The Manufacturing PMI and Inventory Levels Provide Clues for Q1 2023
Once the supply chain issues of 2020 and 2021 started to relieve in 2022, businesses began experiencing higher overall levels of inventory. In part the increased levels of inventory were a result of moving away from just in time inventory methods, but suppliers also began filling purchase orders that had been outstanding for some time, which may have unexpectedly increased the investment in inventory. The intentional and unintentional increase in inventory stressed cash flow and working capital management, and stressed asset-based lines of credit.
A large logistics firm, DP World, and Bloomberg published the following chart showing the boosting of inventory in 2022. The number of companies utilizing just in time inventory methods or less than 4 weeks sales on hand has decreased.
Surveys conducted by DP World showed companies are holding 10.1 weeks of inventory in 2022 compared to 8.9 weeks in 2021.
The Manufacturing PMI®
The Institute for Supply Management (“ISM”) publishes the Manufacturing PMI® report monthly. The December data from survey respondents reported that:
New orders and production are contracting.
Backlogs are contracting.
Supplier deliveries are faster.
Raw material inventories are growing.
The December Manufacturing PMI® was 48.4%, compared to 49% in November. The contraction in the PMI® was the first monthly decrease after thirty months of expansion. In fact, the Manufacturing PMI® in December was the lowest since May of 2020 when the PMI® was 43.5%.
The survey respondents indicated new orders have been slowing for the past seven months, and that companies are slowing their output. Respondents continued to identify labor issues both from a skill perspective and availability of candidates’ perspective. Other respondents indicated they are managing their labor force through hiring freezes, employee attrition and layoffs.
Certain sectors are feeling more supply and labor issues than others, but overall, the December contraction reports a turn from the growth experienced since the pandemic recovery began. This link will allow you to read the entire ISM report for December.
What does this mean?
Companies are continuing to deal with multiple challenges as they forecast 2023 performance and manage their cash flow and operating cycle.
Labor. Businesses are feeling contraction in orders but remain concerned about retaining a skilled labor force. This results in the temptation to limit work force reductions, which keeps manufacturing and operating costs higher. We typically consider labor expenses more a fixed cost than a variable cost because you cannot reduce .5 or .2 of a person, and there is a step function related to staffing production lines, shifts, etc.
Supply Chain. There are some sectors that are continuing to have trouble receiving the goods needed when they are needed, but much of the supply chain issues have been solved. Container costs are back to pre-Covid levels and orders have been filled. Many companies have experienced higher inventory levels because multiple orders were received at the same time once the supply chain issues lessened.
Changing Consumer Demand. Businesses that placed orders based on the remote work and pandemic world are finding themselves with an over supply of the wrong inventory.
Inflation. Costs are increasing. The CPI for the two years ending December 2022 shows a 14% increase over December 2020 levels. The PPI for the two years ending December 2022 shows a 16.5% increase over the period. This means a business may be experiencing operating margin impacts resulting from cost increases in the 14% to 16.5% range.
During 2023 the combination of inflation coupled with labor, supply chain, and demand will continue to cause upheaval. At the same time interest rates have increased with prime rate now at 7.5%, compared to 3.25% a year ago. A business with a $20 million line of credit tied to prime rate could be looking at a $750,000 increase in interest expense in 2023, compared to just a year ago.
Financial forecasting for 2023 needs to be reviewed considering these challenges. Sensitivity analysis and best case / worse case analysis should be prepared. A business can manage through challenges but only if the problems are identified and discussed. This occurs by utilizing budget to actual reporting in real time – preferably with a weekly cash flow and working capital forecast.
Financial management and planning will be key to successful performance in 2023!