Serial killer! How to lose business by the wrong serial numbers

Serial numbers and losing business

Here's a story about how something innocuous and low-level like serial numbers can damage your reputation and lose you business. I have advice on how to avoid the problem too!

(Serial numbers can give away more than you think. Image source: Wikimedia Commons. License: Public Domain.)

Numbered by design

Years ago, I worked for a specialty manufacturing company, its products were high precision, low-volume, and expensive. The industry was cut-throat competitive, and commentary in the press was that not every manufacturer would survive; as a consequence, customer confidence was critical.

An overseas customer team came to us to design a specialty item. The company spent a week training them and helping them design what they wanted. Of course, the design was all on a CAD system with some templated and automated features. That's where the trouble started.

One of the overseas engineers spotted that a customer-based serial number was automatically included in the design. Unfortunately, the serial number was 16, implying that the overseas team was only the 16th customer (which was true). This immediately set off their alarm bells - a company with only 16 customers was probably not going to survive the coming industry shake-out. The executive team had to smooth things over, which included lying about the serial numbers. As soon as the overseas team left, the company changed its system to start counting serial numbers from some high, but believable number (something like 857).

Here's the point: customers can infer a surprising amount from your serial numbers, especially your volume of business.

Invoices

Years later, I was in a position where I was approving vendor invoices. Some of my vendors didn't realize what serial numbers could reveal, and I ended up gaining insight into their financial state. Here are the rules I used to figure out what was going on financially, which was very helpful when it came to negotiating contract renewals.

• If the invoice is unnumbered, the vendor is very small and they're likely to have only a handful of customers. All accounting systems offer invoice generation and they all number/identify individual invoices. If the invoice doesn't have a serial number, the vendor's business is probably too small to warrant buying an accounting system, which means a very small number of customers.

• Naive vendors will start invoice numbering from 1, or from a number like 1,000. You can infer size if they do this.

• Many accounting systems will increment invoice numbers by 1 by default. If you're receiving regular invoices from a vendor, you can use this to infer their size too. If this month's invoice is 123456 and next month's is 123466, this might indicate 10 invoices in a month and therefore 10 customers. You can do this for a while and spot trends in a vendor's customer base, for example, if you see invoices incrementing by 100 and later by 110, this may be because the vendor has added 10 customers.

The accounting tool suppliers are wise to this, and many tools offer options for invoice numbering that stop this kind of analysis (e.g. starting invoices from a random number, random invoice increments, etc.). But not all vendors use these features and serial number analysis works surprisingly often.

(Destroyed German Tank. Image source: Wikimedia Commons. License: Public Domain)

The German tank problem

Serial number analysis has been used in wartime too. In World War II, the allied powers wanted to understand the capacity of Nazi industry to build tanks. Fortunately, German tanks were given consecutive serial numbers (this is a simplification, but it was mostly true). Allied troops were given the job of recording the serial numbers of captured or destroyed tanks which they reported back. Statisticians were able to infer changes in Nazi tank production capabilities through serial number analysis, which after the war was found to be mostly correct. This is known as the German tank problem and you can read a lot more about it online.

Simple things say a lot

The bottom line is simple: serial numbers can give away more about your business than you think. They can tell your customers how big your customer base is, and whether it's expanding or contracting; crucial information when it comes to renegotiating contracts. Pay attention to your serial numbers and invoices!

Inventory: your job may depend on how it's managed

Why should you care about inventory?

For your own job security, you need to understand the financial position of your employer; their true financial position will govern your pay and promotion prospects. Long before they affect your job, you can spot looming signs of trouble in company financial statements. Learning a little of accounting will also help you understand news stories as we'll see. In this blog post, I'm going to talk about one of the easiest signs of trouble to spot, inventory problems. Because it's always fun, I'm going to include some cases of fraud. Bear in mind, innocent people lose their jobs because of inventory issues; I hope you won't be one of them. 

(Is inventory good or bad? It depends. Image credit: Wikimedia Commons. License: public domain.)

Inventory concepts

Inventories are items held for sale or items that will be used to manufacture products. Good examples are the items retailers hold for sale (e.g. clothes, food, books) and the parts manufacturers hold (e.g. parts for use on a car assembly line). On a balance sheet, inventory is listed as a current asset, which means it's something that can be turned into cash 'quickly'. There are different types of accounting inventory, but I won't go into what they are.

Inventory changes can be benign but can be a sign of trouble. Let's imagine a bookseller whose inventory is increasing. Is this good or bad?

• If the bookseller is expanding (more sales, more shops), then increasing inventory is a sign of success.
• If the bookseller is not expanding, then increasing inventory is deeply concerning. The bookseller is buying books it can't sell.

There are two ways of valuing inventory, which opens the door to shenanigans. Let's imagine you're a coal-burning power station and you have a stockpile of coal. The price of coal fluctuates. Do you value your stockpile of coal at current market prices or the price that you paid for it? There are two ways of evaluating inventory: FIFO and LIFO.

• FIFO is first-in, first-out - the first items purchased are the first items sold. Inventory is valued at current market prices.
• LIFO is last-in, first-out - the last items purchased are the first items sold. Inventory is valued at historic market prices.

If prices are going up, then LIFO increases the cost of goods sold and reduces profitability, conversely, FIFO reduces the cost of goods sold and increases profitability. There are also tax implications for the different inventory evaluation methods. 

