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The Siren Song of Inventory Reductions

Don’t be lured in.

The downturn in economic activity caught many firms off-guard. As a result of sales challenges, cash sufficiency has become a very serious issue. For the typical MHEDA member, cash now represents only 2.3 percent of total assets. It is a cash position that does not leave a lot of room for error.

To offset the cash challenge, most firms have looked at reducing the “cash traps” in the business, particularly inventory. While reducing the investment in inventory is a laudable objective, it is fraught with some danger. It is possible, and maybe even likely, that the drive to lower investment levels will trigger further sales declines through a higher occurrence of out-of-stock situations.

Inventory exhibit 1

Inventory vs. Sales
Every firm needs sales volume to survive. It also needs cash to pay its bills. While these two concepts usually go hand in hand, sometimes they do not. To understand the trade-offs between the two, it is useful to look at some of the financial results for the typical MHEDA member:

• Net sales of $25,000,000
• Net profit before taxes of $500,000, or 2.0 percent of sales
• Inventory of $3,180,000, or 28.9 percent of the firm’s total asset investment
• Cash of $250,000, or 2.3 percent of total assets.

Clearly, the amount by which inventory dwarfs cash suggests a major opportunity for reallocation of assets. If the firm could reduce its inventory by 5 percent, which is certainly within the realm of possibility, then inventory could be reduced by $159,000. If all of the inventory reduction was put into cash, then cash would increase by 63.6 percent. From a cash flow perspective, it is an attractive, and possibly even essential, shifting of funds.

At the same time, even a modest 5 percent reduction in inventory has the potential to lower sales volume, if the reduction lowers the firm’s service level. Exhibit 1 reviews the challenges associated with an inventory reduction by looking at current results and three different scenarios.

Given current cash levels, quick inventory reductions are a tempting short-run target, but are also a long-run impediment to success.

In the exhibit, expenses are broken into three categories. Inventory carrying costs are the costs of maintaining inventory, such as interest, property taxes and the like. The inventory carrying cost factor is assumed to be 12 percent of inventory (see sidebar), so these costs are $381,600 (inventory of $3.18 million times 12 percent). Variable costs, such as commission and bad debts, are assumed to be 6 percent of sales, or $1,500,000. All other expenses are in the fixed (or overhead) category.

The first column of numbers merely reviews the results for the typical MHEDA member. The second column explores a 5 percent reduction in inventory that is achieved without impacting sales. The result is that inventory is reduced by the $159,000 figure mentioned earlier.

With no sales reduction, the inventory carrying cost figure drops by the same 5 percent as the inventory reduction. The result is a profit increase of $19,080. Cash has been increased dramatically and profit is up slightly-a perfect scenario.

Inventory exhibit 2

The third column of numbers builds a scenario in which the 5 percent reduction in inventory results in sales declining by the same 5 percent. (This is merely illustrative, as the exact impact of an inventory reduction on sales would obviously vary from company to company.) Even with a very modest sales decline, the impact on profit is severe. The reduction in inventory carrying cost is more than offset by the drop in sales and drives profits down to $219,080, a 56.2 percent decline. The firm still has more cash in the short run, but is mortgaging its sales future.

Finally, the last column of numbers determines the sales decline that will exactly offset the 5 percent reduction in inventory from a profit perspective. As shown, if sales fall by only 0.3 percent (0.318 percent to be precise), then the entire profit impact of the inventory reduction is offset. The firm still has more cash, but has not enhanced its profits.

The unknown factor, of course, is the extent to which sales will fall because of a reduction in inventory. That is dependent entirely upon the methods employed to drive the inventory reduction. In many instances, they tend to be a little ham-handed and do more harm than good.

Even a modest 5 percent reduction in inventory has the potential to lower sales volume, if the reduction lowers the firm’s service level.

Inventory Reduction Opportunities
Ideally, the firm will want to have its cake and eat it too. It desires to lower inventory with no negative impact on sales. If done with care, this goal potentially can be achieved. Often, though, the inventory reduction strategy is to cut inventory across the board, typically through a “stop buying” edict. The immediate impact of such an action is to drive the investment in A items well below needed levels to support sales. The firm suffers both a sales decline and a hit to its reputation due to out-of-stock items.

At the other extreme, the firm may focus only on the slowest-selling items. This is a great long-term strategy as many D items are pockets of excess inventory. However, because the D items are, by definition, slow selling, the inventory reduction process is agonizingly slow when centered here.

Ultimately, firms need to break the inventory investment into pockets of opportunity. Since every firm is unique, it is not possible to make precise recommendations. However, the following figures are illustrative of how much inventory can be reduced without suffering a sales decline:
   • A Items: No reduction
   • B Items: 1 percent to 2 percent reduction
   • C Items: 5 percent reduction
   • D Items: 10 percent reduction.

Over time, this will produce the inventory reduction required to generate more cash. Given that many of the D items are duplicated elsewhere in the assortment, there should be little, if any, sales loss. The payout, alas, will come at a modest pace rather than quickly.

It is essential that firms avoid any inventory reductions that impact sales. Given current cash levels, quick inventory reductions are a tempting short-run target, but are also a long-run impediment to success. The firm would be better served to slowly eliminate redundant items from the assortment. It is a strategy for all seasons that should not be abandoned when the economy improves.

Material Handling Equipment Distributors Association

Albert D. Bates, Ph.D. Meet the Author
Albert D. Bates, Ph.D., is founder and president of Profit Planning Group, a distribution research firm located in Boulder, Colorado, and on the Web at www.profitplanninggroup.com.


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