styles, and materials. It has also been demonstrated in the past by computer, and software manufacturers who manufactured products that were not compatible to the users. As it turned out, companies who used this strategy were affected by their lack of compatibility due to the wave of data transfer, and communication through network interfacing.
There are many factors of consideration when analyzing the most proper method of disposing of an inventory. These considerations, to name a few, include
1. timing,
2. market reaction (acceptance),
3. presentation,
4. potential buyers,
5. absorption rate (supply and demand),
6. seasonal recovery,
7. where, when, and how.
There are factors of consideration that would alter the method of disposal such as the nature of inventory, e.g., manufacturer, wholesaler, distributor, or retailer. Some issues that would be addressed by a liquidator include
1. Should the work-in-process be completed to achieve a higher net recovery?
2. Is the inventory in balance?
3. Is the mix of inventory conducive to a successful auction sale, or would it be better disposed of under orderly conditions?
4. Is the inventory specialized and/or specific enough to require seasonal recovery?
An example of the nature of inventory having an impact on recovery could be a chain of shoe stores. If a company were to liquidate an inventory of shoe stores with multiple locations, there would be two methods of disposal to consider. The first and less desirable method of consideration would be to relocate all inventory contained within each store to one location for disposal. When looking at this method of disposal, an experienced liquidator would recognize the negatives to net value recovery that would occur. The second and most desirable method of disposal would be to liquidate the inventory at each store, on a retail basis, at a reduced price. In this instance, the most likely result would be a recovery greater than historical cost to the owner. This example brings to light the fact that value recovery of inventory is not always less than cost. However, the net recovery can be below cost due to the expense required to conduct such a sale without replenishment.
An example of disposing of an inventory during a specific season having a negative impact on value would be an inventory related to a seasonal activity such as golf. For instance, disposing of an inventory of golf supplies during off-season in the northeast would most likely result in a lower recovery than that which could be achieved during the seasonal months. Additionally, this would be another example of an inventory that would best be disposed of in a retail situation, at a reduced price.
Giving consideration to absorption rate (supply and demand) somewhat dictates the time required for disposal. This is due to the possibility that flooding the market of any one item distinctly drives down the price of recovery.
As cost of an inventory is the foundation of value assignment by the appraiser, it is imperative that the appraiser determines, to the best of his ability, if the indicated standard cost is in line with what is reasonable to the industry (over/under) and whether this cost contains any favorable and/or unfavorable price variances related to burden, buying, and/or accounting practices. In instances where definable standards do not exist due to purchasing, and/or accounting practices, there are methods available for adjusting indicated cost to that which is standard for the industry. One method for making this adjustment is through statistical sampling. To achieve a statistically correct sample, the appraiser must first define the population to be sampled, and then determine the tolerance level. The tolerance level is assigned according to the confidence interval the appraiser determines is appropriate, which is influenced by the characteristics of the respective inventory. For instance, a large inventory with wide variances in price would warrant a low tolerance assignment, whereas, a small inventory displaying a narrow variance in price would not require such a strict tolerance assignment. An inventory such as this would be best valued on an individual basis, and not through statistical sampling.
When statistically sampling an inventory, the priority is to select a random sample of the population to capture a reasonable cross section. This is accomplished when the rolling standard deviation begins to stabilize, and decline, which typically occurs in a sampling of fifty items. An example of tolerance levels, and confidence intervals would be if a 10% tolerance level were required and/or desired, that would dictate a tolerance level of no more or less than 10% of the rolling mean. Subsequently, the rolling standard deviation (range) could be no more or less than 5% of the rolling mean, which achieves a 95% confidence interval or a 10% tolerance. This means that 95% of the time, the average of rolling mean of the population will fall within the calculated confidence interval. This method is best applied when there is no definable standard cost. However, the appraiser must never lose sight that there must always remain a human element of decision in value assignment.
Some questions asked during a recent presentation given to a group of bank examiners and asset-based lenders were
1. How does a license agreement affect the sale and value of recovery of inventory?
2. If a large quantity of inventory has been purchased due to price incentive, how does the appraiser consider the amount that would remain beyond a one-year sales history?
3. What is the difference between slow-moving and obsolete inventory?
4. To address the first question, values reported by the appraiser are gross estimates with the assumption that the inventory being valued is free and clear of all leans, and encumbrances. A license agreement is not typically subject to transfer and, therefore, would consider the inventory ineligible by the appraiser if an investigation revealed this restriction. However, such agreements vary in content just as lease agreements. An appraiser is not a lawyer and may classify such an inventory as ineligible due to such an issue being beyond the realm of that appraiser's expertise.
Large quantities of items that have been purchased due to price incentives that could not be sold by the company within one year are not automatically ineligible. However, a situation such as this would bring up issues such as absorption rate (supply and demand), which would lead to a lower value assignment. This is due to the fact that the liquidator could assume the sale of the whole for one price. In other words, as the items are the same, quantities that could be sold by the company within one year would not bring a different price than that which could not be disposed of in that period.
As addressed above, inventory is primarily slow-moving due to some form of depreciation. Therefore, slow-moving inventory is, in effect, obsolete due to physical restrictions, and/or characteristics inherent in or external to the items. Recovery of items within this classification would be extremely volatile. Therefore, in the appraiser's opinion, the value is affected to such an extent that, although these items are addressed in the study, they may not be included as part of the value assignment. This is due to the appraiser not being in the position to measure the inherent potential financial risk to the lender.
The issue at hand is recovery, and though it may have been standard practice in the past, it is no longer feasible for a lender to advance a set percentage against inventory, without an analysis of that inventory by those who have the background, and experience to do so. That analysis is typically done by an appraiser who is schooled in value assignment, and marketing methods that are necessary to achieve that stated value. Such an expertise is what separates an appraiser from an auditor or accountant. This is not to say that each does not have a position within inventory analysis, it merely points out that each professional's purpose is different.
