Is the financial theory of 
inventory management losing its validity?

by Jane E. Baynard and Scott Benfield

Anyone familiar with distribution over the last several decades has been privy to the financial theory of inventory management. The foremost measure is the turn-and-earn theory of inventory management. As the body of knowledge goes, if you turn a product four times and make a 25 percent gross profit margin, the product’s turn-and-earn index is 1.

The turn-and-earn index is used as a metric that bridges asset management (turns) with market profit (gross margin percent) to arrive at an evaluative mechanism of a product’s performance.

In general, if a product is on the low end of the turn-and-earn index, there are four basic paths for correction or improvement: improve the turns, improve the gross margin, improve both turns and gross margin, or scrap the item. Much of inventory management historically has focused on a single performance statistic, increasing turns. Modern enterprise resource planning (ERP) systems deliver reasonably complex forecasting and economic order quantity (EOQ) calculations, which enhance buy-side management and maximize turns.

In the mature business of wholesaling, increasing gross margins is most effective for low-volume items or non-stock specials (i.e., less price-sensitive products). While there is a real need for system-based pricing, as opposed to cost-plus pricing, increasing gross margin percent is a tough hill to climb.

Another less-used ratio, but based on similar logic, is Gross Margin Return on Investment, or GMROI. Simply put, GMROI puts gross profit dollars over inventory dollars to arrive at a ratio of return on inventory value. For example, if the accounting period’s sales were $400,000 and gross margin percent was 25 percent, there is a total of $100,000 gross margin dollars. To support these sales, suppose there was an average inventory of $80,000 at average cost. Doing the math leads to a gross margin of $100,000 divided by an average inventory of $80,000, for a GMROI of 1.25.

Both turn-and-earn indices and GMROI are common metrics formed from the inventory management school of wholesaling founded some 30 or so years ago. Along with these measures, an equally common idea allocated operating expenses to inventory to give a cost per month of holding inventory. As the story goes, Distributor Z that sold $20 million at a gross margin of 25 percent, had a cost of goods of $15 million. And, if Z turns its inventory four times, the average inventory value is somewhere around $3.75 million. If one follows the Gordon Graham logic^A, then the $3.75 million of average inventory includes 6.5 percent in warehouse fees ($243,750), 3.25 percent in taxes ($131, 250), 2 percent in insurance ($75,000), 3 percent in obsolescence and shrinkage ($112,500), 3.25 percent in material handling ($121,875), and a cost of capital at 10 percent prime of $375,000. All totaled, the costs for Distributor Z were $1,059, 375 in handling costs, or approximately 28 percent of average inventory.

The arguments for the financial school of inventory are well established. It was rather common in years past to attend distributor functions and watch top managers nod their heads when talk began on the insidious cost of inventory and how it could cripple the best of wholesalers. We are of the belief, however, that the financial theory of inventory is not as pertinent to today’s distributor as it once was. We believe the theory was and is far overused, it forces a cost or asset mindset to the detriment of a marketing mindset, and will be less important in the future as the tenets of value switch from products to services. We’ll overview just why we have taken that stand in the balance of this article.

Cost allocations, asset reductions and "expenses"
Several years ago, we met an inventory manager who had reduced average inventory by $12 million, from $50 million to around $38 million. The manager explained how he saved the company not only the value of the inventory, but all of the expenses associated with it. If one buys the previous logic, he “saved” the company 28 percent of $12 million, or $3.36 million plus the $12 million in inventory costs.

Our problem with the inventory manager’s savings claims is that “savings” denotes a reduction in expenses and a corresponding influx of cash. In short, to hear the inventory manager tell it, he saved the company $15 million-plus in cash expenses. We often hear inventory specialists present similar claims and, unfortunately, their math is fairly misdirected.

When average inventory is reduced, the reduction is in the inventory asset. Bankable savings are those expenses that are directly related to that asset. Lowering inventory by $12 million did not save the company $12 million in cash, it simply reduced inventory assets held at any one time. Beyond this, not all of the support costs related to the inventory reduction are cash savings in the near term. Taxes at 3.25 percent, insurance at 2 percent, and the cost of capital at 10 percent are, in general, easily banked savings on the inventory reduction. In essence, these fees are more or less tied to the dollar value of inventory and, if the wholesaler accountant does his or her job, they can take advantage of the direct expenses in short fashion.

