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We don’t need no stinking inventory!

Here’s a compelling overview on how the conventional view of inventory often belies its true value when it comes to the success of your business.

By Robert Shaunnessey

Take THAT! you warehousing Humphrey Bogart. The treasure of Sierra Madre is right there in your warehouse and by eliminating it you can cure all that is wrong in your supply chain.

That is the position of many of supply chain gurus today and I believe it is a misguided perspective. Somewhere there must be at least a nugget of benefit in having inventory. So what are the benefits and costs?

One of the major trends in consumer preference today is immediate, or ondemand, fulfillment of wants, and customers are less patient than ever with out of stocks. As orders grow smaller and SKUs proliferate, the ability to accurately predict demand declines and out of stocks grow. This is because the ability to accurately predict demand relies on the law of large numbers that evens out the unpredictable acts of humans into semi-predictable averages.

The Grocery Marketing Association’s (GMA) recent study shows that out of stocks average about 7.4 percent of the items in the top 25 classes of products in a supermarket. They also found that 40 percent of those out of stocks result in a lost sale. This amounts to about 3 percent of total sales.

Promotional items fare even worse — typically over 13 percent are out of stock. That means over 5.2 percent of sales are lost on those items. So, about 3.5 percent of sales are lost overall. Not surprisingly, online shoppers are even less likely to accept a substitute or wait for a product to become available again.

Let us value the primary costs that make up the inventory trade-off. If we assume 3.5 percent of sales are lost, at somewhere between 30 percent and 50 percent gross margin, the retailer would lose 1 to 1.8 percent of profits just from this initial sales loss.

The only way to overcome lost sales is with inventory. But holding inventory is not without a cost.

There are many ways to measure inventory carrying costs. In general, they include the warehouse and its staff, interest expense, damage, obsolescence, taxes and insurance. A recent survey of logistics executives reported an average carrying cost for their inventories of 18 percent.

This 18 percent carrying cost number seems high when compared to the 3 to 5 percent loss of sales numbers we see from various sources. However, inventory is a static measure and sales are dynamic — an apples versus oranges situation. When you convert the carrying cost of inventory to a percentage of sales you get a much different picture. To make these numbers comparable we need to divide inventory carrying cost by inventory turns.

A common range of inventory turnover is 10 to 15 times per year. When you convert the inventory carrying cost to a percent of sales you get a range of 1.2 to 1.8 percent of sales.

So now we can compare the cost of carrying inventory to the cost of not carrying it. We have derived the range of 1.2 to 1.8 percent as the average cost of carrying inventory. The GMA study gives us an average cost of not carrying it. The loss of sales, according to this report, will generate a 1.0 to 1.8 percent loss of profit margin.

These ranges completely overlap. This tells us that indiscriminate reductions in inventory will tend to reduce profits. We’ve all heard the story of the hunter who drowned in a stream that has an average depth of 6 inches. It just happened he was crossing during a flash flood. The lesson here is that averages can give you a quick look, but if you manage by them alone, the result can be sub-optimal, to say the least. Inventory must be strategically managed by SKU, not just eliminated. For example, more inventory is called for in products with a high gross margin and high turnover.

The equation gets more complicated when you consider not only the loss of profit and overhead on the current sale but also how much you lose when the customer goes away to a competitor; the lifetime value of that customer can be enormous. This loss of clients over time can be significant and has contributed to the failure of many retailers. Yet you rarely see this factor used in the analysis.

Your clients are your gold and minimizing all inventory causes you to lose some of them. The long term loss you face through losing those clients varies but is substantial for many companies. The marketing professionals in your company can give you their estimate of the profit generated by a new client;losing them will be at least the same. The greater the long term cost of losing a frustrated customer, the more inventory you should carry.