When Should a Good Inventory Buy Be Avoided?
You might be asking yourself – if it is a good buy, how could it be bad? First, let’s take a look at several aspects. Companies have always been aggressive with squeezing every margin dollar they could, even more so in this economy. And in order to do this many have looked over seas to foreign manufacturers as a way of increasing the potential margin. The downsides to this is typically larger minimums from manufacturers, in addition to cubing out shipping containers for maximum efficiency, and very long lead times.
Let’s take a look at how some of this can make what seems like a good inventory buy a bad buy. A while back we worked with a company that imported a specific merchandise category from an Asian manufacturer. The lead time for these products was 8-9 months. By doing this they were able to go from an average gross margin of 44% to 55% with an average price point of $51.
Recently they made a purchase from the same manufacturer which allowed them to go from a 55% gross margin to 60% gross margin – or go from $28.05 in gross margin dollars to $30.60. The downside was a substantial increase in the vendor minimum and a much shorter set of payment terms. But still it seemed like a good buy, and they felt like they could sell through the extra quantity.
The reality of the situation was the quantity purchased turned out to be a 15 month supply of inventory causing several problems that made this a very unprofitable buy. Here’s how:
1. A 15 month supply of inventory equates to less than .8 turns annually.
2. With a 60% gross margin and .8 turns annually, the gross margin return on investment (GMROI) is 0.48; in laymen’s terms this means for every dollar they invested in inventory purchases, the income is less than $0.48. This is devastating to the business. You can calculate GMROI by multiplying the decimal equivalent of your gross margin (50% = .50) times your annual turns.
3. The increase in inventory levels and the length of time the product was warehoused cause several issues. First the warehouse was running close to capacity and this prolonged the pain of running low on warehouse space. Secondly, the gross margin was further eroded by the inventory carrying costs, the longer it sat the longer the margin was eroded.
4. Most importantly, the company tied up much more cash in inventory then they should have, by not turning the inventory quickly a significant portion of the inventory will need to be liquidated in order to free up cash and invest in other items. Fifteen (15) months is a long time when you need to continually refresh the product mix with new products. The liquidation will further erode the gross margin.
5. Not only did this tie up more cash than they should have but they had to pay the vendor even faster than normal.
These factors come into play and can make what seems like a good buy a very bad decision. Having to carry more inventory, invest more cash in inventory and pay the vendor in even shorter terms will lead to several problems. You should stick to a well disciplined buying and inventory strategy and run all the numbers before deciding whether or not it is a good buy. If the numbers work out then consider making the investment in inventory. Just don’t erode the increase in gross margin with higher shipping costs, higher inventory carrying costs, and then end up liquidating a large portion of the inventory.
Need help reviewing your inventory strategy, if so we offer inventory assessments for typically $6,500 – designed to be performed quickly with a high ROI and actionable recommendations – click here to learn more.
Brian Barry is a Senior Consultant with F. Curtis Barry & Company, a multichannel operations and fulfillment consulting firm with expertise in multichannel systems, warehouse, call center, inventory, and benchmarking; Learn more online at: http://www.fcbco.com.
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