Snorkeling To Manufacturing Extinction

Everyone knows the analogy Ohno used to describe inventory – that it is represented by the water level in a river full of rocks.  Lean manufacturers seek to constantly lower the water level to expose the rocks, which represent all of the hidden costs and waste in production.  MRP, on the other hand, is a system designed to assure that there is always adequate water to keep the rocks covered.  It is disheartening, to say the least, to realize how far from Ohno’s thinking the financial community and the politicians are.  They not only want enough inventory to cover the rocks, they view it as a sparkling recreational lake, perfect for all sorts of sports and games.

Someone in the Senate foolishly tried to make one of their favorite water sports illegal, and NAM went ballistic.  The President promised to veto the new rules. The S Corporation Association of America is up in arms.  They claim to be "exclusively devoted to promoting and protecting the interests of America’s 3.2 million S corporation owners"  Apparently all 3.2 million of them thoroughly enjoy jet skiing on Lake Muda.  Even the Helicopter Association jumped into the fray.

What’s the big deal? LIFO

LIFO – short for "Last In First Out", is an inventory accounting method that is really nothing more than a tax dodge for lousy manufacturers.  Someone in the Senate had the nerve to include the repeal of LIFO in a recent spending bill, bringing immediate lobbying thunder down upon the head of Majority Leader Bill Frist.  The distinguished gentleman from Tennessee, of course, jerked LIFO repeal from the bill just as quickly as the lobbyists jerked the string they have tied to his wallet.  LIFO repeal is not completely dead, however, Senator Charles Grassley from Iowa is curious about it and has promised to bring it up for a little further study.  So the aforementioned  organizations, and many more, are mobilizing the troops to bury the Senate under an avalanche of Bovine Scatology, or B.S. for short, demanding that LIFO remain part of the American manufacturing fabric.

To give you a little background, LIFO was originated back in 1939, but really got its legs when it was pushed in the 1960’s and 70’s by a cat named Herbert McAnly who was so wound up on the subject, he is referred to in accounting circles as ‘Mr. LIFO’ – he may have even had that put on his tombstone, for all I know, so that future generations of McAnly’s can see what sort of stock they come from.

The idea behind LIFO is this: Let’s say you have one widget in inventory and it cost you $6 to make.  Then you make another one, but this one costs you $7.  Then along comes some customer looking for a widget and you sell him one for $10.  If you have a lick of sense and know the first thing about inventory management, you give him the old one and keep the newer one for the next customer.  Stock rotation is Inventory 101.  According to Mr. LIFO, however, which one you give him really doesn’t matter.  You write off the cost of last one you made, and carry the remaining one on the books for $6, even though it is actually the one that cost you $7.

The benefit to this sort of convoluted logic is that, by writing off the $7 widget, your profit was only $3.  Had you written off the one you really sold, your profit would be $4.  With only a $3 profit, your income taxes are lower.  That should bring up a couple of immediate questions in your mind:

Doesn’t it hurt these companies to have lower profits?  Not really, because the amount they took away from profits in order to pay lower taxes is always prominently footnoted in the financial statements with wording something like "Our $3 profit includes a $1 LIFO adjustment (wink, wink)"  That way all of the folks on Wall Street know that the company really made $4, but used a dollar of it to scam the IRS – a sign of good management to the boys and girls on the Street.

But how can they get away with swapping the cost from one unit to another – shouldn’t the cost of the one they sold to a customer be the cost they reflect on their books?  That’s where the inherent ignorance of manufacturing people shows through.  You are so simple minded that you think the inventory on the company balance sheet has something to do with all that stuff piled up in the warehouse.  A couple of guys from the University of Wisconsin named Blakely and Knutson explained all of this way back in 1963.  They wrote in the Accounting Review that "… accounting is being made for a flow of costs, not goods.  If this latter point were more universally understood, much misunderstanding concerning LIFO could be eliminated, particularly those objections raised that LIFO does not conform to the actual flow of goods and therefore is artificial and invalid."  In other words, the numbers never had anything to do with reality and the sooner you manufacturing rubes figure that out, the sooner we can all get on with the serious business of making money on paper, rather than in factories.

Here are the best arguments for LIFO the Metals Service Center Institute was able to come up with as ‘talking points’ to bring to your Senator or Congressman’s attention:

1. LIFO has been around since the 1930’s

2, The Accounting community is not even thinking about getting rid of LIFO

3. Manufacturers who use LIFO would have to pay higher taxes if it were eliminated

These points are so lame they could have hauled out the old 1963 explanation and made a stronger case.

Here’s the bottom line on all of this:  I like a good tax dodge as well as the next guy.  In fact, since I asked Eric Husman which brand of ale leads to the most creative blogging, and he responded with a fine selection, I plan to write off every nickel I spend on beer this year as a business expense.  However, LIFO is not just a tax dodge, it is very much an anti-lean manufacturing policy.  If the widget in stock cost you $6, the next widget you put in is supposed to cost $5 – not $7.  Effective manufacturers are continuously driving costs down – not up.  Giving a tax break to manufacturers whose cost are continuously increasing, but not manufacturers whose costs are continuously decreasing, rewards bad manufacturing.

For that matter, government policy should be creating incentives for the best manufacturing practices, which means getting rid of inventory.  Instead, inventory is being perpetuated as nothing more than an accounting cesspool, and weak manufacturing management’s first choice of accounts in which to play games to manipulate the bottom line.

In Rebirth of American Industry, I wrote, "The history of manufacturing accounting since the Japanese wake up call in the 1970’s reads more like a computer technology history than anything to do with accounting.  The greatest improvement accounting historians can point to since 1973 is that accounting can now be done with spreadsheets.  The actual financial thinking response from accounting since American manufacturing came under siege has been silence.

The managers of the publicly held manufacturers are in a global fight for survival armed with a fifty year old accounting tool that never worked right in the first place.  There is no wonder they are losing and their efforts to function like Toyota fail."

This is just one more example of accounting’s failure to support manufacturing.  If the accounting community would put half the effort into devising ways to provide manufacturing with timely, accurate cost information that reflects crucial matters like the cost of quality and the invesment benfits from flexible machines that they put into convoluted schemes like LIFO, manufacturing would make so much money they wouldn’t need the paltry tax savings they get from twisting inventory accounts into pretzels.

Maybe Grassley will succeed in getting all of this out in front of the public.  After all, he is a pretty straightforward guy and Iowa is at the front of the lean manufacturing pack.  It would be remarkable when the hearings begin if he would get the opinions of people like Jim Womack and Ross Robson, rather than to simply listen to the likes of NAM and the other lobbyists, and the professional financial community.  This is a manufacturing issue – not a financial issue – and it calls for manufacturing input.

Don’t hold your breath though, unless of course you are planning to snorkel high above the rocks with Messrs. Bush and Frist, and the NAM staff while American manufacturing drowns below you at the bottom of Lake Muda.

Back in the 1960’s and 70’s, when double digit annual inflation was the norm, most manufacturing costs went up every year regardless of management efforts and there may have been some thin justification for LIFO.  Those days are long gone, however.  Now only incompetent managers face cost increases on almost every product every year and need LIFO.