By Ted Hurlbut

When not managed carefully, inventory costs can be the difference between being profitable or losing your shirt.

For most small retailers, inventory is the single most significant asset.  Their inventory, their merchandise, defines who they are and speaks more clearly to their customers about what they’re all about than any ad or marketing message.

In the minds of many smaller retailers inventory is linked directly to sales:  “If I don’t have it, I can’t sell it!”  These retailers see sales as the most critical metric, because it’s the measure of the total cash flowing into their businesses.

Just as importantly, however, the cost of that inventory is the largest expense item on every retailer’s income statement.  Inventory is expensive, and if not managed carefully, the cost of excess inventory can be the difference between a smaller retailer being very profitable and losing money.

The cost of inventory to a smaller retailer is far greater than simply the invoice cost and freight.  There are inventory carrying costs, shrink, damage and obsolescence costs, and even the cost of lost sales due to too much inventory.  These costs can add up quickly, almost imperceptibly.  But these costs are real, and they do end up on the income statement eroding profits.

Let’s explore each of these costs in turn, starting with carrying costs.  Retail inventory carrying costs include inventory financing charges, insurances and taxes, processing and handling expenses, inventory control and cycle counting expenses:

• Inventory financing charges.  For most smaller retailers, working capital financing is primarily financing inventory, especially seasonal inventories.  This is a very easy expense item to identify and measure.  It’s also very easy to manage; the more inventory that you’re financing the more that those financing charges will take out of the bottom line.
• Inventory insurance and taxes.  Both insurance and taxes are variable with changes in inventory value.  Excess inventory is particularly costly here, because it tends to make up a disproportionate percentage of the total inventory value at fiscal quarter and year end.
• Merchandise ordering and processing costs.  There are costs associated with ordering merchandise, receiving merchandise, ticketing it and stocking it.  Every retailer would consider these costs as basic costs of doing business, but the more merchandise you order and process the greater these costs will be.  And if you’re carrying excess levels of inventory, these costs will unnecessarily cut into the bottom line.
• Physical merchandising costs.  These are the costs of physically maintaining retail inventory.  These are the costs of store recovery after each day’s sales, re-merchandising of inventory as it sells down, marking down and re-merchandising for clearance, setting and breaking feature displays.  These costs increase exponentially with excess levels of inventory, because excess inventory remains in stock longer and as a result ends up being handled a greater number of times.  It’s simply much less costly to maintain a store that’s not overwhelmed with merchandise.
• Inventory control and cycle counting.  Cycle counting is a critical activity for keeping inventory records in line and maintaining a heightened sense of awareness to loss prevention.  Cycle counts are also a necessary cost of doing business.  But the cost of doing cycle counts, of periodically counting a portion of your inventory, increases with the level of inventory.  And if you forego cycle counting, and the costs of cycle counting, you pay for that in the form of increased shrink, which is far more expensive.

Ordering and processing costs, merchandising costs, and inventory control and cycle counting costs are primarily labor costs, and can be very difficult to isolate.  Nevertheless, they are real.  Smaller retailers that make the effort to tighten their inventories usually find that they don’t need as many people as they thought they did.

Income Statement, shrink, damage and obsolescence costs

While retail inventory carrying costs typically are buried in the expense items below the gross margin line of an income statement, shrink, damage and obsolescence costs hit gross margins directly.

Shrink and damage costs are pretty easy to understand.  What’s perhaps not as clear is that shrink and damage percentages are almost always greater when there’s too much inventory.  It’s much easier for theft to go unnoticed if displays are overstocked to begin with and sight-lines are obscured by too much stuff.  And when there’s too much stuff, accidents are much more likely to happen, with merchandise breaking, or getting dinged, or packaging ripping or crushing.

Obsolescence is just a fancy word for markdowns, and while markdowns may also seem like a basic cost of doing business, they are incredibly corrosive to profitability.  When there’s excess inventory, markdowns are always higher, because excess inventory invariably slows the rate of sale of everything, and the longer merchandise goes unsold, the greater the markdowns that will be necessary to move it through.

The cost of lost sales

While many smaller retailers think that they need more inventory to be sure they don’t miss any sales, the reality is that too much inventory almost always leads to lost sales.  This is where having too much inventory can actually impact a retailer on the very top line of the Income Statement. 

When there’s too much inventory, stores are simply harder to shop, and when stores are harder to shop customers buy less.  This can play out in several ways:

• When stores are overstocked, it’s simply much harder for customers to find what they came in for, and much more likely they’ll leave without it.
• When there’s too much stuff, aisles can become narrower, discouraging customers from exploring deeper into the store.
• When displays are overstuffed, customers become afraid to touch, afraid of breaking something on a shelf simply packed too tightly, or starting an avalanche on a display piled too high.
• When there’s too much assortment, too many things to choose from, customers can become paralyzed.  If the retailer hasn’t been able to focus the assortment for the customer, how can the customer know with confidence that they’ll be happy with what they purchase?
• When there’s too much merchandise, customers can simply become overwhelmed by it all!

Invariably, when stores bring their inventories in line, clean up their assortments and make it easier for the customers to shop and find what they’re looking for, sales go up.  And in some cases, sales don’t just go up a little bit, they go up a whole lot.  The math is irrefutable.  Inventory costs money, and too much inventory costs a lot more money.  The cost of slower turning inventory is much greater than the cost of faster turning inventory.  And the costs are felt throughout the business, from lost sales, to reduced margins, to increased expenses.  Those smaller retailers that actively manage their inventories, striking the right balance between having what their customer want and having too much, invariably are more profitable than those that don’t.

For additional information on Performance Accounting please contact Sergio Fernandez or Richard Rackers.