Most distributors spend a lot of time developing sales projections and budgets for expenses. Each month these forecasts are compared to actual sales and expenses. If sales are lower, or expenses higher than what was projected, management will usually take corrective action to ensure that the company remains profitable.
Budgets are good management tools. Unfortunately, few distributors maintain budgets and projections for what is probably their largest asset, inventory. It is critical to the success of your inventory management system, and your business in general, to develop a budget for the value of stocked inventory maintained in each warehouse. This budget is referred to as the “target inventory investment.”
To calculate your target inventory investment, we use a variation of the formula used to calculate inventory turnover:
| Target Inventory Investment = | Projected Annual COGS from Stock Sales Target Inventory Turnover |
Projected Annual Cost of Goods Sold from Stock Sales: What is a realistic projection of what your sales from warehouse stock will be (at cost) during the next 12 months?
Target Inventory Turnover: Most hard-goods distributors earning gross margins between 20% and 30% would like to receive five to six inventory turns in a main warehouse, and ten to twelve turns in a branch location. But these optimal goals cannot be achieved overnight. A realistic “incremental” goal is to increase your current turnover rate by 1/10th turn per month. And as we will see, it will probably take three months, after you begin an effective inventory management program, to start to see results.
So, if the inventory of stocked products in your warehouse is currently turning three times annually, and your company initiated an effective inventory management program three months ago, you should try to achieve 3.1 turns next month, 3.2 turns the month after, etc. This gradual increase in inventory turns is usually the result of an aggressive, but achievable, program to reduce the quantity of unneeded material in your warehouse.
Let’s look at an example which illustrates how increased stock turnover leads to lower inventory investment:
| Projected Annual Sales (At Cost) |
Target Inventory Turns |
Target Inventory Investment |
Inventory Reduction |
| $10,000,000 | 4.0 | $2,500,000 | Current Inventory |
| $10,000,000 | 4.1 | $2,439,000 | $61,000 |
| $10,000,000 | 4.2 | $2,380,952 | $119,048 |
| . . . . . . | . . | . . . . . . | . . . . . |
| $10,000,000 | 5.0 | $2,000,000 | $500,000 |
The figures in the table illustrate our goal of a gradual increase in inventory turns resulting in a continuous decrease in inventory investment. By the time we achieve our eventual goal of five inventory turns, our target inventory investment will be $2,000,000 ($10,000,000/5 turns). It may take a year or more to achieve this goal. So, the sooner we get started, the better!
What Items Do You Want To Stock?
OK, you’ve developed a target inventory investment. Now you have to decide what products will comprise this investment. Let’s start by dividing your inventory into three categories:
Dead Inventory: Inventory with no sales or recurring transfers during the past 12 months.
Slow-Moving Inventory: Inventory that has had some movement, but less than one and a half turns a year. That is, you’ve sold the normal shelf quantity less than 1-1/2 times in the past 12 months.
Other Items: Items whose stocked inventory will turn more than one and a half times per year. That is, your “good” inventory.
Please note that depending on your specific market, “good” inventory might have to turn more than 1-1/2 times a year. For some companies, “good” inventory must turn 12 times a year. If you have questions about what your particular situation, please contact us.
If you need to reduce your overall inventory investment to meet your turnover goals, a good place to start is to look at the dead stock and slow-moving items that are stocked in your warehouse. Of course, there are some valid reasons to maintain an inventory of items that don’t currently sell on a regular basis. But, you must realize that if an item doesn’t sell, it doesn’t directly contribute to generating the profits necessary for you to remain in business. It is an expense. And, like a new truck, a computer system, new shelving, your payroll, or any other expense, non-moving inventory must indirectly contribute to the current or future profitability of your company. How can it do this?
- It might be a repair part or other item that you must have on hand to handle customer emergencies. That is, it contributes to your reputation as a reliable supplier.
- It may be an item that you’re fairly certain will sell in the future. You’ve invested in the product today, to receive profits in the future.
As with any other expense, you must control the amount of dead stock and slow-moving inventory you maintain in your warehouse. You can only afford so much of it. In the following discussion, we’ll guide you in establishing a budget for the amount of this inventory that you can reasonably maintain.
