Factors for Taking a Financial View of Your Inventory

Inventory is the largest balance sheet asset in your business.  It’s obvious:  If your margin is 50 percent, that means your cost of goods is 50 percent; in other words, 50 percent of your net sales are spent on inventory and inbound freight.  But if it’s obvious that inventory is so important, why aren’t we more aggressive in dealing with it?  Why don’t we do more to liquidate aging inventory?  Why don’t we look at how to achieve the optimal balance point between high order fill rate and increased inventory?  Owners and senior management need to take a fresh look at their financial approach to measuring and managing inventory.  Let me give you a few examples:

• One of our consulting clients has $550 million in annual sales, 135 stores and a b-to-b catalog and e-commerce business.  We had designed a warehouse which was to last five years.  Three years into its life, they called to say they were running out of space.  Our analysis of the 17,000 products in inventory showed that 60,000 sq. ft. of the 350,000 sq. ft. total was tied up in obsolete and inactive inventory.  This was news to them; their inventory management system did not focus on age of inventory or fast and slow sellers, and they did not have a continuing inventory process for liquidating slow moving items.  Among those in top management (who did not have experience managing inventory), the feeling was that there really wasn’t such a thing as inventory carrying cost.  Their attitude was, “We’ve already paid for the inventory and we own the warehouse outright.”  But they didn’t take into account the cost to prematurely expand ($2.5 to $3.0 million); opportunity costs for doing something else with invested capital; taxes and insurance; and labor to maintain the inventory.  All this amounts to a sizable expense.

• Two other clients for whom we recently completed inventory assessments face problems typical of many multichannel companies.  The vendor minimums to purchase a particular SKU are so high, and the lead time is 18 to 22 weeks, that it means the multichannel company is pushed into buying inventory levels equivalent to several seasons online or appearances in a catalog, and ending up with overstocks.  In most companies, two thirds of all products either break even or lose money.  New products with no selling history are even riskier; you could be off plus or minus 40 percent. With all this risk, companies must have an ongoing approach for liquidating slow sellers.

• At a fourth company, there is a real disconnect between what ownership says they think inventory metrics are and what the actual turns out to be.  When asked how they define old inventory, turns, or initial fill rates, they didn’t have the metrics reported weekly and monthly.  Here is a sampling of the disconnect:

• Old stock is defined as 15 weeks, yet 13% of dollars and 16% of the units, or $3 million, is more than 180 days old.
• They want to achieve 4 turns annually, but after 6 months the turn is 1.8 annually.  Fall season would have to be really fast turnover to reach their objectives.
• Their initial order fill rate, based on 4 days from order placement (rather than the customary 1 day), is 82%, and they want to target 90% in 2 days’ time. 

This isn’t just a disconnect; management is setting or picking goals without measuring and reporting inventory performance. 

The bottom line is, there is plenty of room for improvement in how inventory is managed in the multichannel industry.  Here are ten steps that will allow you to deal with inventory more aggressively and make more profit.

1. Get a handle on inventory status and condition.

Most direct companies use their order management system for inventory control.  But top management is not a user of these systems.  What they use to monitor inventory status may be a summarized or Excel-based report.  Companies need to have a “single version of the truth” for all data: sales, inventory, purchases, stock on hand, etc., including plans and actual. 

Additionally, as we work with these inventory systems, we find there are literally dozens of codes describing inventory status and condition.  The inventory application needs to have status codes used in reporting that can accurately and helpfully describe inventory status to management (i.e., active product, inactive product, assigned to liquidation, appears in future promotion, discontinued, RTV, etc.).  While that might sound basic, in practice it isn’t in many companies.  It’s the root of a lot of inventory management issues and attempts to gain useful reports.

2. Get Senior Management, the CFO and Inventory Manager on the same page.

Inventory management is not a clerical activity but a strategic function.  Come to agreement about which key inventory metrics you can do something about, and how to measure them.  Review on a frequent, scheduled basis.  There are lots of things you can measure, but many are meaningless.  Just by focusing on these inventory metrics, you will see improvement if you can put in place the tactics to improve performance.

3. Analyze age of inventory.

Many companies either cannot report age of inventory or they are less than proactive in dealing with it.  What is old inventory to you?  For some companies the answer may be 12 to 15 weeks on average; for others, 25 weeks.  There are two key points here: 

• Are you as active as you need to be to liquidate slow sellers?  One of our clients said their goal was to turn the inventory at least 4 times annually, up from the current 3.15 turns.  But when we talked about how long they carried inventory before they deemed it as old, their response was 20 weeks.  This is a classic example of where most small to mid-size companies are from an inventory management perspective, and in using KPIs (key performance indicators).  By choosing to focus on inventory as it hits 20 weeks and older, they may end up doing only 2.6 turns annually.  In order for this client to get 4 turns annually, they need to be concerned with inventory as it hits 11-13 weeks on average.   Develop a strategy to liquidate inventory when it’s obvious it’s a slow seller rather than waiting.  It is important for companies to both develop long-term strategies and follow up with the actions or tactics needed to achieve them.  It is also important to understand the goals, agree to how they will be measured and report on them regularly.
• Are you assigning inventory carrying costs?  As with the managers who didn’t think there were such costs because they “owned” the inventory, you must realize that there are costs you incur, including occupancy cost (space and utilities), cost of money or lost opportunity, taxes and insurance, and labor to maintain the inventory.

