Lean Techniques Part 4: Inventory
Volume 146 NO.1 January/February
By David McMahon
In the fourth installment on LEAN retailing, we continue our discussion with a look at how to use LEAN techniques to make your inventory more efficient and productive.
LEAN is the art and science of continuously examining and improving a business’ processes, people and products so that the customer experience flourishes, allowing a business to realize its full potential.
LEAN is about developing an organization. It is NOT about making broad cuts in expenses or people. It is about making cuts in areas of organizational waste so that business productivity accelerates.
LEAN inventory is a balancing act between holding too much inventory and not enough. To be successful, retailers must find their LEAN-ZONE of efficiency. This is where the inventory investment is appropriate, and sales growth is supported. It is commonly expressed with the metric: Average Inventory to Annual Sales Percent.
Look at Three Businesses
To illustrate, this let’s look at three businesses that carry similar merchandise lines and have the same retail footprint: Operations Charlie, Delta, and Bravo.
For this comparison, I will use a target inventory to sales percent LEAN-ZONE of between 16-18%.
Operation Charlie: Too High
First, Operation Charlie has 22% inventory to sales. They are well above their LEAN-ZONE. They carry too much inventory for their particular operation. This results in the following issues:
• Higher payable levels
• Tighter warehousing causing more damages
• Higher inventory carrying costs
• Tighter cash flow
• Slower re-buying of best sellers due to tighter cash flow
• Greater best seller stock-outs causing sub-optimal sales
• Greater percent of “Dog” merchandise causing downward pressure on margins
• Less than optimal merchandise mix
Operation Delta: Too Low
Next, Operation Delta has 13% inventory to sales. They are well below their LEAN-ZONE. They carry too little inventory for their business model. Some may think this would not be an issue, however, if their business model dictates that they must carry back-up stock for their customers, the following issues result:
- Supply shortage for products that customers want now.
- Sub-optimal sales due to best-seller stock-outs of back up merchandise.
- Greater customer order lead times and back-orders.
- Increased reliance on customer deposit financing due to back-orders.
- Best-seller stock-outs due to selling hot items off the floor.
- Less than optimal merchandise mix.
Operation Bravo: Just Right
Lastly, Operation Bravo consistently operates at 17% inventory to sales. They are in their LEAN-ZONE, carrying the appropriate amount of inventory for their sales volume as dictated by their business model. As a result Bravo:
Obviously everyone wants their inventory to be at optimal levels like Operation Bravo. The burning question: What must a retail operation do to enable itself to produce results day-in day-out like Operation Bravo?
- Maximizes best-seller in stock days.
- Minimizes “Dog” merchandise.
- Carries a good retail merchandise mix.
- Backs up best-sellers appropriately.
- Fulfills their customers’ needs fast.
- Minimizes inventory carrying cost.
- Generates higher return on inventory investment and profitability.
- Maximizes their cash flow.
The answer is to follow a LEAN strategy. I’ll explain this using my strategy for implanting LEAN:
Establish benchmarks based on performance metrics: The first step is setting measures that will guide your organization toward improvement. Every functional area in your business should have metrics that guide its purpose (Typically fewer than six metrics for focus). Examples of great inventory metrics include Inventory to Sales, GMROI, Gross Margin, Turns, and sales per square foot.
- Establish benchmarks based on performance metrics.
- Measure performance using 80/20 thinking.
- Find solutions.
- Execute to conclusion.
- Continue improving.
To illustrate this point, let’s use the metric mentioned above: Inventory to Sales %. Let’s suppose an Operation has annualized sales of $10 million. If an average inventory of 17% is desired, that means that it should focus operations around keeping inventory close to $1.7 million.