Obviously, things are more complex than I've described here but we have enough of the basic ideas, so let's get to the fraud stories.

Inventory shenanigans

OM Group produced specialty chemicals from raw materials, including cobalt. In the early 2000s, cobalt was mostly sourced as a by-product from mines in the Democratic Republic of the Congo, a very unstable part of the world. The price of cobalt was going down and OM Group saw a way of making that work to their advantage. Their first step was to use the LIFO method of valuing their cobalt inventory. The next step was to buy up cheap cobalt and keep buying as the price dropped. Here's what that meant; because they used LIFO, for accounting purposes, the cobalt they used in production was valued at the new (low) market price, so the cost of goods sold went down, so profitability went up! The older (and more expensive) cobalt was kept in inventory. To keep the business profits increasing, they needed the price of cobalt to go down and they needed to buy more of it, regardless of their manufacturing needs. The minute prices went up, or they started eating into inventory, or they stopped buying more cobalt, profitability would fall. To put it simply, the boost to profits was an accounting shell game.

OM Group logo at the time. Image credit: Wikimedia Commons. License: Public Domain.)

As you might expect, the music eventually stopped. The SEC charged some of the executives with fraud and reached a settlement with the company, and there was a class-action lawsuit from some company investors. Unsurprisingly, the company later changed its name when the dust settled. If you want to understand how you could spot something like this, there's a very readable description of the accounting fraud by Gary Mishuris, an analyst who spotted it.  

Manufacturing plants run best when producing at a constant rate, but market demands fluctuate. If demand reduces, then inventory will increase, something that will be obvious in a company's financial statements. How can a company disguise a drop in demand? One illegal way is through something called 'channel stuffing', which is forcing your distributors and resellers to take your unsold inventory so you can record it as sales. 

Semiconductor companies are manufacturers and typically have large distribution networks through resellers covering different geographies or markets. For example, a semiconductor company may sell directly to large electronics companies but may serve smaller electronics companies through resellers, who may, in turn, resell to other distributors and so on.

Between 1995 and 2006, Vitesse Semiconductor used channel stuffing extensively to manage its earnings. It had an arrangement with its distributors that they could unconditionally sell back any chips they had bought and not sold. Here's how channel stuffing worked; if Vitesse needed to increase profits in a quarter, they would require their distributors to buy Vitesse' inventory. This would show up as an increase in Vitesse's sales for that quarter. At some point in the future, the resellers could sell the chips back to Vitesse. The chips themselves might never leave the warehouse, but might have been 'owned' by several different companies. In other words, short-term increases in profitability were driven by an accounting scam.

(Vitesse Semiconductor chip. Image credit: Raimond Spekking via Wikimedia Commons. License: Creative Commons)

Of course, this is all illegal and the SEC took action against the company; the executives were indicted for fraud. Vitesse had to restate their earnings substantially downwards, which in turn triggered a class action lawsuit. This fraud has even made it into fraud textbooks.

I want to stop for a minute and ask you to think. These are entertaining stories, but what if you were an (innocent) employee of OM Group or Vitesse Semiconductor? When the SEC arrests the leadership, what are the implications for employees? When the accounts are restated and profitability takes a nose dive, what do you think the pay and job prospects are like for the rank-and-file workers?

Inventory and politics - Brexit

A while back, I was chatting to a Brexit supporter, when a news report came on the TV; UK economic output had increased, but the increase had gone into inventory, not sales. Manufacturers and others were assuming Brexit would disrupt their supply chain, so they'd increased output to give them a buffer. I was horrified, but the Brexit supporter thought this was great news. After chatting some more, I realized they had no understanding of how inventory worked. Let's talk through some scenarios to understand why the news was bad.

• Scenario 1: no Brexit supply chain disruption.  UK firms have an excess of inventory. They can either keep the inventory indefinitely (and pay higher costs than their overseas competitors) or they can run down inventory which means fewer hours for their workers.

• Scenario 2: Brexit supply chain disruption.  UK firms can't get parts, so they run down inventory until supply chain issues are fixed. Selling inventory means fewer hours worked by the workers.

In both scenarios, UK firms have incurred production costs earlier than their overseas competitors, which reduces their cash flow.

(Image credit: Wikimedia Commons - Tim Reckmann. License: Creative Commons.)

This is obviously highly simplified, but you get the point. None of these scenarios are good for firms or for workers.

If increasing inventory without sales is so good, why don't firms do it all the time? In fact, why bother with the pesky business of selling at all when you can just produce for inventory? The question seems silly, but answering it leads you to consider what an optimum level of inventory is. The logic pushes you towards just in time, which leads to an understanding of why supply chain interruptions are bad.

Closing thoughts

Your job security depends on the financial stability of your employer. If you work for a company that produces public accounts, you have an opportunity to make your own risk assessment. Inventory is one factor among many you should watch. Here are some things you should look out for:

• Changes to inventory evaluation methods (LIFO, FIFO).
• Increases in inventory not matched to growth.
• Increasing sales to distributors not matched to underlying market demand (especially when the inventory never leaves the company).

Yes, some companies do produce fraudulent accounts, and yes, some do hide poor performance, but you can still take steps to protect your career based on the cold hard reality of financial statements, not on hype.