Removing Items from Your Approved Stock List
By Matt and Jon Schreibfeder
A client sent an email last month stating that he was running out of space in their warehouse(s). His company had already reduced excess stock of currently stocked items but still needed to free up some space (and cash) for new products. They wanted to establish some criteria for helping to identify the products to discontinue. This is commonly referred to as “product rationalization”. In developing an action plan, we focused on the goal of effective inventory management. That is, “to meet or exceed customers’ expectations of product availability while maximizing net profits.” This goal presents two questions:
• What do our customers expect to be available for immediate delivery?
• How can we buy and price these products to maximize net profitability?
Related questions can help identify products that might be discontinued:
• What products that we currently stock are not required by customers for immediate delivery?
• What inventory items fail to meet our company’s profitability goals?
We can answer the first question by examining slow moving items in each branch, store or warehouse. Typically, we will review established products (i.e., those that were not introduced within the past six months) that have had sales or usage in three or fewer of the past 12 months. It is effective to list these items in descending order based on current on-hand value. Afterall, you are probably more interested in evaluating a product that has several thousand dollars of onhand inventory than one that only has less than five dollars of available stock. This way if there is not time to review the entire list, you have examined the items that have the most impact on
your inventory investment:
As you review each listed product ask if customers realistically expect the item to be available for immediate delivery. Can it be special ordered or transferred in as necessary from another one of your locations? If no one has a good reason to stock the item, remove it from that location’s approved stock list or ASL.
The next step is to examine the profitability of those products that remain on that location’s ASL. Many organizations assess profitability by calculating the gross margin of products. Gross margins are calculated with the formula:
Annual Profit Dollars ÷ Annual Sales Dollars
The problem with this metric is that the amount of inventory maintained in stock is not considered in the calculation. Whether $1,000 or $100,000 is maintained in stock the gross margin will be the same. This may encourage buyers to overbuy to receive a lower cost per piece and increase the gross 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 of a product. This might be the average ending inventory value over the past 12 months. The carrying cost percentage is the cost of maintaining a dollar’s worth of inventory for an entire year. Your organization’s carrying cost percentage (also known as the “K Cost”) can be calculated by answering the questionnaire in the resources section of www.EffectiveInventory.com. Today, typical carrying costs in North America range from 14% to 27%. This means that it costs somewhere between 14 and 27 cents to maintain a dollar’s worth of inventory for an entire year.
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!
For a product to be profitable, you need to earn an adjusted margin that is greater than your company’s expenses that are not included in the inventory carrying cost. We refer to this as the Non-Inventory Related Expense Percentage or NIREP. You can calculate your NIREP when you determine your K Cost answering the Carrying Cost questionnaire in the Resources section of our website. Today typical NIREP values in North America range from 7% to 9%. Closely examine products remaining on your ASL that have an adjusted margin less than your NIREP. That is less than 7% to 9%. You are not earning a net profit on these items. Should these items be discontinued along with the products that are not requested that often? Not necessarily.
Next month we will continue our discussion of product rationalization by discussing:
• How eliminating surplus inventory can raise adjusted margins to a profitable level.
• If you should consider raising the selling price for an item so it can be retained on a location’s ASL.
• When it is appropriate to evaluate adjusted margins for an entire vendor line rather than an individual item.
• How you might want to consider some low adjusted margin items as “loss leaders” to achieve greater overall profitability for the organization.
In the meantime, please let us know if you have any inventory or replenishment related questions
or would like to schedule a time to discuss your organization’s specific challenges.