Taking Stock Of Inventory Costs
“Profit Myths In Wholesale Distribution” is written by Albert Bates, DBA of Profit Planning Group. Bates has spent 30 years analyzing distributor financial statements. His findings boil down to this conclusion: Much, and possibly even most, of what distribution managers know about improving profitability is wrong. Good economic times mask this fact, while challenging times make this fact absolutely dangerous.
The following is excerpted from chapter 4 of the book.
What is the potential payoff in the effort to lower inventory? Exhibit 4-1 (pg. 64) examines how a reduction in inventory for the total firm impacts ROA. For the moment, all attention should be focused on the heavier, solid line in exhibit 4-1.
The reduction in inventory ranges from 0 percent to 25 percent. It is assumed that as merchandise is sold, not all of it is replenished. Initially, such reductions in inventory would result in a commensurate increase in cash. Exhibit 4-1 takes the next step and assumes that the reduction in inventory also reduces total assets.
The exhibit also assumes that, as inventory is reduced, sales do not fall. At the 5 percent level this may well be possible. At the 25 percent point, however, a sales decline is almost inevitable. Therefore, the exhibit puts inventory reduction efforts in the best possible ROA light.
If any exhibit could ever be described as counterintuitive, it’s this one. As the level of inventory is reduced by 5 percent to 25 percent, ROA for the total firm increases only modestly. In particular, with a 25 percent reduction in inventory, ROA advances only from 7.5 percent to 9.5 percent. This is the result, despite the fact that reducing inventory has a two-pronged impact:
• It lowers expenses and thereby raises profits.
• It lowers the overall level of asset investment.
Exhibit 4-1 shows that the road to financial success does not traverse the realm of inventory reductions. Given that, it’s difficult to accept the myopic attention paid to inventory reductions by distributors over at least the last decade. There are two primary reasons for the inventory focus:
• Firms may be overly concerned about having cash on hand. They may feel forced to engage in inventory reduction efforts even if they have exhibit 4-1 firmly imbedded in their daily decision processes. This reasoning loses some credence when we consider that most firms have at least some lines of credit and the potential to negotiate for longer datings from suppliers to finance inventory. Thus, this logic is often more of an excuse than a well-reasoned strategy.
• Few executives understand the nature of the slope in exhibit 4-1. Given the counterintuitive nature of the line, this is not surprising. The reasons behind the misunderstanding are critical.
One last note regarding exhibit 4-1: There are several parallel graphs for sales, gross margin and the like throughout the rest of this book. Proving the legitimacy of the graphs in the text would disrupt the flow of the discussion.
Misunderstanding Inventory Costs
Managers tend to overestimate the cost of carrying inventory and underestimate the cost of being out of stock. While either one of these scenarios is merely bothersome, taken together, they threaten a firm’s ability to produce high-profit financial performance.
The Cost of Carrying Inventory
The inventory carrying cost (ICC) measures what it costs a firm to carry inventory in stock for a full year. The number is expressed as a percent of the inventory value. For example, a figure of 30 percent says that for each $1 of inventory investment, the firm spends 30¢ each year carrying the inventory. Realistically, we can estimate the ICC with some precision by simply taking the interest rate a firm pays and adding 4 percent to 5 percent for non-interest costs. With an interest rate of say, 7 percent, the ICC would be somewhere around 12 percent. The conventional wisdom in distribution is that the ICC is somewhere between 24 percent and 36 percent. This is a wildly overstated figure. Since exhibit 4-1 uses 12 percent, while the rest of the world is using 24 percent to 36 percent, some explanation is in order.
There are three factors that must appear in the ICC calculation: interest, insurance and property taxes (for those states that assess a tax on inventory). Everything else is subject to conjecture. Four traditional considerations not necessarily relevant to an ICC calculation are especially interesting:
Handling costs. If handling costs were germane to the ICC, then as inventory is lowered, handling costs would decline. In reality, when inventory is reduced, handling costs generally go up. The reason is that with less inventory, the company is ordering in smaller quantities more frequently. As a result, there are more trucks making deliveries and more orders being placed on shelves. If handling costs are also factored in the ICC calculation, they should be considered as a reduction in the carrying cost rate.
Sustainable value. Some products such as bananas depreciate with age. Firms selling high-tech gear probably experience depreciation, too. But for most firms, the long-term trend has been for inventory to increase in value. Except for extremely perishable products or market-priced commodities, we need not presume a reduction in value in the ICC.
Shrinkage. The level of billing errors and theft is not related to the amount of inventory on hand, but to the efficiency of inventory control systems. Shrinkage should not be in the ICC.
Warehousing costs. Traditional wisdom suggests that as inventory is reduced, there is a commensurate reduction in rent and utilities; under normal circumstances, there is no way that fixed warehousing costs can be included in a calculation of ICC.
