As a retail owner, one of your primary goals is to boost profit margins. You know that good inventory management is essential to producing top-notch profits. You also know that bad inventory management can cause big problems with profit. However, you may not know the actual cause and effect of bad inventory management.
The “Diamond of Doom” illustrates the problems created by carrying too much inventory (and this diamond is definitely not a girl’s best friend).
Let’s take a closer look at the cause-effect chain reaction of this inventory “diamond.”
The Impact of Excess Inventory
Cause: High inventory leads to excessive inventory obsolescence, theft, maintenance, insurance and taxes.
Effect: Lower gross margin.
Consider the expenses that you incur due to purchasing, holding and selling merchandise in your business. These may include freight, storage costs, insurance expenses, external or internal theft, obsolescence, spoilage and taxes.
Studies have shown that the annual additional cost of holding excess inventory can be 25% to 32%. For ease of calculating, let’s round that off to 30%.
How else might this excess inventory affect profits?
Cause: Lower gross margin causes pressure to get sales volume up, bringing on higher selling and advertising expenses.
Effect: Lower operating profits.
When you hold more inventory than you need, your income statement suffers in two ways: a lower gross margin and increased operating expenses. Both of these lower your operating profit.
If you are carrying an excess level of inventory, you will incur additional and probably unplanned selling and advertising expenses in order to sell the excess merchandise. These added expenses will lower operating profits.
Cause: High inventory causes poor cash flow, thus creating pressure from suppliers.
Effect: Excessive debt servicing.
With every sales transaction, cash is generated, which drives the system. Cash is used to purchase inventory and pay expenses. When inventory is sold, it is converted to either cash or receivables (which eventually turn to cash). The faster this cycle turns, the more efficient and expedient is the use of your investment.
But excess cash can be tied up when inventory is too high. When suppliers don’t receive payments on a timely basis, retailers will feel the pressure to pay or have their supply terminated.
As you juggle to keep suppliers satisfied, you will inevitably wind up at the doorstep of your banker or investor.
Hopefully you have a good lender who will inform you of the destructive cycle that is beginning. If he or she loans you money, they will also want to improve your inventory control to squeeze the excess cash out of your merchandise.
This problem may appear temporary, but it may not be. The loan is a short-run solution; it will not eliminate the long-run problem.
Cause: Excessive debt servicing causes increased interest expense.
Effect: Lower operating profits.
The need to borrow to pay off your suppliers, rather than generating those funds internally is obviously costly. It means your interest expense is higher than it needs to be. When the prime lending rate goes up even one-quarter of 1%, the interest you pay on that inventory-related loan increases.
So, if you have more inventory than necessary, you pay more interest, which increases as the prime rate increases. This higher interest expense draws on your cash supply — cash that could have been reinvested in new inventory.
Sales therefore are inhibited, and growth is restricted as profits are reduced.
Plan for Inventory Needs
How do you know if you have high inventory?
One way to judge is to determine your current inventory turnover rate (sales divided by average inventory at retail; or cost of goods sold divided by average inventory at cost). Now compare your inventory turnover rate to the average turn of your industry.
To get the most out of your inventory, settle on a turnover rate producing just the right flow of merchandise to enhance sales, optimize cash flow and maximize your profits.
Effective inventory management takes planning — not luck. Do not merely consider sales, but also project the figures to find the optimum turnover rate for cash flow and profits as well as sales. It’s the balance you are after.
The importance of planning your inventory needs cannot be emphasized enough. This is why it’s important to implement an open-to-buy system, which enables you to commit yourself to receiving a certain amount of inventory in a given amount of time. These amounts are predetermined based on a carefully calculated sales plan and corresponding inventory level, based on your targeted turnover goals.
High Costs of Excess Inventory
In summary, inventory levels that are too high depress your gross margin, increase operating expenses and have a negative effect on cash flow — all of which result in reduced operating profits.
Proper inventory levels require management control and discipline, but the results justify the attention. Keep this in mind before you embark on your next season’s purchases.
Patricia M. Johnson and Richard F. Outcalt are certified management consultants and co-founders of The Retail Owners Institute. They are strategists for retailers, workshop presenters and publishers of a free and popular newsletter for store owners and managers. Sign up for The ROI News for free at RetailOwner.com. They can be reached at 206-623-3973.