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Recently, many distributors have faced serious cash flow problems, largely as the result of dramatically reduced or even negative sales growth.
As a result, cash now represents only 0.1 percent of the total asset base for the typical NWFA distributor member. This cash position does not leave any room for error.
These cash-challenged firms have looked at ways to reduce investments in other major asset categories. Two categories stand out as being both large and controllable—inventory and accounts receivable. As a result, they have made concentrated efforts to empty these cash traps.
While reducing inventory and accounts receivable is a laudable effort, the action is fraught with danger. In both cases it is possible, and possibly even likely,that lowering investment levels will trigger further sales declines. Inventory reductions could lead to a higher occurrence of out-of-stock situations. For accounts receivable, excessively stringent credit policies could have a negative impact on sales.
In the case of inventory, it's important to examine the trade-off between maintaining sales volume with a proper and required investment versus having too much money tied up in non-productive assets. To do this, two key issues must be addressed:
• The need for both sales and cash—how does inventory impact both the company's cash position and its sales and profitability?
• Inventory reduction alternatives—where can inventory be reduced without impacting sales volume?
Approaching the trap
Every firm needs sales to survive and cash to pay its bills. These two concepts usually go hand-in-hand,but occasionally they do not. To understand the trade-offs between the two, it is useful to look at financial results for the typical NWFA member. Typical means that half of the NWFA members perform better and half do worse on any given measure. This typical firm has the following key characteristics:
Net sales: $14,000,000
Net profit before taxes: $210,000 or 1.5 percent of sales
Total assets: $3,783,784
Inventory: $2,153,846 or 56.9 percent of total assets
Cash: $14,000 or 0.1 percent of total assets
Clearly, the magnitude by which inventory dwarfs cash suggests there are major opportunities for the reallocation of assets. If the firm could reduce its inventory by 5 percent, which certainly lies within the realm of possibility, cash on hand would be increased by a staggering 769.2 percent. From a cash flow perspective, this is an attractive, and possibly even essential, shifting of funds.
At the same time, even a modest 5 percent reduction in inventory has the potential to lower sales volume if the reduction lowers the firm's service level. Figure 1 examines the challenges associated with an inventory reduction by looking at current results and three different scenarios.
The first column of numbers reviews the results for the typical NWFA member. The second column explores a 5 percent reduction that, through either luck or great planning, is achieved with no impact on sales. The result is an inventory reduction of$107,692, 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 decrease in inventory carrying costs, which increases profits. This scenario represents the perfect world toward which inventory reductions are always aimed. The ability of the typical NWFA member to reduce inventory by 5 percent with no negative sales consequences is doubtful, however.
The third column of numbers builds a scenario in which the 5 percent reduction in inventory results in sales declining by 2 percent. This merely is illustrative, as the exact impact of an inventory reduction on sales would 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 $170,154, a 19 percent decline. From a profit perspective, sales are much more important than the inventory reduction.
Finally, in the last column of numbers,if a 5 percent reduction in inventory were accompanied by an equivalent 5percent decline in sales, the results would be disastrous. Profits fall to only$86,154, a reduction of 59 percent. At this point, the entire effort to reduce inventory in order to create 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 reduction remains an appealing alternative.
The challenge is to find a way to reduce inventory while maintaining sales levels. With patience, this actually is an attainable objective. It will not, however,provide an immediate cash transfusion to the company.
Safely springing the cash trap
Reducing inventory requires both a realistic goal and a specific methodology. The 5 percent reduction used in Figure 1 is a reasonable goal. For the vast majority of companies, goals in excess of a 5percent inventory reduction probably are not achievable without creating major sales problems for the company. Even the 5 percent figure requires the company to proceed with caution.
In order to reach even a 5 percent 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 Figure 2. Since such information is not routinely collected for the industry, this example is for illustrative purposes only. Most firms follow this model fairly closely,but a few may depart dramatically.
Figure 2 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 percent of the SKUs but provide 60 percent of the sales volume. They are where the sales action is. The B items generally are another 10 percent of the SKUs and contribute another 20 percent 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 approximately30 percent of the SKUs, while providing only 15 percent of the sales. Finally, the D items are approximately 50 percent of the SKUs but generate just 5 percent of the sales.
The 80/20 rule is so commonplace that many firms don't even think about it anymore. As a result, they tend to overlook it in their planning. However, this concept needs to be given new attention,especially when it is expanded to consider the inventory investment required to generate sales.
The columns toward the right of Figure 2 indicate that while the A items account for 60 percent of the sales, they absorb only 40 percent 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 percent of the sales coming from 20 percent of the inventory investment. Their rate of inventory turnover almost always is 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 because they sell in large quantities. However, this is where out-of-stock problems could 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 generally are painless from a sales-loss perspective.
In order to empty the inventory cash trap, it is necessary to set some sub goals for inventory reductions. Assuming that a 5 percent overall reduction continues to be realistic, the firm probably should think in terms of the following:
A Items: No reduction
B Items: No reduction
C Items: 5 percent reduction
D Items: 10 percent reduction
Over time, this will produce the inventory reduction required to generate more cash. Given that too many of the D items are redundant, and that there are duplicate items in the assortment, there should be little, if any, sales loss. The payout, however, will come slowly rather than quickly.
The mouse takes the cheese
It is essential that companies avoid any inventory reduction that impacts sales. Given current cash levels, quick inventory reductions are a tempting short-run expedient. They also are a long-run impediment to success. The firm would be better served to set specific targets for slowly eliminating redundant items from the assortment. It is a process that should not be abandoned when economic conditions improve. It should be a strategy for all seasons.