Inventory is booked as an asset in the Balance Sheet. However, from an operational standpoint, any excess inventory is an operational liability. To determine what constitutes “excess inventory”, one must determine what is the optimum inventory.
Optimum inventory would be considered the minimum level of inventory that is required to prevent stock outs and ensure a steady fill against existing or potential market demand. It is generally assessed by calculating inventory turns. An inventory turn of 6 suggests that the company is holding inventory for 60 days while an inventory turn of 8 suggests that a 45 day hold period. The higher the turns, the lower the hold period and less dollars are tied up in inventory. However, if the hold period is too low vis a vis demand, that would mean that the company may lose customers to other competitors and the loss of margin is greater than the costs of holding inventory. Inventory turns is defined as the Cost of Goods Sold of the Product divided by the Average Inventory Balance for the Period. Thus, if COGS increase and inventory balance does not change, the turns would increase. Another way of looking at this is that if the Gross Margins go down, inventory turns would go up, assuming that the average inventory balance does not change.
A common metric that is often used as a rule of thumb is that excess inventory has a carrying cost of 20% per annum. In other words, if the company carries $5M of excess inventory, then the costs of carrying the excess could translate to $1M. These are costs associated with tying down cash and hence the interest that you pay on the cash or lose on the cash, warehouse costs, staffing, general inefficiencies in the operational infrastructure, shrinkage, obsolescence risks and potential liquidation and markdown triggers.
The optimum inventory level also has the same carrying costs but the key underlying assumption is that the velocity of sales against the inventory level and the accompanying margins offset the costs sufficiently enough to make holding an optimum level of inventory at all times to be a strategic asset(s) in the organization. Note that the optimum inventory can vary: it can go up and down depending on market demand and sales forecasts and the internal corporate stock out policy.
So how do you determine what is the optimum inventory level? The key drivers are the following:
- Market demand and the volatility of market demand
- Lead time to fill inventory
- Order Costs
- Frequency of Orders
- Safety Stock requirement
- Product Margins
- Carrying Cost of the Inventory
A steady market demand makes it easy to define what the optimum inventory level would be. You would know how much to order and when and in theory, if there is no variability in the demand, you may not even have to factor in safety stock. You would optimize flow of inventory against the lead time and the order costs and manage the frequency of the orders. This is the best case scenario, but alas … very few companies work at that rhythm.
However, if there is market demand variability, then managing to an optimum inventory level creates significant challenges. The first order question is to determine what are the risks of a stock out? Some companies are more impacted by stock outs than others, and thus they may decide to hold a larger safety stock. The loss of margins and customer goodwill offsets the costs of holding the extra inventory. Once that is determined, the next step is to assess how many days of inventory you must hold. A quick and dirty approach is to look at companies in the same space and calculate their inventory turns based upon a review of their financial statements. You can then adjust your metric based on scale differences or internal capital constraints. Some companies are well capitalized and can afford to hold more inventory and thus have less turns. Their main focus is market penetration and the carrying costs of “excess inventory” is in lieu of marketing and advertising spend. But smaller companies have less degree of freedom and thus they may hold themselves to higher inventory turns that will optimize how they allocate their capital. Once the inventory days are assessed and internally agreed upon, then the company has to ensure that the projections are revisited in a timely manner. High inventory turns would require shorter and more frequent forecasting cycles. In addition, purchasing has to be tightened up. Some companies would implement a purchase cap. To get even more granular, purchase caps can be established not at a dollar value but at a unit value. The inventory turn would be calculated at a product level based on Units Sold at a particular time period divided by Units Held for the equivalent time period. Once the turn has been agreed upon, the next item is to assess how much inventory flows in and out within a specific time period. If more comes in then goes out, inventory will start piling up. Conversely, you may exhaust inventory fast and quickly dip into the safety stock thus reducing your flex against the market demand. The flow of inventory can be regulated by analyzing demand at the increment, and a series of other basic maneuvers like breaking up inventory orders into smaller lots, mixing products to accompany the demand composition, opening up new channels to move inventory, reducing lead time for filling inventory, etc.
But now that we have arrived at an understanding of some optimum dollar value or units of inventory that we carry, anything over that would constitute excess. The process of managing the excess inventory is critical. The objective is to ideally take it out completely. However, realities of the market and the lack of optimal operational efficiencies could preclude that from happening. The high level question to start the analysis would be to understand the costs. As mentioned before, the general rule of thumb is 20% and if you are carrying $5M in excess inventory, you are exhausting $1M of capital every year. Let us say a company makes 10% EBIT to the bottom line. That means that excess inventory is taking the wind out of $10M of incremental sales. That is an important point. If a private company wants to focus on bottom line impact, it would be wise to reallocate resources to develop process to reduce the excess inventory. Aside from the immediate impact, these process improvements tend to be sustainable and its beneficial impact carries over into the future fiscal years. So what can be done?
- Open New Channels to push the excess inventory out
- Markdown Inventory to incentivize purchases. Technically, a 20% markdown against cost is the appropriate breakeven.
- New Promotions or Marketing Programs
- Incentivize Sales in a tiered compensation to move inventory out. Provide the benefit of accelerators and spiffs.
- Use inventory as rewards or gifts. This obviously depends on the value of the inventory and you need to be prudent to use this method. It has to be measured against the value of the goodwill earned.
- The least preferable obviously is to turn the inventory over to liquidators. But as noted, the worst case scenario is that it would save a $1M annual leak of capital and at 50 cents a dollar, you would get another $2.5M. You would walk away from $1.5M which is a bad thing obviously but interestingly … this also suggests that your breakeven time of holding excess inventory is 18 months in the event you are able to sell all inventory at cost. Being that it is an unlikely scenario and holding long may lower the value of the inventory over time, limiting your losses to a fixed target may still be a prudent move.