Late Night Discussions
Number 5

by Dr. Eliyahu M. Goldratt

"It's amazing isn't it?"

"What is so amazing?" Jonah inquires, more out of politeness than real interest.

"The power of a guiding statement," I answer impatiently. Jonah's right eyebrow is moving upward, a clear indication that he doesn't have any idea what I'm talking about.

"The extent to which a nation can prosper just because it is determined to follow one concise statement," I fill him in.

"What's so amazing about it?" is Jonah's flat response. "A verbalized goal has always been one of the most powerful forces in the history of nations."

What can one say after such a comment? Giving up on the possibility of having a lively discussion tonight, my eyes return to the hypnotic dance of the flames in the fireplace.

Five minutes later Jonah breaks the silence, "Alex, what nation and what type of statement did you have in mind?"

"The Japanese, of course."

"Yes, of course. I should have remembered your fixation about Japan. So let me guess that the statement that you have in mind is not a statement of a goal, but some worn-out cliche, like ... 'eliminate waste'?"

"No Jonah," I smile. "I've already learned that if one concentrates on saving one cent here and another cent there the outcome is savings of two cents, no more. That's certainly not the way to make a fortune in industry."

Jonah doesn't seem convinced.

"The Japanese products are no longer the cheapest in the market place," I remind him. "On the contrary, they are quite expensive. Moreover, the salaries in Japan are considerably higher than the corresponding ones in Europe or the US and the currency exchange rate has swung significantly against them in the last few years. Thus the only reasonable conclusion is that their advantage cannot possibly be in the arena of concentrating on savings in operating expenses, but something that impacts the ability to raise throughput. 'Eliminate waste' cannot be the core statement. The statement that I had in mind is 'inventory is a liability'.

"Exactly as I thought," Jonah murmurs to himself. A little irritated I continue to force the issue, "The fact that the Japanese are religiously following this statement is, in my eyes, the key to their astounding success."

"Really?" Jonah asks.

How much I hate this word! When Jonah says it, in his Israeli accent, rolling the R and emphasizing the E, rrreeelee, he means, 'you are totally, utterly, decisively wrong, and you are going to fully realize it within the next few minutes.' This time he is wrong. This time he fell into my trap. I know what line of attack he's going to use and I'm ready to counteract.

"Yes," I confidently say. "In spite of what everybody is claiming, it's not 'quality!' and I can easily prove it. In the last few years the American and European manufacturers have closed the quality gap. For most products their quality level is on par if not superior, but nevertheless the trade imbalance continues to be tilted in favor of Japan, just as before. If this is not a decisive proof, I don't know what is. As I said, the thing that gives them the overwhelming edge is their strong conviction that 'inventory is a liability'," I conclude in a triumphant voice.

Jonah doesn't seem impressed, on the contrary, he seems to be actually amused. Something in my logic must be wrong, but where? With shakened confidence I'm waiting for his response.

"Alex, don't get excited," he says in a soft voice. "And especially don't dig yourself an emotional trench. I totally agree that quality, even though it's an important ingredient, is not the core of the Japanese success. But, if I'm not mistaken, the subject on the table is whether or not the attitude toward inventory is the core, or once again just an ingredient."

Seeing the expression on my face he hurriedly continues, "Please, don't tell me that you've already taken ownership of that statement. Don't forget that like 'quality!', 'inventory is a liability!' is also a statement claimed by everybody,

"Fine," I say. At the end, the fact is that I like my discussions with Jonah because the purpose is not to win an argument or to prove who's smarter, but to gain a deeper understanding of a subject. So I swiftly brush away irrelevant ego trips and anxiously wait to see how Jonah's logical scalpel will cut into this particular subject.

"I think that you would agree with me that it's unlikely that an erroneous statement could cause an entire country to prosper. We have suggested that the statement 'inventory is a liability' is the core for the Japanese success. Thus the minimum that we should do is to examine whether or not this statement is an erroneous statement."

"How do you suggest we approach it?"

"By asking, for example, a very 'innocent' question like: Is inventory actually a liability?"

"Makes sense" I agree. And then after a moment, "I still don't know how to proceed."