Understandably it will be impossible to keep inventory cost at exactly this level. There are always fluctuations in receiving and delivered sales. Thus, a responsible range or LEAN-ZONE should be established. This may be, for example, 1% of sales on either side of 17%. So, that’s 16-18% inventory to sales, in dollar terms it’s a range between $1.6 million and 1.8 million provided sales are targeted at $10 million and there is little seasonality. If sales levels show a trend toward increasing or decreasing, inventory should follow suit as quickly as possible. It is not a perfect science, but it is far better than the alternative of not having or tracking the LEAN-ZONE.
When establishing your LEAN-ZONE it is important to note that your individual business model must be factored in. The range I used in my example would be totally inappropriate for some companies. It may be far too high or too low. An Ashley Homestore for example has a model of value-priced, fast-turning inventory that is pulled from corporate distribution centers. They would operate with a lower LEAN-ZONE of inventory to sales. Alternatively, a customizable contemporary operation selling premium products with a true interior design focus may require a higher LEAN-ZONE to operate efficiently. Whatever your business model, seek to establish metrics around your most productive inventory level.
Measure performance using 80/20 thinking: 80 / 20 thinking focuses on identifying the minority of inputs that are producing the majority of outputs. With respect to merchandise, it can be used in a variety of ways including:
For example, in the case of SKU’s that produce the greatest gross margin dollars, you can rank your inventory top down by margin dollars produced for a given time period, say 3 months. This will let you easily see which products are your cash earners and which are your cash burners.
- Determining the minority of vendors that produce the majority of return on investment.
- Determining the minority of categories that produce the highest returns.
- Determining the minority of SKU’s that produce the majority of gross margin dollars.
- Determining the minority of SKU’s that produce the majority of customer service issues.
You can then establish an inventory class ranking system assigning a numeric or alpha rating to highlight the importance levels within your line-up. This allows you to focus on the big picture and then execute ongoing tactics to keep inventory flowing.
Find solutions: After deciding what your top performance metrics will be and analyzing merchandise performance, you can focus on solutions and systems to help you improve.
Here are a few common practices and solutions that businesses perform to enable a LEAN inventory:
- To avoid overstock situations and keep inventory in your LEAN-ZONE: Create an open-to-buy for new merchandise that revolves around inventory to sales percent.
- To maximize vendor performance: Set a minimum standard for vendor GMROI in each category.
- To push the “fat” out: Use a routine item aging system to identify slow merchandise so you can take appropriate action sooner.
- To keep your top inventory items producing: routinely check their gross margin, display status, merchandising, current availability, price point, and sales person awareness.
Some solutions you implement deal with an obvious opportunity that you might have. Other solutions may be ongoing functions you perform to enable the profitable growth of your business.
Execute to conclusion: It is important to repeat the same mantra you’ve hopefully read in the three previous Furniture World Magazine installments on LEAN retailing: After you put your LEAN strategy into motion, keep moving! Don’t drop the ball. Follow through on your LEAN inventory way of life. If you decide that you must keep inventory at approximately $1.7 million for your sales volume, then focus your team on actions to accomplish this, don’t assume that it will be done perfectly. Manage your processes and constantly fine tune operations to suit your unique situation. As a manager, ensure that your team flows best sellers at a rate that optimizes sales, and deal with that stagnant inventory immediately. Check the health of your merchandise often and expect results.
Continue Improving: Your inventory is LEAN and your mix is good. Provided you have LEAN marketing practices to pull in decent customer traffic, and LEAN sales operations to service and sell at high levels, your business is ripe for growth in volume, profit and cash flow.
LEAN is a continuous process. If you find that you have become exceptional in one area of inventory management, keep tracking that metric, but move your attention on to another area of inventory management that needs improvement. Then set tracking metrics, analyze, find solutions, and execute to conclusion for that metric as well. Business managers who are students of their operations and are never 100% satisfied, are those that excel. This is the heart of LEAN.
David McMahon is a Certified Management Accountant and Consultant with PROFITconsulting, a Division of PROFITsystems. Questions about this article, or to request a similar analysis on your financial statements contact him at Davidm@furninfo.com or call 8oo-888-5565.
Read other articles by David McMahon