Most distributors' warehouses are filled with two things: stock and stuff. Stock is the material intended to be in the warehouse; stuff is everything else. Stuff includes dead stock, leftover quantities of special-order items, unwanted returns, etc. It also may include some slow-moving products. To effectively manage your inventory, the first task is separating the good stock from the “stuff” by developing and maintaining an approved stock list for each branch or warehouse.
When you stock a product, you make a commitment to have that product available in reasonable quantities for immediate delivery to the customer. The more frequently customers request a product, the more reason you have to stock it. A “hit” represents an appearance of a product as a line item on a customer order, regardless of the actual quantity ordered. Whether the customer orders one piece or 1,000 pieces, it still represents one hit. If your computer system records the “hits” for each product, sort your inventory based on the number of hits recorded in the past 12 months. Does each item that sold only once or twice in the past year have to be retained as a stock item?
If your computer system does not maintain the number of hits by product, an alternative method exists to examine the data. You probably can look at the number of months with usage activity in the past 12 months. To do this, download the item number, description and 12 months usage history into Excel or another spreadsheet. Let's take a look at what you might find. See Fig. 1 on page 56, which looks at a couple items over the last year.
Now, the Excel command “countif” can be utilized to determine how many of the past 12 months had usage activity. Other spreadsheets have similar commands or functions. The Excel command for this sample spreadsheet is:
=countif(c2.n2,">0")
That is, count how many of the cells between Columns C and N have a value greater than zero. The results are shown in Column O of Fig. 2 on page 56.
Item A100 had sales in two of the past 12 months. Could this item be special ordered when customers require it? Could the customer be sold a similar product in place of this one? Could a common stock of the product be maintained in a central warehouse? On the other hand, item B200 was sold in each of the past 12 months. This item should definitely be retained in stock inventory.
Many distributors find that more than 50 percent of their inventory items are requested less than three times a year or sold in less than three months. I am not suggesting you discontinue 50 percent of your inventory items; but you should have a good reason for maintaining them as stock items.
Let's perform an analysis that will divide your inventory into three categories:
The Good
Stock inventory that provides a positive return on your investment. You make money when you sell the product.
The Bad
Inventory that doesn't provide a return on your investment but contributes to other profitable sales. For example, you might have to stock a line of slow-moving repair parts to support the sales of other, hopefully very profitable, products. Bad inventory is a necessary evil. It's not an investment but an expense. That is, it's an expense of doing business.
The Ugly
Inventory that doesn't provide a return on your investment and doesn't contribute to profitable sales. If you're in business to make money, there is no reason for this stuff to be in your warehouse. We'll discuss getting rid of ugly inventory in future articles.
The best reason for stocking a product is to make money. This is “good” inventory. But, how does the typical distributor define profitability? If you ask someone in the sales department, they'll probably talk to you about the company's gross margin:
Gross Margin = (Annual Sales Dollars - Annual Cost of Goods Sold) ÷ Annual Sales Dollars
The higher gross margin, the better. Under most circumstances, salespeople would rather sell a product with a 24 percent margin than an item with a 20 percent margin. Why? Because many salespeople are paid based on gross margin. But does the company get a better return on investment on the product with a 24 percent margin? Maybe, maybe not. It depends on the average value of inventory the company must maintain to generate the sales of the item.
The average inventory investment will depend on such factors as:
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Cost of the item.
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Variations in customer demand.
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Reliability of the vendor and method of transport.
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Quantities that must be purchased in order to sell the item at a competitive price.
Distributors often have to carry a relatively large quantity of low-hit products. There may be a lot of money tied up in this inventory. The higher the investment, the more it costs to maintain or “carry” the inventory in your warehouse.
What expenses do you incur in carrying inventory?
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The cost of putting away stock receipts and moving material within your warehouse.
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Rent and utilities for the portion of your warehouse used to store stock inventory.
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Insurance and taxes on inventory.
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Physical inventory and cycle counting. The more material in your warehouse, the longer it takes to count.
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Inventory shrinkage and obsolescence. The more material in your warehouse, the higher the possibility of shrinkage and obsolescence. After all, it's hard to steal something that isn't there.
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Opportunity cost of the money invested in inventory. How much could you make if you were to take the money you're investing in inventory and invest it in a more traditional investment?