"I guess" Jonah says, "that we should start by clarifying to ourselves those things we usually call liabilities, and then it will be easy to distill the inherent property that causes us to refer to them as liabilities. Once this property is identified we'll just have to check if inventory has this property."

I nod my head in approval.

"What do we call liability? The only thing that jumps to mind right now is the joke about the bridge engineer and his mother-in-law. Better that you continue the analysis. Do you mind?"

"Not at all," I pick up the ball. "A loan to the bank is a liability, alimony is a liability, anything that we must do and we don't like to do is a liability. Liabilities are the chains around our necks. We are always delighted to get rid of liabilities. If my banker calls me tomorrow and asks me to allow the bank to erase my debts, you don't have to be a genius to predict my response. Unfortunately it's not very likely to happen. Where does it lead us? Oh, I see. Who is preventing us from getting rid of inventory? What prevents us from dumping them into the deep ocean tomorrow morning? Of course we don't even dream of doing it. No inventory also means nothing to work on and nothing to sell. How many times did I pray to have some inventory to satisfy a screaming customer. Besides, writing off inventories is equivalent to writing off valuable assets, that is stupid."

"Well, well." Jonah is laughing. "Don't tell me that you have succeeded to convince yourself that inventory is, all of a sudden, an asset."

"Why not, that is the category under which inventory appears on our balance sheet. And as we agreed a long time ago, at the end, the bottom line is what counts."

"Alex, are you serious?"

"No Jonah, just joking. Don't worry, I didn't convince myself that having more inventory is better. We know very well that excess inventory reduces the ability to compete in the market and thus reduces future throughput."

"So what is inventory? A liability or an asset?" Jonah asks.

"According to our analysis, inventory in general can't be either or. Thus the real question should be: when is inventory a liability and when is it an asset? To answer this question we should remind ourselves that the purpose of inventory is nothing but to protect throughput. At the same time we know that excess inventory jeopardizes the potential for getting more throughput. .Following these guidelines I think that it will not be too difficult for me to outline a procedure that can distinguish between the asset and liability parts of inventory. I think that it's important to establish such a procedure, especially in the light of circumstances that are changing so rapidly on our organizations. Why won't we devote one evening to discussing it?"

Jonah doesn't seems to be overly enthused.

"Come to think about it," I say after few minutes, "There is another very important related issue. Today, inventory is registered under the title assets on every company's balance sheet. If inventory is not always an asset, if we agree that a considerable portion of it is actually a liability, how should we handle the corresponding required change on the financial reports?

"Now you're talking." Jonah is involved again.

Enthusiastically I charge on. "If a company is getting rid of a liability, by reducing its excess inventory, it shouldn't have a negative effect on the bottom line but a positive one. Yes, the required change has severe implications."

"Like?" Jonah is encouraging me to continue.

"Like the ramifications on Wall Street evaluations and thus on the top managers of companies whose shares are traded on the stock exchange. Like the impact on companies who owe money to the banks. And not less important--the implications on taxes."

"Well," Jonah says "maybe we should devote a night to discuss those issues."

"Definitely. But Jonah, first I would like to wrap up our original topic. I was quite convinced that I had found the core of the Japanese success, but now I see that it was just another ingredient. Let's summarize where we stand. We know that it's not cheap labor, it's not favorable currency rates, it's definitely not government aid or custom barriers. What we have concluded tonight is that it's not the drive to 'eliminate waste', 'quality' or the drive to 'reduce inventory' - they are all important ingredients but not the core. But what we do know is that the core is something that relates to the ability to constantly increase throughput."

"Yes Alex, that we do know. Do you have any idea what it is."

"Not even a clue," I admit. "What I do have is a fast-developing headache."

"I take it as a hint that we've had enough," Jonah gladly agrees.

"Frankly, yes. But give me at least a clue, give me something to hang onto so I can continue to think about it on my own. Not tonight that is."

"My speculation is," Jonah responds, "that the Japanese have broken out of the mold of cost accounting to the extent that they understand that product price is a concept that was derived from product cost plus margin. What they probably realize is that since the notion of product cost no longer applies to our reality, the notion of a fixed, given product price is also devastating."

"You call that a clue!?"

This "Late Night Discussion" is Copyright © 1991 Dr. Eliyahu M. Goldratt