Rational Product Rationalization

Rational Product Rationalization
By Jon and Matt Schreibfeder

The goal of effective inventory management is to “meet or exceed customers’ expectations of product availability while maximizing your net profits.” Last month we began a discussion about removing unneeded, and possibly unprofitable, items from your approved stock list. That is, those items currently in one or more of your warehouses, that your customers don’t expect to be available for immediate delivery and/or are not profitable. The process of “pruning” the list of products you stock is typically referred to as “product rationalization”.

But like pruning a tree, product rationalization must be done carefully to avoid mistakes and harming your company’s reputation with your customers. We tell our clients to use a scalpel rather than a hatchet in making these decisions. Consider these guidelines:

Should a Slow-Moving Product Only be Stocked in a Central Warehouse?

You stock a product in a facility so that it is available for immediate delivery. Would a customer be willing to wait a day or two to receive the product? By keeping minimal stock of a slow-moving item in a central warehouse or distribution center, you might be able to satisfy the needs of customers normally served by several of your company’s locations.

Can You Achieve Acceptable Profitability by Buying Less and Reducing Inventory?

It is not uncommon to use Gross Margin to measure an item’s profitability, but because it does not account for the cost of carrying inventory it is not a complete view on an item’s performance.

Gross Margin % = (Annual Sales$ – Annual Cost of Goods Sold) / Annual Sales$

A better indication of profitability is using an Adjusted Margin.

Adjusted Margin % = [Annual Gross Profit Dollars – (Average Inventory $ * Carrying Cost %)] ÷ Annual Sales Dollars

A slow-moving product stocked by one of our clients had these characteristics:

Annual Sales Dollars = $533.00
Annual Cost of Goods Sold = $400.00
Annual Gross Profit Dollars = $133.00
Gross Margin % = $133.00 ÷ $533.00 = 25.0%
Average Inventory = $400.00
Annual K Cost = 24%
Adjusted Margin = [$133.00 – ($400.00 * .24)] ÷ $533.00 = 6.9%

Their profitability goal is a minimum adjusted margin of 9.0%. So, this situation was not meeting their set goals.

The reason they keep $400 in inventory is that they had to buy a full case to get the best price. If they bought by the piece, they could buy any quantity but would have to pay 10% more. What if they maintained smaller quantities in stock:

Annual Sales Dollars = $533.00
Annual Cost of Goods Sold = $440.00
Annual Gross Profit Dollars = $93.00
Gross Margin % = $93.00 ÷ $533.00 = 17.4%
Average Inventory = $110.00
Annual K Cost = 24%
Adjusted Margin % = [$93.00- ($110.00 * .24)] ÷ $533.00 = 12.5%

Even though the cost of goods sold increased, the adjusted margin almost doubled! This item now meets the company’s profitability goal. Note that the gross margin decreased while adjusted margin increased. Gross margin percentages often provide misleading results and should not be utilized in analyzing profitability!

Is the Item a “Loss Leader”? – Examine sales transactions that include the product. Is it typically ordered along with other high margin products? Do the profits generated by the other items make up for the loss you experience on this slow-moving product? Remember that you want to maximize the overall net profitability of your company, not the profits of individual items.

Is a Slow-Moving Item Purchased by a Very Profitable Customer? – Before discontinuing a product, examine sales orders to see who is purchasing the product. A slow-moving product should normally not be discontinued if it is purchased by an important and very profitable customer.

Do You Stock a Similar, More Popular Product? Many distributors carry several brands of essentially the same item. If one or more of these nearly identical products is slow moving or doesn’t generate acceptable profits, can we persuade customers who are buying the less popular brands to purchase a better performing alternate? Encourage your salespeople to sell those products that contribute most to the success of your company!

Inventory is one of the largest, if not the largest asset for most companies. Unless you run a pet store, your products do not have feelings. Stocked items will not cry or feel pain if they are liquidated. For the overall health and wellbeing of your organization, and your employees (who
do have feelings), it is critical that you remove unwanted inventory from your warehouse(s). The money you receive from liquidating this stock can be reinvested in other products that will generate more profits!

Please let us know if you have any questions or would like to set up a time with us to discuss how EIM can help your organization achieve effective inventory management.

Announcing the Release of the EIM Spreadsheet Set Version 6.1

We are proud to announce the release of the EIM Spreadsheet Set Version 6.1. It is the perfect companion to the new Achieving Effective Inventory Management – 7th Edition. We have enhanced each of the 11 inventory-analysis spreadsheets with additional features, comprehensive graphs, and 44 pages of comprehensive documentation. Spreadsheets in the set include an updated version of our Forecasting/Analysis spreadsheet that allows you to perform a comprehensive analysis of up to 100 stock items at a time. Other spreadsheets in the set include:

• Price Break by Item Spreadsheet
• Price Break by Vendor Line Spreadsheet
• Price Break with Freight Allowance and Terms Spreadsheet
• Rebate Analysis
• Value of Lost Material Spreadsheet
• Landed Cost Calculator
• Cost of Filling Order Calculator
• Carrying Cost and Replenishment Cost Calculator
• Replenishment Parameter Analysis
• Price Increase Analysis

In addition to more features, we’ve improved the user interface and present results in easy-to-understand formats. It is a great tool for dealing with today’s supply chain challenges!