The age of your inventory has far reaching consequences for operations expenses and store profitability.
"This would be a great business to be in except for one thing… inventory,” said a client on our first day of working together. I understand how he feels. After twenty years in the business he has finally gotten the sales improvement he desires, yet he is experiencing negative growth on his bottom line. Why?
He is not managing his inventory. He has gut feelings about the performance of his inventory, but he doesn’t know specifics. He doesn’t know the average age of his inventory by vendor, or by category, or by line item.
This is not another article about GMROI. This installment provides practical information on inventory age and its impact on the logistics and profitability of a furniture store. Most owners are not paying attention to this one category of performance measurement. Those who do pay attention run some of the most profitable retail operations.
The owner mentioned above had an inventory situation that was dragging down profitability. He had not focused on inventory management to the same degree as sales management. Thirty-five percent of his inventory was more than a year old. Half of that amount (seventeen percent of gross inventory) was more than two years old and more than half of that amount (nine percent of gross inventory) was more than three years old.
A visual check on some of those older items, revealed pieces purchased as far back as 1994. Unlike fine wine, furniture does not get more valuable with age.
When asked why he still had these items in the warehouse, he explained that someone would buy them eventually and that he would then get his money back. The problem with his hypothesis is that very few of his customers get the “warehouse tour”. The reason given for having so much older inventory stockpiled in the warehouse was that this practice cleared floor space in the showroom for newer items. The new items moved faster, but the old items relocated to the warehouse never moved at all!
Let’s look at how this kind of thinking affected profitability. The thirty-five percent of inventory that was over one year old represented an investment of about $455,000 at cost. That is just the initial cost and does not include shipping costs, handling costs, space occupancy costs, insurance and taxes. These costs vary from operation to operation, but the working number that can be used to approximate annual inventory carrying costs (in advance of a review of actual records) is twenty-five percent of original cost.
Most storeowners calculate a selling price based on gross margin targets. When a store buys a piece of inventory for $1,000 and it sits on the floor for a year, the effective investment in this piece goes up to $1,250. This store with $455,000 in aging inventory had carrying costs of about $113,750 a year.
Why won’t this storeowner ever get his money back? To compensate for inventory carrying costs he would need to adjust the selling price upward to reflect his additional investment and protect the gross margin. The more likely scenario is that this older merchandise will need be marked down.
A second problem with aging inventory is that it occupies space. Many stores take slow moving inventory off the floor and relocate it into the warehouse to create floor space for new items. In the example above, the store was operating his warehouse at capacity and considering renting a second warehouse at a cost of $3,500 per month.
An analysis of his inventory pointed out how holding on to that aging inventory was about to do a double negative hit on his bottom line. In addition to spending $3,500 per month on new warehouse space, he would need to spend another $100,000 to equip the warehouse with racks, fire suppression and material handling equipment.
On top of those initial improvement investments, there would be ongoing issues and staffing expenses. What impact would these capital investments and added expenses have on his ability to buy new merchandise?
An inventory analysis showed that 25% of his rack space was occupied with aging inventory. Cleaning out these items would free up the space needed to avoid a warehouse expansion
How did the owner get in this position?
He got into this position because he was not applying the same level of management attention to his inventory that had been focused on sales improvement. It is a familiar story. Storeowners focus on growing the top line so much that they lose track of what really matters – the bottom line.
There are several important performance indicators you can use to help manage your inventory assets as well as you manage your selling processes. In the selling processes, you should manage your salespeople using the three numbers that are in their control. These are Average Sale, Close Ratio and their Performance Indicator Number (for more information on using these three sales indicators, see articles posted to the FURNITURE WORLD archives at www.furninfo.com in the “Sales Management Index”.
There are two similar variables you can apply to inventory. They are average inventory age and rate of sale.
Average Age: The number of days an item has been in your inventory.
Sid Levitz, former CEO of Levitz Furniture back in 1995 predicted the eventual bankruptcy filing by Levitz long before there were any signs of trouble. Back in 1995 Levitz was flying high and ruled the furniture world, so it was interesting to hear this contra point of view. His reasoning: “They aren’t flowing the goods anymore, they are stocking.” He was later proved to be right when Levitz filed for bankruptcy.
If you look at when you bought your inventory, you may be able to avoid this terrible fate. Look at how many days it has been on the showroom floor or in your warehouse and make a decision if this is the best possible use for your limited inventory dollars. If the item has been sitting on your floor for some period of time (six months can be used as a benchmark) without a sale, it probably should be discounted and moved out with the money converted into something that is selling.
Rate Of Sale: The number of days between sales of these items.
Just because an item has sold a few, does not mean it is the best inventory investment you could make. Suppose you bought ten units of a particular dresser and in the first six months two of these were sold. One on the first day the item was on the floor, and the second 150 days later. This is probably an item you do not want to reorder. In fact, you may want to aggressively move the remaining items out of your inventory. If the number of days between sales is long, you are accumulating carrying costs that are driving down the profit on the sales of these items as time moves forward.
Owners who pay attention to these two numbers usually have stores with higher than average inventory turn rates, lower than average inventory levels compared to other stores doing the same level of sales volume, and healthy bottom lines.
Every storeowner can use these two simple measures to help clean up inventory and improve turn rate and profitability. Look at your merchandise and grade it. When the number of days between sales begins to increase for a particular product, consider cutting back on orders and keep close watch so you can determine when it ceases to be profitable. Move old inventory as soon as possible and convert generated cash into faster moving items.
By watching these two numbers, and taking action quickly you will begin to see profit margins and inventory turns begin to grow.
John Egger, CEO of Profitability, Inc., helps retailers refocus their marketing strategies from the current M.A.D. (Mutually Assured profit Destruction) policy trend, to compete against other industries and stores based on value. Inquires can be sent to John care of FURNITURE WORLD at firstname.lastname@example.org.