When not managed
carefully, inventory costs can be the difference
between being profitable or losing your shirt.
Originally published by
By Ted Hurlbut
Hurlbut &
Associates
For most small retailers, inventory is the single most
significant asset. Their inventory, their merchandise,
defines who they are and speaks more clearly to their
customers about what they're all about than any ad or
marketing message.
In the minds of many smaller retailers inventory is
linked directly to sales: "If I don't have it, I can't sell
it!" These retailers see sales as the most critical metric,
because it's the measure of the total cash flowing into
their businesses.
Just as importantly, however, the cost of that inventory
is the largest expense item on every retailer's income
statement. Inventory is expensive, and if not managed
carefully, the cost of excess inventory can be the
difference between a smaller retailer being very profitable
and losing money.
The cost of inventory to a smaller retailer is far
greater than simply the invoice cost and freight. There are
inventory carrying costs, shrink, damage and obsolescence
costs, and even the cost of lost sales due to too much
inventory. These costs can add up quickly, almost
imperceptibly. But these costs are real, and they do end up
on the income statement eroding profits.
Let's explore each of these costs in turn, starting with
carrying costs. Retail inventory carrying costs include
inventory financing charges, insurances and taxes,
processing and handling expenses, inventory control and
cycle counting expenses:
Inventory financing
charges. For most smaller retailers, working capital
financing is primarily financing inventory, especially
seasonal inventories. This is a very easy expense item
to identify and measure. It's also very easy to manage;
the more inventory that you're financing the more that
those financing charges will take out of the bottom
line.
Inventory insurance and
taxes. Both insurance and taxes are variable with
changes in inventory value. Excess inventory is
particularly costly here, because it tends to make up a
disproportionate percentage of the total inventory value
at fiscal quarter and year end.
Merchandise ordering and
processing costs. There are costs associated with
ordering merchandise, receiving merchandise, ticketing
it and stocking it. Every retailer would consider these
costs as basic costs of doing business, but the more
merchandise you order and process the greater these
costs will be. And if you're carrying excess levels of
inventory, these costs will unnecessarily cut into the
bottom line.
Physical merchandising
costs. These are the costs of physically maintaining
retail inventory. These are the costs of store recovery
after each day's sales, re-merchandising of inventory as
it sells down, marking down and re-merchandising for
clearance, setting and breaking feature displays. These
costs increase exponentially with excess levels of
inventory, because excess inventory remains in stock
longer and as a result ends up being handled a greater
number of times. It's simply much less costly to
maintain a store that's not overwhelmed with
merchandise.
Inventory control and
cycle counting. Cycle counting is a critical activity
for keeping inventory records in line and maintaining a
heightened sense of awareness to loss prevention. Cycle
counts are also a necessary cost of doing business. But
the cost of doing cycle counts, of periodically counting
a portion of your inventory, increases with the level of
inventory. And if you forego cycle counting, and the
costs of cycle counting, you pay for that in the form of
increased shrink, which is far more expensive.
Ordering and processing costs, merchandising costs, and
inventory control and cycle counting costs are primarily
labor costs, and can be very difficult to isolate.
Nevertheless, they are real. Smaller retailers that make the
effort to tighten their inventories usually find that they
don't need as many people as they thought they did.
Income Statement, shrink, damage and obsolescence
costs
While retail inventory carrying costs typically are
buried in the expense items below the gross margin line of
an income statement, shrink, damage and obsolescence costs
hit gross margins directly.
Shrink and damage costs are pretty easy to understand.
What's perhaps not as clear is that shrink and damage
percentages are almost always greater when there's too much
inventory. It's much easier for theft to go unnoticed if
displays are overstocked to begin with and sightlines are
obscured by too much stuff. And when there's too much stuff,
accidents are much more likely to happen, with merchandise
breaking, or getting dinged, or packaging ripping or
crushing.
Obsolescence is just a fancy word for markdowns, and
while markdowns may also seem like a basic cost of doing
business, they are incredibly corrosive to profitability.
When there's excess inventory, markdowns are always higher,
because excess inventory invariably slows the rate of sale
of everything, and the longer merchandise goes unsold, the
greater the markdowns that will be necessary to move it
through.
The cost of lost sales
While many smaller retailers think that they need more
inventory to be sure they don't miss any sales, the reality
is that too much inventory almost always leads to lost
sales. This is where having too much inventory can actually
impact a retailer on the very top line of the Income
Statement.
When there's too much inventory, stores are simply harder
to shop, and when stores are harder to shop customers buy
less. This can play out in several ways:
When stores are
overstocked, it's simply much harder for customers to
find what they came in for, and much more likely they'll
leave without it.
When there's too much
stuff, aisles can become narrower, discouraging
customers from exploring deeper into the store.
When displays are
overstuffed, customers become afraid to touch, afraid of
breaking something on a shelf simply packed to tightly,
or starting an avalanche on a display piled too high.
When there's too much
assortment, too many things to choose from, customers
can become paralyzed. If the retailer hasn't been able
to focus the assortment for the customer, how can the
customer know with confidence that they'll be happy with
what they purchase?
When there's too much
merchandise, customers can simply become overwhelmed by
it all!
Invariably, when stores bring their inventories in line,
clean up their assortments and make it easier for the
customers to shop and find what they're looking for, sales
go up. And in some cases, sales don't just go up a little
bit, they go up a whole lot. The math is irrefutable.
Inventory costs money, and too much inventory costs a lot
more money. The cost of slower turning inventory is much
greater than the cost of faster turning inventory. And the
costs are felt throughout the business, from lost sales, to
reduced margins, to increased expenses. Those smaller
retailers that actively manage their inventories, striking
the right balance between having what their customer want
and having too much, invariably are more profitable than
those that don't.