4. Free up cash from inventory.

Inventory turnover is an age old retail inventory metric.   It’s surprising how many owners and business managers don’t have it reported or use it, especially e-commerce companies that have started up in the last 10 years.  Think about inventory turnover this way:  How many days does it take to get your cash out of inventory?  If your turnover on average is 3.0 times annually, then it takes 122 days on the average.  If you are a b-to-b company selling wholesale and the customer negotiates terms that are 60 days, your average for a 3.0 turnover becomes 182 days—almost half a year.  Big box retailers are the masters at this; they don’t pay for anything until it’s sold.  Start measuring turns by product and meaningful product categories and put in place liquidation and purchasing strategies which increase turns and improve profits.

5. Dynamically project end of period inventory.

Many companies can’t project, to the end of the month or sales period, where the stock on hand will come out.  To do this you have to update the planned sales, stocks, purchases, etc. with the actual for the month.  The inability to do this dynamically means that management loses a timely view of how sales trends affect inventory value.  Retail companies are more apt to use a Dollars Open To Buy (OTB) process (think of it as a purchase checkbook for inventory).  But the key is that management of an OTB is dedicated to staying within the plans.  How many companies have plans by month and can project month end?

6. Use fill rates to determine how well you are serving the customer.

It’s important not to forget the customer in all of this.  What are your customers’ expectations for being in stock?  Our experience is that with the advent of e-commerce, customers have developed a point–click–deliver mentality.  Initial customer order fill rates (the percent of orders that are shipped complete within your DC’s standard for in-stock product) provide an inventory view of your customer service, and should be reported weekly.  Have you found the optimal balance point between improving fill rates and increasing inventory levels?

Recently we added a vendor initial order fill rate to a client’s system.  It was really interesting to see that, while 70% of the vendors shipped in an acceptable period of time, the bottom 30% had initial order fill rates that were dismal.  In the bottom 30% focus on vendors with key products. 

Do you think about inventory in a segmented manner, such as an A, B, C approach where the segments are defined by core products or by fill rates you want to achieve?  An example: Do you have core products you never want to be out of?  Are core products coded on the inventory file?  What is the fill rate for each of those products?

7. Take a fresh look at Vendor Management.

There’s no doubt that you need to strengthen vendor relationships; without good relationships there is no business.  Being upfront with them and understanding the pressures they are dealing with will build trust.  But remember, they need you as much as you need them.  Consider:

• Do you have too many vendors?  Can you get better pricing, service, etc. from fewer vendors?
• How financially strong are the vendors?
• There should be no sacred cows.  Re-negotiate everything:  terms, delivery, discounts, prices, etc.
• Are there alternatives to owning inventory?  Examples include consignment inventory, vendor managed inventory or vendor drop-shipped inventory.  I can hear some say, “That won’t work for us.”  I used to say the same thing, except I have seen many startup e-commerce companies operating in unique ways.  It all depends on your type of products.
• Where can vendor compliance policies help the financial management of inventory?  Have you implemented one that reduces back orders? 
• Develop a vendor scorecard.  Include demand dollars, cancellations, return rates, gross margin, cost of backorders and fill rate by vendor, and purchase orders delivered late.  Issue it quarterly and use it in negotiation. 

8.  Use Gross Margin Return On Investment (GMROI)

Put inventory turnover and gross margin metrics together—gross margin (decimal equivalent) times annual inventory turnover—and report it quarterly.  For example, if I give a merchant $1 to buy inventory, 3.0 turns annually in a 50% margin business yields $1.50.  But step it up to 3.25 turns and a 50% margin yields $1.625, or an 8.33% improvement.  In terms of days in stock, 3 turns means 122 days while 3.25 turns is 112 days.  Do your merchants and inventory managers see the significance of these measures?

9.  Consider cost of back orders versus retail and lost gross margin

Over the years, we have tracked the cost of back orders in hundreds of studies of catalog and e-commerce companies, and found the typical cost per back ordered unit of merchandise is $7 to $12.  Note that I’m not saying “per back order” but “per back ordered unit of merchandise.”  These costs include “Where is my back order?” calls for call center, and second shipping costs, extra dunnage and packing materials, picking, and pack labor for fulfillment.  They don’t count lost shipping & processing revenue, lost customer lifetime value, buyer time chasing down back orders, etc.

E-commerce companies that don’t take back orders may say, “That’s why you shouldn’t take back orders.”  But do you know how many sales you lose?  Best sellers that are temporarily out of stock might add 15% to 20% more demand.  You’re passing up sales.

We have added functionality to some of our clients’ inventory approaches that shows, for the first time, the back order product history rather than just the quantity of units back ordered in the last processing cycle.  It gives a clear picture of how high the number of back ordered units is annually.        

10.  Effectiveness of Your Inventory Management Staff

Given the financial importance of successfully managing inventory, do you have in position the right people to achieve good performance?  Historically, purchasing and rebuying inventory have been looked at as assistant buyer or highly paid clerical tasks.  Given the size of merchandise assortments, the complexity of the supply chain and systems involved, and the number of vendors and purchase orders, doesn’t the effort require more strategic thinking?   And finally, do you pay the staff commensurate with what you want them to achieve financially?

Summing Up

Today, multichannel retailers operate on many more channels, and business is more complex.  But the strategies needed to take a financial view of inventory and manage it profitably remain the same.  If you would like to discuss these inventory management topics further or have other questions call us at (804) 740-8743.