In part one of a three part series on profitability, Pieter Lotz, solutions director for New ERA Solutions, will look at the challenges around managing stock to ensure that it has a positive effect on a company’s bottom line.
We specifically look at:
- Challenges that effect profitability;
- Why dead stock does not provide a return on investment;
- How money invested in excess stock is not available for other opportunities to earn profits;
- Why stock shortages result in a loss of productivity and potential loss of customers; and
- And how inefficient warehouse operations result in excessive labour and equipment usage.
Without a proven enterprise resource planning (ERP) system in place with comprehensive management capabilities, it’s virtually impossible to streamline processes and effectively manage inventory to maximise profits. Problems such as dead stock, incorrect calculation of pricing and inaccurate stock control, are detrimental to your bottom line and devastating to customer relationships
Is inventory (stock) an asset or a liability?
Inventory, or stock, is defined as the raw materials, work-in-process goods and completely finished goods that are considered to be the portion of a business’ assets that are ready or will be ready for sale. Inventory represents one of the most important assets that most businesses possess, because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company.
On a company’s balance sheet inventory is classified as an asset, however, there are instances when inventory can become more of a liability. If inventory is not properly managed, although you have the physical asset, that asset might be costing you money rather than generating it. Here are three simple but important facts about inventory:
- As a distributor, the process of making money on goods does not begin when goods enter your warehouse; it only generates income when it leaves;
- While stock is waiting to be sold, it costs money to store it; and
- The longer it stays in a warehouse, the less likely it is that it will be sold.
What is dead stock?
Dead stock is inventory that has not been sold within a reasonable amount of time, normally 12 months. At the point where stock becomes dead it is no longer considered an asset.
To calculate the impact of dead stock on profitability you must look at gross margin return on investment (GMROI) which is calculated by dividing the company’s annual gross profit by its average inventory investment.
Here is an example: If the gross profit of a customer over the last 12 months is R50-million and the average stockholding is R40-million, their GMROI is 1.25.
Let’s say that 12% of the stock holding did not have any movement in the last 12 months so it was classified as dead stock. Then their GMROI would have been R1.42. This means that there would have been a 13.6% increase in the return on investment. This is a dramatic improvement on profitability and therefore proves it is worthwhile for companies to focus on eliminating dead stock.
Based on studies conducted, the inventory carrying costs of a typical company is estimated to be approximately 25% per year as a percentage of their average inventory. This means that the average cost of keeping dead stock is quite significant.
Most companies deal with dead stock once it is part of their inventory; however, this can be avoided. The only way to do this is to implement a warehouse management system to manage your warehouse, ensure accurate ordering, reduce wastage and streamline processes.
What causes dead stock?
Buying stock specifically for a customer often results in leftovers that the customer may not buy, thereby reducing profitability and potentially becoming dead stock. This is made worse if the salesperson has been paid a commission on the gross margin and if it excludes the cost of warehousing, transport and the man hours wasted counting it during stock take.
The solution to this is to accurately calculate the customers’ needs to ensure that they purchase the entire quantity of stock ordered. The sale price to the customer has to be based on the complete cost of material and other services such as transport so that the total cost of the non-stock product purchased is charged against the sales person’s commission.
Avoid customer specific inventory
If you need to keep specific inventory to supply a handful of customers it is important that you keep tabs on their purchasing habits. Have you ever found when a customer has stopped buying a product from you, you did not realise until someone asked you, “When was the last time customer X bought some of this? We have a lot on the shelf?”
It is critical to review the status of stock for customer-specific inventory at least once a month to prevent stock silently dying on the shelf or not being able to meet customer demands if you run out of stock.
Bringing new products into stock is important, but it often means that other stock will become obsolete. So plans need to be in place to move obsolete stock so that it doesn’t stand still. This could be done, for example, through special pricing or discounts on old stock to move it before the new stock arrives.
New products can also become obsolete quickly if the market uptake is not as expected. You need to plan in advance and implement procedures for introducing new products, which should include feasibility studies, and liquidating obsolete stock when introducing new products.
The longer obsolete stock remains in your inventory, the less likely you are to sell it.
How to avoid dead stock?
The only way to avoid dead stock is to have strict control over the ordering process. For example, basing careful inventory planning on monitoring customer and market trends. A proven ERP system with warehouse management capabilities is critical to this process.
This makes it possible to manage stock and generate detailed reports in real time to assist with planning and to ensure that you can meet the exact customer’s needs on time. This helps to reduce the amount of dead stock directly impacting on profitability.
One of South Africa’s leading suppliers of quality, value-for-money branded welding products recently discovered that special orders were causing a significant amount of dead stock that was negatively affecting their bottom line.
After the successful implementation of a world class ERP system, they noted a significant decline in dead stock. They are now able to accurately manage and streamline stock control with an end-to-end solution that gives them visibility through detailed reporting to facilitate forecasting and bolster their bottom line.