Smart Business Chicago

On the shelf

Is inventory your biggest asset or biggest liability? By Mike Rudd

Eighty percent of your revenue is generated by 20 percent of your customers. It is also true that 80 percent of your profit is generated by 20 percent of your customers. But we often fail to recognize that these are often not the same customers.

The customer that places inordinate demands on delivery, pricing, payment terms and inventory stocking requirements can cost you gross margin. The customer that places orders on time, expects a reasonable delivery schedule and pays on time makes a good profit for you and reduces the stress on you and your employees.

As the old saying goes "You can’t sell from an empty shelf." This may have some validity. But a shelf full of nonmoving or obsolete product is a profit drain. This is compounded by squandering working capital and contributes to increased borrowing and interest expense.

Before analyzing inventory stocking requirements, reorder points and all of the other factors that go into managing your inventory, you need a game plan that reflects all facets of your business. Your business must make the transition from working in the business to working on the business.

There are several factors that must be taken into consideration.

Identify the customers that are most profitable. These may not be your best customers. This includes identifying the minimum gross profit acceptable for your business to achieve a return on the risk of doing business.

A customer that habitually pays in 60 or more days is less profitable that the customer that pays in 30 days or fewer. A customer that constantly demands special treatment due its inability to plan creates a cascading effect that forces adjustments in schedules.

Promises can be broken, and your profitable customers can become displeased. That could send them to a different supplier that appreciates the business.

Give your sales team incentives to produce profitable sales, not just sales. The most effective way to hold salespeople accountable is to have a program that rewards and pays a higher commission based on gross profit, and pays a lesser or no commission for sales that do not meet the company’s standards.

Not doing so results in increased sales, but the company "grows" itself out of business. This same philosophy of profit-based incentives should be used for all employees. Incentives must be tied to cost areas that employees have control over — labor hours, material costs, overtime, inventory waste and consumable supplies.

This is in direct contrast to an incentive that does not reflect the direct contributions of employees.

Develop a system for accurately tracking and managing financial information on a daily, weekly and monthly schedule. If there is a lack of truly useful information, it is impossible for the business owner to make informed decisions.

Without accurate information based on historical percentages, it is impossible to measure the impact on break-even rate, overhead application, inventory levels and pricing matrixes. Relying on gut feelings and an annual financial statement leads to misinformation and a false sense of security. Solid, accurate information is developed by analyzing critical functions, developing a financial statement to reflect them and implementing specific productivity goals.

In creating this matrix of information, you will be able to identify the profit holes in the business and take decisive action to correct the problems.

Identify working capital and cash flow requirements. Most businesses start with inadequate working capital and never reach the point where they have enough capital so they can manage their daily and weekly cash flow requirements and grow the business profitably.

Identify your business needs and maintain an adequate safety net to compensate for the unexpected. Predicting and improving cash flow are functions of clearly understanding the revenue and expense cycles of the business.

Once you have a clear understanding of all of the facets of your business — and possess the tools to measure and react to the ever-changing business climate — you can answer the question about whether inventory is your biggest asset or your biggest liability.

MIKE RUDD is director of client services for IPA. IPA’s 1,700 employees offer consulting services to businesses throughout the United States, including Alaska and Hawaii, as well as Canada. Reach Rudd at (847) 808-5590, mike.rudd@ipa-iba.com or www.ipa-iba.com.