Accounting Best Practices, Fifth Edition

16–36. Shift Raw Materials Ownership to Suppliers

The raw materials portion of a company’s inventory can consume a major part of its working capital investment, money that could otherwise be used for other activities. Also, the occasional purchase of excessive quantities of stock will eventually result in a large proportion of the inventory being obsolete. Manufacturing companies will find that these are particularly large problems that have a major impact not only on cash flow but also on profits.

One way to mitigate the adverse effect of raw materials inventory is to shift its ownership to suppliers. Under this scenario, suppliers deliver goods to the company in whatever quantities they want, above a designated minimum, as long as they do not exceed the physical storage area set aside for their use. The company logs these items out of the storage area when it uses them and pays the supplier for the amounts used. This has the obvious impact of eliminating a company’s investment in raw materials, and shifts the burden of obsolescence to the supplier. In exchange, the supplier obtains a single-source contract with the company, ensuring itself of sales for at least one year and possibly for several, and using a pricing schedule that both parties have agreed to in advance. In addition, the supplier can park extra inventory at the customer location, thereby avoiding the cost of just-in-time deliveries.

Unfortunately, there are several problems with this best practice that limit its ...