Best Practice: Sales Growth through Inventory Reinvestment

By Dr. Barry Lawrence, Texas A&M University




and Dr. Ismail Capar, Texas A&M University



One step forward and two steps back is what it seems at times with this economy. Still, most are starting to look at growth as the next objective. Distributor growth will, in fact, be the next consortium for the Council for Research on Distributor Competitiveness (CRDC), the joint research effort of the NAW Institute for Distribution Excellence and Texas A&M’s Supply Chain Systems Laboratory. The NAW Institute Board of Directors selected the topic even before the recovery began, and the concept is now gaining momentum in the industry.

In last month’s blog, we addressed growing sales from a customer stratification and sales force redeployment perspective. This month we will discuss another growth perspective: Inventory Reinvestment. Distributor growth can be thought of as moving along in three dimensions: organic, vertical and horizontal integration, and expansion.

Organic refers to growing business with existing customers or new ones coming to us through our standard business practices. Strategies surround creating a more effective sales effort and marketing tools.

Vertical integration involves moving up or down the supply chain by taking on manufacturing or retail processes. Horizontal integration refers to taking on new functions like repair or consulting services. Strategies include acquisitions or developing new service capabilities.

Expansion takes on two forms: geographic and product driven. Geographic expansion refers to growing within new territories. Strategies include opening new operations and acquisitions. Product-driven expansion involves new product offerings. Strategies include taking on new product lines from existing suppliers or adding new suppliers. Each of the foregoing expansion strategies requires some sort of investment. Since most firms have limited resources, the strategies require an understanding of how return-on-investment (ROI) will be affected by each strategy. Those growth strategies with the highest ROI should get the scarcest resources. An even more difficult decision requires comparing existing investments to new strategies to potentially stop doing one thing in favor of a new higher ROI opportunity.


The new NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we are introducing a best practice and how it can improve earnings and/or ROI under current economic conditions. Through this blog, we encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.





Best Practice: Sales Growth through Inventory Reinvestment

In our August blog entry, we addressed inventory reduction through best practices like inventory stratification. One approach is to reduce inventory, which eases cash flow problems and improves ROI through reducing the denominator (assets) in the equation. The strategy does not, however, grow sales. Pursued too aggressively, in fact, inventory stratification will reduce sales on C and D inventory and not add any back. Inventory stratification can be performed at branch level—or local ABC—and company level—or global ABC—and combined in a single matrix to determine inventory deployment strategies and business decisions at the company level. Common strategies are:

• Increase service levels. If items are A and B at both branch and company level
• Review/eliminate. If items are C and D at both branch and company level
• Evaluate. If items are A or B at branch level and C or D at company level
• Redeploy. If items are C or D at branch level and A or C at company level

World-class distributors receive a 300% or better ROI on their A and B item inventory (based on gross margin contribution). No other investment can give a greater return, so a reduction in inventory to invest in other forms of business does not make sense. The most powerful approach would be to reinvest in A and B inventory. The strategy is organic in nature and requires that the opportunity to reinvest be available.

Reinvestment can take the form of increasing inventory on A and B items to improve their fill rates. A higher fill rate on the most important items will lead to an increase in sales, since fewer stock outs mean fewer lost sales and the resultant higher customer satisfaction level will lead to a greater share of the customer’s business. The process is doubly effective since the high turn rate on A and B items means that the small changes in inventory (lower holding costs) will have a big impact on service levels (lower stock out costs). Properly applied, you can have your cake (lower inventory) and eat it too (increased sales) by significantly decreasing C and D items and marginally increasing A and B items. Best practice purchasing policies are shown in the following figure.

In an interesting example, a distributor for grocery stores was trying to decrease C and D inventory. The company decided to implement a rule that when the purchasing department placed an order, they could not use C and D items to make truckload quantity. Purchasing would have extra space on the truck and would buy larger quantities to make truckload freight rates. Since volume levels on A and B items guaranteed the highest discount possible, purchasing logically took on more C and D items to get discounts there as well. The practice had created large slow-move inventories.

Purchasing, therefore, was forced to use A and B items to make truckload. The company reduced C and D inventory significantly, but was surprised when overall fill rates rose and sales increased as stock outs on A and B items dropped.

An Expansion Example

A number of distributors have used a technique called “storefronts.” The process consists of opening more locations with “A” item inventory only and serving other items from regional distribution centers. Contractor-serving distributors will commonly use this method to combat the “big boxes” (retailers). The distributor’s advantage comes from more locations closer to the customer coupled with a professional sales force. Retailers follow a similar strategy of “A” item inventory only, but they do not field as strong a sales force.

The inventory requirements are minimal since the storefronts can be replenished from a central warehouse on almost a daily basis along with slow-move items not carried by the storefront. As a result, facilities can be kept very small. The process allows for high sales with fewer assets (high ROI). The decreased need for inventory assets frees up resources to open more storefronts (geographic expansion).

An Integration Example

Integration has failed many times when manufacturers have purchased distributors. Distributors have a slightly better record when they add light manufacturing. Common examples have included building materials distributors who take on paint mixing lines (vertical integration). Fluid power distributors often will carry out systems integration responsibilities by building larger, more complex or specialized, power units from products they already carry (horizontal integration).

Integration takes advantage of assets already in place to add a new function or service. It often fails when the new process is performed poorly (not a core competency) and ROI requirements are not achieved.

Home Depot attempted horizontal integration when it purchased Hughes Supply. When the firm added distribution as a function, it found that the new division, HD Supply, could not meet the firm’s ROI requirements, and so they were forced to sell it.

Reinvesting

Inventory strategies allow for many reinvestment opportunities. If nothing more can be done with existing A and B items and no new products can be added, other forms of expanding inventory impacts, like storefronts or integration, can be employed. Whatever the choice, ROI is king and failure to optimize it guarantees failure. The following exhibit describes the link between stratification and shareholder value.