During the Great Recession, many distributors faced severely low cash positions. An implied consensus among firms in the industry emerged: Running short of cash was not going to happen again. One result of this cash focus was a decadelong movement to lower inventory levels to free up cash. It is a movement that continues even now.Programs that eliminated dead or redundant items to generate cash were successful initially; however, there has been an almost endless effort to keep reducing the inventory investment further. In too many instances, the reductions have crimped service levels and probably resulted in lost sales.Let’s examine the nature of inventory reduction programs from two perspectives: The inventory/sales trade-off: an analysis of the break-even point for an inventory reduction that also results in a reduction in sales.Inventory reduction guidelines: a discussion of the opportunities to reduce inventory without negatively affecting sales. Trade-Off Between Inventory and Sales for Typical PEI Member Income StatementCurrent Results10% Inventory ReductionBEP Sales ReductionNet Sales $10,000,000 $10,000,000 $9,936,170Cost of Goods Sold 7,150,000 7,150,000 7,104,362 Gross Margin 2,850,000 2,850,000 2,831,809 Expenses Inventory Carrying Cost (15% of Inv.) 150,000 135,000 135,000 Variable Expenses (5% of Sales) 500,000 500,000 496,809 Fixed Expenses 1,900,000 1,900,000 1,900,000 Total Expenses 2,550,000 2,535,000 2,531,809 Profit Before Taxes $300,000 $315,000 $300,000 Inventory $1,000,000 $900,000 Sales Decrease to Break Even 0.6% The Inventory/Sales Trade-OffMost inventory reduction programs are predicated on the assumption that reducing inventory will have a two-pronged financial impact. First, the inventory reduction will be converted to cash to provide financial stability for the firm. Second, lowering inventory will increase profits because the cost of carrying the inventory will be reduced. There is seldom any consideration that the reduction in inventory could negatively affect sales.The figure above examines the nature of the trade-off between inventory and sales for the typical PEI member based upon the latest “Distributor Profitability Report.” As can be seen in the first column of numbers, the firm generates $10 million in revenue, operates on a gross margin percentage of 28.5 percent of sales and produces a pretax profit of $300,000, or 3 percent of revenue.There also is a memo item for the total investment in inventory. In the case of the typical firm, this is $1 million — a substantial figure. The idea of reducing inventory is enticing.To understand the impacts on inventory and sales, it is necessary to break the firm’s expenses into three categories: inventory carrying costs (ICC), variable expenses and fixed expenses.The most important of these for analyzing inventory is the ICC. The ICC is the cost of carrying inventory for a year. It includes interest, obsolescence, shrinkage and the like. It typically is estimated by inventory specialists to be around 15 percent of the inventory investment each year. Using that figure, the ICC is $150,000.Variable expenses are the costs that rise and fall right along with sales. The most important of these is commissions. For purposes of the figure, variable costs are assumed to be 5 percent of sales, or $500,000.Fixed expenses are overhead expenses. They are the costs that must be covered each year regardless of sales volume. For ease of calculation, they represent all of the remaining expenses, or $1.9 million.The second column of numbers examines the impact of a 10 percent reduction in inventory. That is a sizeable reduction and would require concerted effort on the part of the firm. Inventory becomes $900,000 because of the 10 percent reduction. The ICC also falls 10 percent and is now $135,000. Sales, gross margin and all of the other expense items remain the same. As a result, the entire reduction in the ICC goes to the bottom line.The final column of numbers looks at how much sales must fall to offset the profit impact of the inventory reduction. This means the sales decline necessary to return profit back to the original level of $300,000.For the typical PEI member, the sales decline is only 0.6 percent. Sales, cost of goods sold, gross margin and variable expenses all fall by this percentage while fixed expenses stay constant. As a result, profit falls back to its original level. The impact of even a modest decline in sales is pronounced.The firm continues to have its improved cash position even if sales fall; however, in the long term, cash is produced by generating sales at a profit. The inventory reduction effort has stymied that effort somewhat. This suggests that inventory reduction programs should be approached with caution. Inventory Reduction GuidelinesFew analysts argue with the idea that the inventory investment can be fine-tuned. Offsetting that is the nearly universal desire of customers for distributors to increase their inventory investment.What customers want from distributors has been researched extensively for more than four decades. Nearly every research project reports the same top two desires of customers: Enhanced in-stock position. Customers continually argue that distributors are out of stock too often.Greater depth of assortment. Customers also look for the opportunity to engage in one-stop shopping. Both of these approaches strongly suggest that distributors should carry more, not less, inventory. Reconciling this need with the desire to develop a strong cash position requires fine-tuning the inventory. It cannot support the heavy-handed, across the board cuts that are overused.The solution is twofold and involves eliminating redundancies and continual sales monitoring. Redundancies. Most of the problems with dead inventory can be attributed to redundant items. That is, there are slow-selling items that basically are duplicates of faster-selling ones. In some industries, the slow sellers are nonsellers. Large chunks of items haven’t sold at all in the past six months or a year. Eliminate them, even if it means selling them below cost. Sales monitoring. In a fast-paced world, items move through their life cycles with greater speed than before. Today’s great-selling item often becomes a good seller too quickly. Eventually, it might be another problem item. Make efforts to clear inventory as soon as the item is past its prime. If not, the entire excess inventory issue will arise again. Constant sales tracking is essential to this process. Moving ForwardFirms encounter a continual challenge to maintain an adequate cash position, particularly as they increase their sales. Efforts to increase cash by reducing inventory, however, must be thought through carefully. Any inventory reduction program that reduces sales or diminishes sales growth must be avoided. The trade-off is in favor of sales over inventory. Albert D. Bates is director of research at the Profit Planning Group. His recent book, “Breaking Down the Profit Barriers in Distribution,”is the basis for this report. It is available in trade-paper format from Amazon and Barnes & Noble.