Just one more note before we go on. You must separately categorize dead stock and slow-moving inventory for each company warehouse or location. An item might have a lot of activity in one branch, but be as “dead as the market for eight-track tapes” in another location. If you’re too young to know about eight-track tapes, don’t worry. Just realize that you can’t go down to the music department in Walmart, Target, or another store and find them next to the CDs and cassettes. But they were very popular just 25 years ago…
Dead Inventory
These items have had no sales or transfers during the previous 12 months. As we said before, there are two reasons to maintain stock of these products:
- They are critical repair parts
- They are new stock items that a customer has committed to buy, or a salesman has committed to sell
If an item does not meet one of these criteria, you should probably discontinue it and dispose of your current stock.
Slow-Moving Inventory
Slow-moving items are similar to dead stock items, but they have experienced some (but not much) customer demand during the past 12 months. These items may also be candidates for being discontinued. Carefully review each of these items and ask yourself, or your sales department, these questions:
- Do we expect customer demand for this product to continue or increase during the next 12 months?
- Do our customers expect us to always have the item on the shelf and available for immediate delivery?
- Is there another source (an alternate vendor, company branch, or even a competitor) for this item that will allow us to meet our customers’ expectations without maintaining warehouse inventory?
- Is the product very inexpensive, and therefore does not require a significant investment in inventory?
You may receive the response, “Go through all of these items? You must be kidding! There are just too many of them!”
If someone says this, ask them if they were to go to Las Vegas and win $1,000 in quarters from a slot machine, would they try to collect all 4,000 coins from the floor? Many companies agonize over the purchase of a $1,000 computer, but will not spend the time necessary to analyze dead stock and slow-moving inventory. This is strange, illogical thinking. The same asset (i.e. available cash) that is used to purchase new goods is literally tied up in dust-covered stuff in your warehouse. If you stock more items than you can keep track of, you’re stocking too many products… or you need more help in inventory management!
Budget for Dead Stock and Slow-Moving Inventory
It’s tempting to continue maintaining all of your dead stock and slow-moving items in stock. There is a “warm and fuzzy” feeling associated with knowing you have, in stock, anything any of your customers could possibly want. But can you afford this feeling? Remember that maintaining inventory that doesn’t sell is a cost of doing business. We need to set up a budget for this expense.
The first step in calculating this budget is to calculate the average value of all of the dead stock and slow-moving inventory you plan to continue to maintain in each of your company’s warehouses.
Consider the value of dead and slow-moving inventory to be equal to the current available quantity of each item times its average cost. If you don’t have the average cost for an item, you may substitute the product’s replacement cost.
Is this a conservative measurement? Yes. After all, dead stock and slow-moving items are sold on occasion. So the available quantity of at least some of these items will decrease during the year. You may even sell an entire vendor package! If you want to calculate the actual average value of the inventory of each of these items, fine. But most distributors only have the time and resources to perform this analysis based on the current inventory value.
Let’s consider an item that you feel is a “critical repair part” and should always be on the shelf, available for immediate delivery. The cost of the product is $15.00. At first glance, $15.00 does not seem to be a lot of money to maintain an item in inventory, especially an item that has been designated as a “critical repair part.” But if you consider the hundreds or thousands of slow-moving or dead stock items stocked by many distributors, as the late Senator Everett Dirksen once said, “a million here, a million there, pretty soon you’re talking about real money.”
Most distributors should limit the total amount of money they have tied up in non-moving inventory (i.e. dead stock) to no more than 10-15% of their total inventory investment. And, slow-moving inventory usually should not exceed an additional 15% to 20% of total inventory. If your investment in dead stock and slow-moving items exceeds the budget amount, you have two choices:
- Go back and discontinue more items.
- Reduce your target inventory turns so that the value of dead stock and slow-moving inventory you plan to maintain equals 35%, or more, of your target inventory investment. But, make sure everyone involved in the decision of which products to stock is aware of the negative effect this action will have on corporate profits.
Next month, we’ll look at how to dispose of this inventory and receive the most return. We’ll also look at identifying surplus quantities of popular products. In the meantime, get those lists of items to be liquidated ready!