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The Diamond of Doom

The High Costs of Excess Inventory

by Patricia M. Johnson, CMC and Richard F. Outcalt, CMC  

As a retail owner, one of your primary goals is to boost profit margins—right? 

You know that good inventory management is essential to producing top-notch profits. You also know that bad inventory management can cause big problems with profit. However, you may not know the actual cause and effect of bad inventory management. 

The following diagram, the “Diamond of Doom,” illustrates in simplest form the problems created by carrying too much inventory. (And this diamond is definitely NOT a "girl's best friend"!) 

Diamond of Doom of Excess Inventory

High Inventory Hurts!

Let’s take a closer look at the cause-effect chain reaction of this inventory “diamond”.


Cause: High inventory causes excessive inventory obsolescence, pilferage, maintenance, insurance, and taxes.

Effect: This results in lower gross margin.

Consider the expenses that you incur due to purchasing, holding, and selling merchandise in your business. These may include freight in, storage costs, insurance expenses, external or internal theft, obsolescence, spoilage, and taxes.

Studies have shown that the annual additional cost of holding excess inventory can be 25 percent to 32 percent. For ease of calculating, let’s round that off to 30%.


Find the Cost of Excess Inventory in Your Store

To see how excess inventory is affecting expenses in your store, first estimate the total inventory @cost you currently have on hand. For example, say you have $100,000 of inventory @cost on hand.  If you carry 10 percent more inventory than actually needed, what is that costing you?

$100,000 inventory x 10% excess = $10,000 in excess inventory
$10,000 excess inventory x 30% = $3,000 annual waste in expenses

You might consider that this cost of holding excess inventory could be avoided by investing in an inventory management system that would last you the life of your business, and possibly pay for itself in a year’s time.


How else might this "excess inventory" be affecting your profits? 

 

Cause: Lower gross margin causes pressure to get sales volume up, bringing on higher selling and advertising expenses.

Effect: This results in lower operating profits.

When you hold more inventory than you need, your income statement suffers in two ways—a lower gross margin (see #1) and increased operating expenses. Both of these lower your operating profit.

If you are carrying an excess level of inventory, you will incur additional and probably unplanned selling and advertising expenses in order to sell the excess merchandise. These added expenses will lower operating profits.

For instance, if you are spending 4 percent of your sales on advertising costs for which 25 percent is devoted to moving out excess inventory, the saved one percent of your sales volume (25 percent of 4 percent) becomes increased profits.


Cause: High inventory causes poor cash flow, thus pressure from suppliers. 

Effect:  This results in excessive debt servicing.

With every sales transaction, cash is generated, which drives the system. 

Cash is used to purchase inventory and pay expenses. When inventory is sold it is converted to either cash or receivables, which eventually turns to cash. The faster this cycle turns, the more efficient and expedient is your use of your investment.

But when your inventory is too high, your excess cash is tied up in inventory—cash that could be used to pay suppliers. 

When suppliers don’t receive payments on a timely basis, you will feel the pressure to pay or have your supply terminated. 

As you juggle to keep them satisfied, you will inevitably wind up at your banker’s doorstep. 

Hopefully you have a good banker who will inform you of the destructive cycle that is beginning. If your banker loans you money, he or she will also want to improve your inventory control to squeeze the excess cash out of your inventory. 

This problem may appear temporary, but it may not be. The loan is a short-run solution: it will not eliminate the long-run problem.


Cause:  Excessive debt servicing causes increased interest expense.
Effect:  This results in lower operating profits.

The need to borrow to pay off your suppliers, rather than generating those funds internally is obviously costly. 

Interest expense is higher than it need be.  When the prime lending rate goes up even one quarter of one percent, the interest you pay on that inventory-related loan increases. 

So, if you have more inventory than necessary, you pay more interest, which increases as the prime rate increases. This higher interest expense draws on your cash supply—cash that could have been reinvested in new inventory. 

Sales therefore are inhibited, and growth is restricted as profits are reduced.


Plan for Inventory Needs

How do you know if you have high inventory? 

One way to judge is to determine your current inventory turnover rate (sales divided by average inventory at retail OR cost of goods sold divided by average inventory at cost). 

Now, compare your inventory turnover rate to the average turn of your industry. (Refer to your retail industry’s Cost of Doing Business Survey or check the benchmark numbers for your retail segment here at The Retail Owners Institute.)

To get the most out of your inventory, settle on a turnover rate producing just the right flow of merchandise to enhance sales, optimize cash flow, and maximize your profits.

Inventory Management Does Not Depend on Luck!

Effective inventory management takes planning—not just luck! Do not merely consider sales, but also project the figures to find the optimum turnover rate for cash flow and profits as well as sales. It’s the balance you are after.

We cannot emphasize enough the importance to plan your inventory needs, which means implementing an Open-to-Buy system. This enables you to commit yourself to receiving a certain amount of inventory in a given amount of time.

These amounts are predetermined based on a carefully calculated sales plan and corresponding inventory level, based on your targeted turnover goals.

Those High Costs of Excess Inventory

In summary, inventory levels that are "too high"...

  1. depress your gross margin
  2. increase operating expenses
  3. have a negative effect on cash flow
  4. all of which result in reduced operating profits.
“Proper” inventory levels require management control and discipline, but the results justify the attention. Keep this in mind before you embark on your next season’s purchases.


©Copyright, The Retail Owners Institute® and Outcalt & Johnson: Retail Strategists, LLC.

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