In short, the ICC is best calculated by taking a firm’s interest rate and adding 5 percent, as shown in exhibit 4-1. It indicates that the impact of inventory reductions on ROA is modest.
Managers, who have been told for 30 years that the cost of carrying inventory is extremely high, inevitably have trouble with exhibit 4-1 since it uses 12 percent as the ICC. Consequently, the dotted line in this exhibit uses an ICC of 36 percent, and the slope of the line changes only slightly. When using the 12 percent ICC, a 25 percent reduction in inventory causes ROA to increase to 9.5 percent. When substituting a 36 percent ICC, the same 25 percent reduction in inventory only increases ROA to 12 percent. While a 12 percent ROA is higher than 9.5 percent, the slope of the line changes only slightly. It should also be noted that inventory reduced by 25 percent is a dramatic change that goes far beyond fine-tuning. Reductions in inventory have only a modest impact on both dollar profit and ROA. Using a more realistic figure of 12 percent, the impact is very modest.
The Cost Of Being Out Of Stock
Compounding any assessment of the inventory reduction problem is the fact that the cost of being out of stock is always underestimated for two equally important reasons:
1) It is almost impossible to measure the service level by comparing supply and demand with sufficient accuracy (also called the fill rate) to determine how often the firm is out of stock. The underlying difficulty is that to measure out-of-stock situations, the firm must track both attempts to buy and associate sales simultaneously. Even the most sophisticated management information system grinds to a halt when trying to measure demand properly.
2) It is nearly impossible to put an accurate dollar value on a stock-out situation. In some cases, a replacement product can be substituted with no consequences; in others, the firm may be out of stock often enough to lose its customers. There is a body of knowledge that suggests that many distributors have dissatisfied their customers with low in-stock performance, but it’s hard to put a price tag on this phenomenon. (See Scott Benfield’s book, “ValueAdded: Assessing Service Offering of Electrical Distributors, NAED Education and Research Foundation, 2006.”) Even without knowing the frequency or the cost of being out of stock, we can work backward to see how bad the situation would have to be to create a profit problem. Exhibit 4-2 (pg. 66) illustrates how low sales would have to go to offset a reduction in inventory. The formula is nothing more than a variation on the break-even formula. It uses information for Mountain View taken from exhibit 1-1, and the discussion of inventory reductions, to show how much sales would have to fall to offset a 25 percent reduction in inventory.
Mountain View’s current profit before taxes is $1,500,000, and its fixed expenses are $8,500,000. Both numbers are in the numerator of the formula in exhibit 4-2. If inventory is reduced by 25 percent, the total reduction is $1,875,000 ($7,500,000 of inventory times 25 percent). With a 12 percent ICC, the cost savings from the inventory reduction is $225,000 ($1,875,000 times 12 percent). This figure has been subtracted from the numerator to gauge how much of a sales decline would absorb the profit improvement associated with reducing inventory.
The denominator is simply the gross margin percentage minus the variable expense percentage. Variable expenses are assumed to be 5 percent of sales. Numerically, this means the denominator is 20 percent: a gross margin of 25 percent minus variable expenses of 5 percent.
If Mountain View suffered a sales decline from $50,000,000 to $48,875,000, it would exactly offset the impact of a 25 percent reduction in inventory. It is a sales decline of only 2.2 percent. It seems almost certain that an inventory reduction on the order of 25 percent would have to trigger at least a 2.2 percent sales decline given the likelihood of extensive out-of-stock situations. The economics of the firm are overwhelmingly against inventory reductions.
Moving Inventory Around
The previous comments might suggest that inventory management is unimportant. To the contrary, inventory management is still extremely important. There are many problems associated with inventory that need to be resolved; they just don’t deal with the level of inventory investment. One of the most significant inventory problems is dead stock. In most cases, distributors have far too much dead inventory. In the industrial sector where the problem is most endemic, it is not unusual to have as much as 20 percent of the total inventory investment having no sales activity at all during the last year.
Even within companies where the dead-stock percentage is only 10 percent, or even 5 percent, there is a pressing need to liquidate dead inventory. Such liquidations may be painful, resulting in revenue that is well below the book value of the items being liquidated. However, the funds acquired can be used to reinvest in fast-selling items that will most likely become out of stock. This does not lower the value of the inventory overall. Rather, it places new emphasis on having the right merchandise to drive higher sales, a topic that we’ll revisit in chapter 5.
In short, lower inventory levels do not tend to increase profits. Unfortunately, too many distributors have been resolutely marching in the wrong direction for the last decade.
This excerpt is reprinted with permission of the NAW Institute for Distribution Excellence. To order “Profit Myths in Wholesale Distribution,” go to www.naw.org/profitmyths or call 202-872-0885.
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