Don’t Let Your Inventory Become a “Blob”
By Jon and Matt Schreibfeder
Many organizations ask for our help because their inventory is out of control. Like the title character in
the 1950’s science fiction movie “The Blob”, material in their warehouse increases at a far greater pace
than sales. How do we fix this problem? By changing their focus. Making sure their objectives
contribute to the goal of achieving effective inventory management:
“To meet or exceed customers’ expectations of product availability while maximizing your organization’s
net profitability.”
Let’s look at a situation where one of our new clients’ strategies was contributing to their inventory
problem. Salespeople’s commissions were based on gross margin, due to the company attempting to
maximize gross margin on every sale. Gross margin is calculated with the formula:
(Sales Dollars – Cost of Goods Sold Dollars) ÷ Sales Dollars
Salespeople did everything they could to maximize gross margins by pressuring buyers to replenish
inventory at the lowest possible cost per piece. Typically minimizing cost per piece requires purchasing
very large quantities. It was not unusual to see a purchase equaling many week’s or month’s supply of a
product. Inventory level is not considered in gross margin calculations and was in no way considered
when reviewing profitability. Whether $1,000 or $100,000 is maintained in stock the gross margin
will be the same. To solve the client’s out of control inventory problem, we introduced new
goals based on the adjusted margin.
The adjusted margin is similar to the gross margin in that it divides profit dollars by the average
inventory investment. But this metric subtracts the cost of carrying the average inventory
investment from the profit dollars. The adjusted margin is calculated with the formula:
[Annual Profit Dollars – (Average Inventory Value * Carrying Cost %)]÷ Annual Sales Dollars
The average inventory value is the average amount of inventory you will have on hand during
the time it takes to sell or use the entire purchased quantity. For example, if you buy six month’s
supply of inventory, the average inventory value would be a three month supply. The carrying
cost percentage is the cost of maintaining a dollar’s worth of inventory for an entire year. A 20%
annual carrying cost means that it costs you 20 cents to maintain a dollar’s worth of inventory for
an entire year. Right now in North America, inventory carrying costs typically range from 15%
to 26%. Your organization’s carrying cost percentage can be calculated by answering the
questionnaire in the resources section of www.EffectiveInventory.com.
Let’s look at the gross margin and adjusted margin of two products:
Product “A”
Annual Sales: $12,500
Annual Cost of Goods Sold: $ 9,500
Average Inventory Value: $ 7,500
Annual Inventory Carrying Cost: 20%
Gross Margin = ($12,500 – $9,500) ÷ $12,500 = 24%
Adjusted Margin = [($12,500 – $9,500) – ($7,500 * .20)] ÷ $12,500 = 12%
Product “B”:
Annual Sales: $12,500
Annual Cost of Goods Sold: $10,000
Average Inventory Value: $ 2,500
Annual Inventory Carrying Cost: 20%
Gross Margin = ($12,500 – $10,000) ÷ $12,500 = 20%
Adjusted Margin = [($12,500 – $10,000) – ($2,500 * .20)] ÷ $12,500 = 16%
Even though product “B” has a lower gross margin, its adjusted margin shows that it contributes
more to the company’s profitability! It will take some time to sell off our new client’s excess
inventory. But by introducing new goals based on adjusted margin, the size of the inventory
“blob” is shrinking, and their net profitability is growing!