Inventory: Cash Trap or Sales Driver?

Profit Improvement Report

®The Need for Both Sales and Cash An examination of how inventory impacts both the firm's cash position and its sales and profitability.

®Inventory Reduction Alternatives A review of where inventory can be reduced without impacting sales volume.

®Net Sales: $6,750,000

®Net Profit Before Taxes: $189,000 - 2.8% sales

®Total Assets: $2,142,857

®Inventory: $723,068 or 33.7% of total assets

®Cash: $128,250 or 1.9% of total assets

Clearly, the magnitude by which inventory dwarfs cash suggests some major opportunities for reallocation of assets. If the firm could reduce its inventory by 5.0%, which is certainly within the realm of possibility, then cash on hand would be increased by 28.2%. From a cash flow perspective it is an attractive, and possibly even essential, shifting of funds.

At the same time, even a modest 5.0% reduction in inventory has the potential to lower sales volume, if the reduction lowers the firm s service level. Exhibit 1 examines the challenges associated with an inventory reduction by looking at current results and three different scenarios.

The first column of numbers merely reviews the results for the typical DHI member. The second column explores a 5.0% reduction that, through either luck or great planning, actually is achieved with no impact on sales. The result is that inventory is reduced by $36,153, which increases cash by the same amount.

With no sales reduction, the top half of the income statement remains intact. The reduction in inventory is accompanied by a reduction in inventory carrying costs which increases profits. This represents the perfect world towards which inventory reductions are always aimed. The ability of the typical DHI member to reduce inventory by 5.0% with no negative sales consequences is problematic.

The third column of numbers builds a scenario in which the 5.0% reduction in inventory results in sales declining by 2.0%. 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 costs is more than offset by the drop in sales and drives profits down to $154,868, a 18.1% decline. From a profit perspective, sales is much more important than the inventory reduction.

Finally, in the last column of numbers, if a 5.0% reduction in inventory were accompanied by an equivalent 5.0% decline in sales, the results would be disastrous. Profits fall to only $95,536, a reduction of 49.5%. At this point, the entire effort to reduce inventory in order to make gains in the cash flow position has been wasted.

Clearly, the economics of the firm overwhelmingly favor maintaining sales volume. In particular, some of the more panic driven approaches to inventory management, such as cutting inventory across the board, are doomed to failure. At the same time, most firms need to strengthen their cash position and inventory remains an appealing alternative.

The challenge is to find a way to make the inventory reduction and maintain sales levels too. With some level of patience, that is actually an attainable objective. However, it is not attainable in such a way that it provides an immediate cash transfusion to the firm.

Reducing inventory requires both a realistic goal and a specific methodology. For a goal, the 5.0% reduction used earlier is a reasonable undertaking. For the vast majority of firms, goals in excess of that number are probably not achievable without creating major sales problems for the firm. Even the 5.0% figure requires the firm to proceed with caution.

In order to reach even a 5.0% reduction without a sales loss, it is necessary to break the inventory investment into pockets of opportunity. The results of such an analysis are presented in Exhibit 2. Since such information is not routinely collected for the industry, this exhibit needs to be viewed as illustrative. Most firms will follow fairly closely, but a few may depart dramatically.

The exhibit takes the widespread approach of dividing the firm s SKUs into A, B, C and D sales volume categories. The A items, which are the fast sellers, represent only about 10.0% of the SKUs but provide 60.0% of the sales volume. They are where the sales action is. The B items are generally another 10.0% of the SKUs and contribute another 20.0% of the firm s sales. This relationship is consistent with the age-old 80/20 rule which is well understood in distribution.

To continue with the 80/20 rule line of reasoning, the C items are about 30.0% of the SKUs, while providing only 15.0% of the sales. Finally, the D items are around 50.0% of the SKUs, but generate just 5.0% of the sales.

The 80/20 rule is so well known that too many firms don t even think about it any more. As a result, they tend to overlook it in their planning. The concept needs to be given new attention, especially when it is expanded to consider the inventory investment required to generate the sales.

The columns toward the right of the exhibit indicate that while the A items account for 60.0% of the sales, they absorb only 40.0% of the overall inventory investment. The result is that they have an inventory turnover level that is far above that produced by the total firm.

In contrast, the B items achieve almost exact parity, with 20.0% of the sales coming from 20.0% of the inventory investment. Their rate of inventory turnover is almost always exactly equal to the turnover for the firm overall.

Both of the remaining categories require proportionately more inventory than sales. At the C level the problem is significant, while at the D level, the inventory imbalance is nothing short of critical. Any effort at inventory reduction should be aimed at the D items with some support from the C items.

The problem is that the inventory on the A items can be reduced quickly as they sell in large quantities. However, this is where out-of-stock problems will arise with the greatest severity. At the other extreme, reducing the inventory on D items is a slow, almost agonizing process. It is at this level, though, where the inventory reductions are generally painless from a sales loss perspective.

In order to drain the inventory cash trap it is necessary to set some sub-goals for inventory reductions. Assuming that a 5.0% overall reduction continues to be realistic, the firm should probably think in terms of the following:

®A Items: No reduction

®B Items: No reduction

®C Items: 5.0% reduction

® D Items: 10.0% reduction

'2002 Profit Planning Group. DHI has unlimited duplication rights for this manuscript. Further, DHI members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited.