According to GAAP (generally accepted accounting practices), “inventory” is classified as an asset. But oddly enough, inventory, under circumstances, can convert itself from a beneficial asset to a burdensome liability.
“Holy cow, Batman, this can’t be so!” I’m sorry to say, Mr. or Miss retailer, but it is true and also very common. Perfectly good inventory stops being a beneficial asset when the quantity of inventory either exceeds its sales rate or stops selling altogether.
The principal problem here, is that commonly the retailer fails to grasp the relationship between how much inventory is needed to support projected sales or fails to scrap inventory which has lost sales appeal.
When inventory exceeds its sales rate or when inventory is no longer saleable, the here-to-fore asset becomes a destructive expense creating both actual costs but also obliterating cash flow.
So, what is the “magic” that converts the asset of inventory to a liability which creates both additional expenses as well as acts to diminish cash flow? Moreover, why does it happen? Why doesn’t the retailer just take corrective action?
Inventory can wear two masks. If the inventory comes into the company and is then sold within three to four months, then the goods in question will create sales, gross margin dollars and net profit assuming expenses are under control.
On the other hand, inventory on hand which exceeds its capacity to sell through in less that six months, then carry costs begin to exceed the gross margin dollars harvested. There are some significant costs associated with owning inventory in excess of sales rate over the course of the year.
Low turns in relation to profits
Inventory consumes cash, and without sufficient cash, a business will fail. But why will low turns potentially create negative profits?
(1) As cash is consumed through investment in slow moving inventory, there is an associated opportunity cost. If you had the cash, you could invest it in inventory that sells very well or invest it in stocks or bonds. E.g. the annual return in the stock market over time is 10% annually. Very few businesses generate a 10% return on operations.
(2) Physical inventory has real but latent costs associated with it. For example, if you had $300,000 of inventory that was obsolete, excessive or slow moving, you will incur costs for handling/warehousing, insurance, obsolescence, shrinkage and incremental labor costs associated with inventorying, handling, warehousing and displaying the obsolete inventory.
(3) Old slow moving inventory also has a negative effect on sales to the extent that such inventory consumes both space and cash which could be devoted to new, fresh and appealing inventory which motivates consumer sales. Stores that have a constant array of new inventory consistently enjoy greater sales and consumer loyalty.
So, how does a retailer rate their ability to maximize sales, profit and cash flow? The easiest and most reliable metrics for measuring the productivity of one’s inventor is turn rate, gross margin return on investment (GMROI) and net profit as a percent of sales.
If your inventory turn rate is below 3 (that’s a 4 month’s supply of inventory) or if your GMROI number is below 1.75 (gross margin dollars divided by average inventory as cost) or if your net profit as a percent of sales is below 4%, then you are leaving profit on the table.
It is incumbent upon you to create a regimen of reviewing these metrics, understanding what the numbers mean and what steps are required to implement positive changes.
Remember, if you can’t see the target clearly, you’ll never hit the bullseye!