VMI and Off Balance Sheet Obligations

Recently, a consultant from Thrive Technologies posted a simple blurb on the LinkedIn APICS Group Page, “Why inventory turns is not a good metric!” As questions go it seemed a bit obvious but to my surprise it created 42 thoughtful and passionate responses. What struck me most from the discussions was many if not all folks responding to the question were mum on inventory obligations outside the four walls of their respective business.

Sarbanes Oxley requires corporations to disclose off balance sheet obligations. With the rapid adoption of Lean Manufacturing and subsequently Point of Use and Kanban Systems off balance sheet obligations are growing at a commensurate rate. Should these obligations be included in inventory turn calculations? Our view is that they should. (Below you can read the details of the regulations).

Our experience shows many companies with VMI solutions significantly underestimate their off balance sheet obligations. We have found that many suppliers even make it hard for the customer to know what the real obligation is. Often time it bubbles to the surface as a defensive tactic by the supplier when a customer desires to make a change.

We recommend you work with the suppliers of your VMI programs to disclose all non-cancelable non-returnable inventories carried on your behalf to support the VMI and have a formula in place to calculate agreed inventory levels. The formula should include but not limited to demand over lead time, MOQs, lot sizes, safety stock and manufacturers lead time. If they do not comply it’s time to look to others that will.

Should the off sheet obligation (i.e. non-cancellable and non- returnable) be counted in Inventory Turns? We think so what about you?

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Section 401a (off-balance-sheet obligations disclosure) is an addition to the Securities Act of 1934. Section 401a requires disclosure of "material off-balance-sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer [that is, the company itself, an issuer of securities] with other entities or persons" if these arrangements may have a current or future material effect on the firm's financial condition, operations, and so on.

This particularly affects service contracts, such as those typically written with ocean carriers and vendor managed inventory (VMI) arrangements undertaken to hedge risk and move assets off the balance sheet. Increasingly, businesses that adopt VMI practices to reduce current inventory assets may include some form of penalty clause in their contracts for failure to use materials or early cancellation of agreements, and Section 401a clearly requires time-phased listings of these potential obligations. Also, market conditions might change and cause firms to cancel long-term purchase agreements with suppliers, with cancellation penalties or restocking charges as a result. SOX requires enterprises to outline the precise details of these potential charges and penalties. Along similar lines, companies must report and document any early termination or cancellation fees in any lease agreements or letters of intent (which are sometimes used to aid with delivery schedules and manufacturing lead times for critical items).