Maximizing Profitability through Inventory Management

by Carl J. "Skeet" Haag, CPA

What would you say is the No. 1 cause of bankruptcy in most businesses today? It's not lack of sales. It's not overpaid executives. And it's not overstaffed operations. It is mismanaged assets. In inventory based companies, what is the No. 1 asset? That's right - inventory. Many times the paperwork affecting the value of this asset flies around the office like a whirlwind blew through the office window with some of the paperwork landing where it should, some landing close and some never landing at all.

Inventory - The Lifeblood of a Company

Let us take a look at the characteristics of a company that is generally acknowledged to have an excellent inventory system. Do you recognize this company?

• Inventory is stored inside a fenced stockroom with preassigned bins and an overflow area that is clearly defined.
• The fence has a door with very few keys distributed only to authorized individuals.
• No unauthorized people ever wander in and out.
• Service is prompt and the hours the stockroom is open are known in advance.
• Every receipt is accompanied by a proper document.
• Every issue also has a corresponding document identified with it.
• The stockroom staff are well trained; there is a job description available and on-the-job training is available for new people prior to their replacing anybody leaving.
• The objective of zero defects is clearly understood and expected.
• Time is allowed every day to reconcile transactions with inventories.
• Audits are taken periodically and discrepancies are totally unacceptable.
• The users have complete confidence in the stockroom's integrity and that is the most critical element.

The inventory in this company is cash and the stockroom is the community bank, from which a lot can be learned. It is remarkable that a company, with several million dollars in inventory - more than a community bank would ever have in cash, does not insist on similarly stringent procedures. If a company could somehow convince its employees that inventory actually represents dollar bills sitting on the shelves or racks, how would it be treated? Would it be handled as it does now?

Would a company allow people to substitute fives for tens, or tens for twenties without properly recording it? The answers may seem obvious, but how many of us can relate to any one of these situations? Attitudes of all employees must be changed to view inventory as the lifeblood of the company and their livelihood.

Information Systems

Obviously, to get a good handle on how to manage inventory, one must have correct up-to-date information. Properly managing inventory requires a system that will produce enough timely information to make informed management decisions. How to select a proper computer system is not within the scope of this article, but one basic concept needs to be remembered: The primary objective of any system is to provide predictable results. If certain benchmarks or standards are set to help manage a business, the system should capture the data consistently and measure those standards correctly. For example, if inventory turnover and customer service levels are measured to help manage inventory, a good computer system will consistently measure these and give warnings when they are out of line with the established standards.

Key Performance Indicators

Once a good information system is up and running, a determination should be made of which key performance indicators need to be calculated. What are key performance indicators? They are data that if consistently measured and properly monitored, will have the biggest impact on where you are and where you want to go. Sales calls per week, number of new customers and sales and gross profit volume per customer represent a sample of key performance indicators for sales. For inventory, the primary indicators deal with inventory turnover and customer service levels. Maintaining the best possible customer service while maintaining the optimum levels of inventory should be the goal of any inventory system. A delicate balance between the two must be maintained to achieve maximum profitability.

Inventory Turnover

Exactly, what is inventory turnover? Inventory turnover is a measurement of inventory use. It expresses how many times per year the stock inventory is used. It is calculated as follows: turns = annual cost of sales (from stock only) divided by average inventory. For businesses that have direct shipments to customers, only the stock inventory should be used. Otherwise, the turnover results will be overstated. Inventory turnover rates should be measured, ideally, at least on a monthly basis. Some businesses may choose to use the end of month inventory as the denominator, and that is acceptable. It is very critical, however, to be consistent in the calculation for each period. Otherwise, correct trends cannot be identified. Exactly how many times should inventory turn? It depends on what industry is being served and what the profit margins are. The lower the profit margins are, the higher the inventory turns should be, and vice versa. Gordon Graham, the "dean" of inventory experts in the distribution industry, makes this illustration.

"If a durable goods distributor has gross margins on sales of 20 to 30 percent, the inventory should turn approximately six times. If the gross margins approximate 15 percent, eight to 10 turns should be achieved. If margins are somewhere near 40 percent, then inventory can turn only four times and a nice profit can still be achieved."* There are no generic right answers. Do not become consumed with increasing inventory turns. There must be a balance between maintaining the right inventory levels and maintaining excellent customer service.

Customer Service Levels

Since good customer service is the other part of the formula, it too needs to be measured and monitored regularly, preferably on a weekly basis. However, measuring customer service is not as easy as measuring inventory turns. Many times conversations occur and decisions are made that never hit the computer. When sales orders taken compared to sales orders shipped are at a 97 percent rate, one may think excellent service has been achieved. However, customers may have had to accept substitutes for their original orders; or delivery may occur one to two days late. Customers may have been very dissatisfied. But based on the 97 percent fill rate on orders taken, customer service levels appear high.

So, how does a business properly measure customer service levels? Again, there are no generic answers for all industries. However, as Gordon Graham points out, customer service performance should only be measured against items that are in stock. When customers order nonstock items, it should be pointed out to them what has to be done to fill that order. On stock items, three events to occur to ensure good service:

• Fill at least 90 percent complete on the first attempt in the warehouse, with no backorders or shortages.
• The customer gets the brands requested if they are on the stock list.
• If substitutions are made, even with the customer's approval, no credit is given for that item.
• Lastly, if the customer has ordered early enough to receive delivery today and it was promised to the customer today, then even if it is a full shipment, no credit is given if it is shipped the next day.

Given these parameters, service levels should be measured as follows:

Number of line items completely filled divided by total number of line items on sales orders received. Remember that when computing line items completed, no credit is given for those line items partially filled, items substituted, or late deliveries. For example, a line item may be 99 percent filled or 100 percent filled that includes a substitution, but no credit should be given. These parameters may appear to be harsh, but at least they will take into consideration any negative impact of partial shipments or substitutions. Likewise, with a 100 percent correctly filled order that is delivered one day late, no credit should be given.

Summary

Changing the inventory mindset of employees and creating a system of benchmarking and accountability is not done overnight. Properly managing inventories is a battle businesses have long fought. Successful companies have found that employees committed to change combined with great customer service and optimum inventory levels, lead to great profits. They have also found it is very difficult to achieve all three at the same time. There is one obvious fact: those companies that are not committed to achieving these three goals, better get out of the way of those that are. When is a good time to start this process if you have not already? There is no better time than today!

Reference

*Graham, Gordon, Distributor Survival in the 21st Century. Richardson, Texas: 1992

About the author

Carl J. "Skeet" Haag, CPA, is a partner at Reynolds, Bone & Griesbeck PLC, a certified public accounting firm in Memphis, Tenn. Haag is a member of the Tennessee Society of Certified Public Accountants (TSCPA), the state professional organization for more than 8,000 CPAs in government, education, industry, business and public practice and its Memphis Chapter. TSPCA's Memphis chapter is one of eight chapters across the state with more than 1,500 members in three counties. For more information on small business issues, visit the Tennessee Society of CPAs' Small Business Resource Center on the Web at www.tscpa.com.