The most liquid assets on the balance sheet are cash, accounts receivable, and inventory. Of these, inventory is usually the largest in value. Properly managed, it also can be a source of increased profit.
Consider a construction supply company with annual stocking sales of $30 million and a cost of goods totaling $22.5 million. This company has a 25% gross margin and an inventory value of $3,214,286. Now consider how many inventory turns it does. To calculate that number, divide the average inventory value on a monthly basis by the cost of goods sold. In this case, it's, $3,214,286 over $22,500,000 which results in seven turns. (In my example, I calculated the turns by the ending inventory value.)
Now, how would your inventory value change if it turned over that $22.5 million worth of goods sold by eight times a year rather than seven? Take the $22.5 million and divide by eight. The result is an inventory value of $2,812,500. That's a difference of $401,786.
How You Benefit
Going from seven to eight turns pays off in a number of ways:
- Interest Savings: If you are paying 8.5% interest on the inventory you will save $34,152 on an annual basis.
- Cash Flow: Less money spent to acquire the goods means you have more cash available to put to other uses.
- Shrinkage: Less inventory means less shrinkage.
- Warehouse Space: If your inventory has been reduced, you can free up space in your warehouse and yard without adding warehouses and yard space to your facility as your sales grow.
Keys to Victory
- First and foremost, you must practice good data hygiene. Click here to learn more.
- Do not run out of stock on your top items. For a ranking of items, you can view my Transparent Pricing Spreadsheet [see 2% ranking]. Using an A, B, C, D ranking system, you never want to be out of stock on your A and B items. This is a common mistake for companies that want to achieve an additional turn.
- Watch out for "Dog Items." These are products that have been in inventory for an extended period of time-180 days, say--with no sales. Consider a report of your inventory older than 180 days, ranked by highest dollars. These items may be sold as substitutes or at reduced prices to move the inventory. Since these will probably not be reordered, any reduction of these items will directly add to turns.
- Calculate your sales of special order items separately and do not include in your turns. Doing that will distort your results.
More Inventory Management Tips
- Sub-dollar items may cost more to ship, price, stock, and inventory than the cost of the items. It makes sense to order low priced items in larger quantities because there are costs associated with stock the item. For example, if you stock a 2x4 fence bracket that costs you 50 cents and you sell 50 per year, why would you only stock a few when you could purchase enough for the entire year for $25?
- Floors or Minimums: Some items require a minimum quantity for a job. For example, if you stock a rare color roofing shingle and on average it takes 40 squares for a house, why would you stock less than 40? If you stock less than 40, you may never sell the item or you will have to special order the item. If you choose not to stock the item, then treat the item as a special order.
- In an effort to streamline reporting and purchasing, consider reducing the number of vendors. This could help you speed up payment process and increase accuracy.
- Depth vs. breadth: Do you need to have a variety of SKUs for each product line in order to handle your customer needs or can you get by with fewer SKUs? One of my clients sold windows from five different manufacturers, stocking multiple product lines in each. The client then met with its top customers and decided to stock one vendor's line as a primary series and a second vendor's line as a backup. The result? Sales soared. The dealer's staff became product experts on one line instead of multiple lines. You have heard it, "Don't become a jack or all trades and master of none."
- Listen to what customers want. Going deep rather than broad isn't always the right path for every product. The dealer that trimmed its window varieties increased its door lock line to include multiple vendors because their customers requested a broader selection.
- Block buys: If you can make a great buy on commodity items, purchasing in larger quantities, it will reduce your turns. You must figure out what is the best investment. Here's a simple formula is: If it can be purchase for less than the cost of regular stocking inventory out of warehouse or at current purchasing levels, minus the carrying costs (which is overhead for warehouse space and interest expense), then purchase the larger volume of inventory in bulk.
- Market Swings: If you are hedging your bets that the lumber market will increase and you have an opportunity to buy in now at discounted prices, you may load up on materials at reduced prices which may lead to a higher GMROI.
GMROI (Gross Margin Returns on Inventory) equals the turns times the margin percentage. In order to move the number up, you must either increase your margin or increase your turns. I am a big fan of moving the GMROI up, but don't do it at the expense of stock outages.
As you begin the process of increasing your turns, include your top customers' understanding their purchasing needs over the next year. Also, include your top vendors' understanding the availability of products. You would not be in business without each group.