|
May 31, 2006 The Full Cost of Carrying Inventory Take a look at your balance sheet, what is your single largest asset shown? Your Inventory! Also the cost of your inventory is generally the single largest expense item on most distributors’ income statements. In last week’s newsletter, guest writer Jon Schreibfeder, brought up the point that you have to examine the cost of carrying your inventory when evaluating your true profitability. Gross margin, inventory turn, and gross margin return on square foot are just a few of the ways many companies evaluate their productivity, but each one of these puts companies at a distinct disadvantage. The real cost of inventory extends far beyond just inventory at cost or the cost of good sold. Other costs such as maintaining and managing the inventory in your warehouse are significant and should not be ignored. These inventory carrying costs when incorporated into your Gross Profit calculations will determine your ADJUSTED GROSS PROFIT. Studies have shown that inventory carrying costs generally fall between 21% and 25%. This means it costs you anywhere from 21 cents to 25 cents to maintain a dollar’s worth of inventory in your warehouse for an entire year. Fortunately, for many distributors, their food software systems can keep track of inventory carrying costs for them and automatically figure them into pricing. Let’s look at an example of how one commercially available food software solution handles carrying costs. Inventory carrying costs can also be referred to as “Pad” or “Burden”, which when you think about it makes sense as it allows you to price your products correctly to make sure you have a safety pad to cover the costs of carrying those same inventory items. INVENTORY CARRYING COSTS = PAD = BURDEN !!
In this example we look at expensive Product “A” Colavita Olive Oil. The true cost of the product is listed at $45 a case, however to cover the costs of maintaining and managing this item in the warehouse our example distributor uses a 21% Pad rate. In this example the distributor wants a 20% gross profit margin so the sales from one case of Product A will be $56.28. Sales – Cost of Good Sold = Gross Profit $56.28 – $45.00 = $11.28 In this case the distributor (who is ignoring the costs of carrying product A) thinks that if he makes $11.28 he will hit the 20% gross margin percent he wants. BUT when you look at it from an Adjusted Margin perspective you realize that these numbers are not true. One case of Product A would need to be sold at $68.06 to actually garner a 20% gross margin. Your software should calculate 21% of the $45 total cost to discover an inventory carrying cost of $9.45. (.21 * 45 = 9.45) Therefore, you must add the cost of carrying your inventory to your total cost to make sure you are covering all your expenses and garnering a real gross margin of 20% profit off this sale. Sales – {Cost of Goods Sold + (PAD * Cost of Goods Sold)} = Adjusted Gross Profit $68.06 – {45.00 + (.21 * 45.00)} = $13.61 When you don’t make adjustments for Burden Costs you won’t hit the gross profit % your striving for!
Now when you take a look at an inexpensive product you might carry in your warehouse, in this case Product “B” Plastic Straws, this illustrates how inventory carrying costs distinctly differ depending on the product. If you striving for the same gross margin percentage of 20%, then the sales from one case of Product B must be $15. Sales – Cost of Good Sold = Gross Profit $15.00 – $12.00 = $3.00 In this case the distributor (who is once again ignoring the costs of carrying product B) thinks that if he makes $3.00 off of each sale he will hit the 20% gross margin percent he wants. BUT when you look at it from an Adjusted Margin perspective you realize that these numbers are not true. One case of Product B would need to be sold at $18.17 to actually garner a 20% gross margin. Your software should calculate 21% of the $12 total cost to discover an inventory carrying cost of $2.52. (.21 * 12 = 2.52) Therefore, you must add the cost of carrying your inventory to your total cost to make sure you are covering all your expenses and garnering a real gross margin of 20% profit off this sale. Sales – {Cost of Goods Sold + (PAD * Cost of Goods Sold)} = Adjusted Gross Profit $18.17 – {12.00 + (.21 * 12.00)} = $3.65 Remember the more costly the item, the bigger the effect on carrying costs has on gross profit, as you can see by the example of olive oil vs. straws. When you don’t make adjustments for Burden Costs you won’t hit the gross profit % your striving for! Understanding that carrying costs vary between each item in your inventory will help you identify where the opportunities for saving are. It will not only help you identify which products are not “worth their salt” or underperforming, but it will illustrate for you what a financial drag it is on your company’s bottom line. Reducing unneeded inventory by liquidating under performing stock or tightening up stocks of front line essential inventory has the benefit of freeing up capital for other uses and reducing costs directly variable with inventory levels. Furthermore, you are provided with the opportunity to re-assess both mixed and fixed costs to identify other potential cost savings. By reducing your inventory you in turn free up invested capital and create the potential for reduce expenses and increased cash flow. WHEN INVENTORY IS REDUCED, OPPORTUNITIES TO IMPROVE PROFITABILITY ARE CREATED! To Unsubscribe
to this newsletter please respond to email with "UNSUBSCRIBE" in the subject line.
|
|