The often overestimated savings for inventory reduction is allocated warehouse space, material handling, and obsolescence and shrinkage. In the previous example, our guess is that the distributor’s warehouse expenses remained more or less the same whether average inventory was $50 million or $38 million. It is difficult at best to take a portion of the warehouse and rent it out to another company. And, unless this is done, the warehouse expense remains more or less the same. This is not to say that the freed up space can be stocked with better moving, more profitable inventory.

Material handling expense also will remain roughly the same. The physical assets (tow motor, pallet jacks, transfer lines) are more or less fixed and the warehouse labor will remain roughly the same. Most wholesalers cross-train warehousemen, and the lessened inventory may let the employer post the workers to another position. In our experience, however, wholesalers staff warehouse labor to cover peak customer demands, not the average inventory level.

And finally, the obsolescence and shrinkage fee is not 100 percent correlated to the reduction in average inventory. An inventory reduction of 24 percent ($12 MM/$50MM) does not automatically equate to a 24 percent reduction in obsolescence and shrinkage cost. Much of average inventory reduction has to do with the “A” items and better buying through forecasting and shortening the supply chain. “A” items, by definition, are not the most likely candidates for obsolescence and shrinkage. Obsolete inventory is often the “C” and “D” new product offerings that don’t make it. And shrinkage is typically the larger dollar or odd items that don’t have marked bins and end up being lost in the black hole of the warehouse.

All totaled, the savings from reducing inventory are primarily the direct costs of taxes, insurance and cost of capital. Other allocated fixed costs may be better used, but it is hard to derive a short-term savings purely from more efficient asset management. And, finally, the reduction in average inventory does not translate into cash savings, but a reduction in an asset.

The bigger picture and the new investment for value
A reasonably new school of thought says that wholesaling is more of a service business than a product business. Although wholesalers price for products, they largely control and add value through services that support these products. This thinking is gaining momentum as government economists are beginning to research the service value of the supply chain to upgrade the product-based pricing indices.^B As the new theory of value changes away from a product basis, the financial measurements derived from product accounting and analysis become less relevant.

Inventory value and the allocated costs are less relevant to influencing revenues than the support knowledge and systems for services. An example of this is the wholesaler that found a large segment of the market that would pay for training on procurement software. The wholesaler began to staff and train its organization to provide an array of knowledge-based services. The training and revenues derived from training services are independent of the inventory stocked. Also, the asset base to drive the service is human knowledge or “brain capital.” To our knowledge, traditional accounting doesn’t have set standards for brain capital. Nonetheless, the value for a service-based business is often not related to product movement, and the evaluative mechanisms for service costs are found in activity costing or flow charting and cost estimating of the discrete events that make up the service.

A little known detriment of the attention to inventory management is that company officers look at the asset base and buy-side costs and don’t focus on creating value in the market place. A common statement is, “We make more buying and turning than we do selling.” Translated, this means that wholesaler managers derive more value from the buy-side and asset management than they capture and create for the customer on the front end of the business. The result is that managers are driving the business by looking in the rear view mirror (inventory and buy-side) and not steering the business by looking out the windshield at the roadway of the customer marketplace.

As wholesaling begins to move from a value proposition of service and away from products, accountants and financial managers will be challenged to move away from the financial theories of inventory to service valuations. In the end, the shift in value will create a shift in measurement and a lessening of importance of inventory-based financials.

Inventory management is a critical component of an efficient supply chain that, in turn, can be the fulcrum for success in the business. The financial knowledge of inventory management and its importance has reigned for the past generation of wholesalers. As we explore its misconceptions and change the value proposition to service provision, the theories of the past become less important. Prudent managers will understand the financial and accounting measurements of inventories, but the best of the lot will also know their weaknesses and begin to rearrange their measurements, thinking and counting to the new frontier of service value as derived from the free market.

A. Percentages for cost of inventory are from Inventory Management for the 1990’s, Gordon Graham, page 93.
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B. Benfield Consulting, conversation with economist from the Bureau of Labor and Statistics on current research on service value of the industrial supply chain.
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