Is Your Company Making Money? – Part 2
By Jon and Matt Schreibfeder
For the past several months, we have been discussing profitability. Our goal is to ensure that every product you stock is either profitable or leads to other profitable sales. In the first article in the series (August newsletter), we introduced the adjusted margin, a profitability measurement that subtracts the cost of carrying your investment in a stocked item from gross profit dollars. Last month, we showed that it might be advantageous to stock a money-losing item if you need it to support the sales of another high profit product. This month we are going to explore stocking products primarily or exclusively for a single customer.
If a customer requests (or possibly insists) that you stock a product exclusively for them, you are taking a significant risk. The risk that they will stop buying the product, and you will end up with dead stock. How often have you found inventory in your warehouse that is covered in dust and wondered, “when is XYZ Corp. going to buy this item like they said they would?”
To ensure your company’s success, you must closely monitor the sales of “customer specific” inventory items. We like to question why those products in this category that haven’t sold in 60 days, or where sales are less than 50% of what the customer committed to buy, should remain in inventory.
But what if a salesperson, when confronted with a customer-specific item that hasn’t been sold says, “We have to keep the product in stock just in case XYZ Corporation needs it. If we don’t carry this item, we will lose their business.” We need to see if XYZ Corporation’s profits are large enough to compensate for our losses on customer-specific inventory. Let’s look at an example from one of our clients. As they said in the old Dragnet TV series, the names have been changed to protect the guilty.
XYZ Corporation buys $100,000 dollars’ worth of material from our company each year at a 15% gross margin. That results in $15,000 gross profit dollars. But over time our company has accumulated an average inventory of $50,000 stocked specifically for XYZ Corporation. Much of this customer-specific inventory resulted from customer requests given to our salesperson, Sally Smith. Sally’s compensation was based on gross margin. Additional inventory didn’t affect her. In fact, it built additional sales. As a result, the salesperson received additional commissions while excess inventory accumulated. We recommend that salesperson’s compensation be based on adjusted gross margin rather than gross margin.
What would the adjusted margin be in this situation:
Annual Sales $ $100,000
Annual Cost of Goods Sold $ $85,000
Average Inventory $ $50,000
Annual Cost of Carrying Inventory 20%
Adjusted Margin = [($100,000 – $85,000) – (.20*$50,000)] ÷ $100,000 = 5%
The company’s NIREP (i.e., the break-even point we discussed in the last article “Are You Making Money”) was 7.9%; significantly above the adjusted margin 5%. This was not a profitable situation. We met with the salesperson and explained that we either had to substantially raise the gross margin percentage or substantially reduce the customer-specific inventory to eliminate this money losing situation.
Be sure that everyone in your organization understands that it costs money to maintain stock inventory. And the cost of carrying this inventory must be considered to ensure that your company is making money.
Please let us know if you have any questions about profitability or if you would like to discuss how we can help your organization achieve effective inventory management.