The carrying cost percentage is calculated by dividing the sum of these expenses (along with the opportunity cost) by the average inventory value. It's the amount of money it takes to maintain one dollar's worth of inventory for an entire year. Typically, the carrying cost of inventory is 20 percent to 30 percent per year of the average inventory value. That means it costs between 20 and 30 cents to maintain a dollar's worth of inventory in your warehouse for an entire year. However, it's important for you to know your company's specific inventory carrying cost.
Will the cost of carrying inventory affect a company's profitability? Does a product with a gross margin of 24 percent always contribute more to a company's bottom line that another product with a gross margin of only 20 percent? Let's look at an example:
Product “A”: Annual Sales = $12,500
Cost of Goods Sold = $9,500
Gross Margin = ($12,500 - $9,500) ÷ $12,500 = 24 percent
Product “B”: Annual Sales = $12,500
Cost of Goods Sold = $10,000
Gross Margin = ($12,500 - $10,000) ÷ $12,500 = 20 percent
At first look, item “A” contributes more to the company's profitability. But, what the gross margin doesn't reflect is that we must maintain an average inventory of $5,000 of item “A” and $2,500 of item “B.” If we subtract the yearly cost of maintaining this average inventory investment from the annual profit dollars (i.e. sales — cost), the result is a new measure of profitability, the adjusted margin:
Adjusted Margin = (Annual Sales Dollars — Annual Cost of Goods Sold) — (Average Inventory Value × Carrying Cost %) ÷ Annual Sales Dollars
Let's look at the adjusted margin of our two products:
Product “A”: Annual Sales = $12,500
Cost of Goods Sold = $9,500
Average Inventory Value = $5,000
Carrying Cost % = 25 percent
Adjusted Margin = ($12,500 — $9,500) — ($5,000 × .25) ÷ $12,500 = 14 percent
Product “B”: Annual Sales = $12,500
Cost of Goods Sold = $10,000
Average Inventory Value = $2,500
Carrying Cost % = 25 percent
Adjusted Margin = ($12,500 — $10,000) — ($2,500 × .25) ÷ $12,500 = 15 percent
Even though product “B” has a lower gross margin, its adjusted margin shows that it contributes more to the company's profitability.
You may be asking, “But how do we know if the company is making money on this item?” The answer is actually fairly simple. You compare the adjusted margin to the percentage of “non-inventory related expenses” or NIREP. The NIREP is calculated with this formula:
NIREP = Annual Non-Inventory Related Expenses ÷ Total Annual Sales
Annual non-inventory related expenses include all of the expenses incurred other than what was included in the carrying cost. This includes all selling, marketing and administrative costs. Therefore, every expense from your profit and loss statement should be included in either the carrying cost or NIREP. If your adjusted margin is 14 percent and your NIREP is 10 percent, you're making money. (Please see the article “The Mysterious Cost of Carrying Inventory” at www.EffectiveInventory.com for more information.)
If your NIREP is higher than your adjusted margin, you're looking at either “bad” or “ugly” inventory. The inventory is “bad” if you can combine this item with other items and their combined adjusted margin is greater than your corporate NIREP. The combined adjusted margin is defined as:
Combined Adjusted Margin = Annual Profit $ of Both Items - (Average Investment of Both Items × Carrying Cost %) ÷ Annual Sales $ of Both Items
Or you might experience “bad” inventory if you stock an item to support a specific customer. In that case, an adjusted margin is calculated based on the customer's profitability:
Adjusted Margin = Annual Profit $ from Customer - (Average Investment of Customer Specific Inventory × Carrying Cost %) ÷ Annual Sales $ from Sales to the Customer
This customer-specific inventory must be greater than the NIREP for the item to be classified as bad instead of ugly inventory. Remember that ugly inventory is not profitable and does not lead to other profitable sales. Items with little usage that fall into this category should probably be removed from your approved stock list.
Get started developing your approved stock list for each branch or warehouse. Next month, we will discuss how to properly maintain replenishment parameters for the items you maintain in inventory.
With more than 36 years of experience, Jon Schreibfeder is president of Effective Inventory Management Inc., a firm dedicated to helping distributors maximize the profitability and productivity of their investment in inventory. Contact Schreibfeder at (972) 304-3325 or via e-mail at [email protected].