Best Practice: Inventory Stratification

Best Practice: Inventory Stratification

By Dr. Barry Lawrence, Texas A&M University





The current economic environment is frustrating to say the least. Many have adjusted to lower volume and reduced their capacity (inventory, human resources, value added services, and even facilities) to reflect a lower business volume. Manufacturers have dramatically scaled back with some cutting capacity by as much as 80%. Demand has not decreased as much so most believe that soon (end of the year or sooner) production will be needed again (albeit at a lower level) and the economy should start grinding slowly forward. Issues with the banks, excess real estate inventories, and consumer debt will linger, however, and are expected to make the recovery a slow one.

Aggressive firms are already thinking about the recovery and seizing market share from weakened rivals. Those still gasping for air are trying to make it through the end of the year and praying for relief. Others want to sell out as soon as the markets recover. Still others are fighting off bankruptcy. In the midst of this chaos and with so many different priorities among distributors, how does one come up with a common set of strategies we can all discuss and share for the betterment of the distribution community?

The new NAW Institute for Distribution Excellence book Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line 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 will introduce a best practice and how it can improve earnings and/or ROI under current economic conditions. 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.

The book breaks business processes into seven groups (the 7S process group includes SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on the STOCK group. The STOCK group has seven processes and we’ll discuss inventory stratification here.




STOCK: Inventory Stratification

Inventory stratification prioritizes investments in inventory based on customer service or shareholder value. Customer service often drives large, inefficient inventories in an attempt to be all things to all people. Shareholder value seeks to carry only profitable products, at reasonable levels (asset efficiency), producing maximum sales (cash flow), while also increasing market share (growth).

Inventory stratification techniques are well known but often not applied correctly. The practice levels for inventory stratification are as follows:

COMMON practice: 1) No inventory stratification (2) Product line grouping (3) Not connected to purchasing

GOOD practice: (1) Volume (sales $) based (2) Logistics (hits) driven

Revenue driven models, like sales in units or dollars, emphasize fast movers often at the expense of more profitable products. Customer service driven models, like hits, emphasize always having what the customer wants, when they want it, often at the expense of ROI.

BEST practice: (1) Profitability (GMROII) based (2) Multiple criteria based (3) Combination method

Profitability driven models, like Gross Margin Return on Inventory Investment (GMROII) or Turn and Earn, emphasize profitability often at the expense of economies of scale created by higher sales. The best approach will be some sort of combination model tied to the purchasing process.

A properly executed inventory stratification will ensure shareholder value and direct all purchasing decisions towards the firm’s financial strategy. An example purchasing scheme might be to carry “A” items with a solid safety stock, carry “B” items with a limited safety stock, “C” items with no safety stock, and eliminate “D” items.

Upon hearing such a strategy many will ask “How am I supposed to eliminate ‘D’ items when important customers require us to carry them?” The question demonstrates a fixation with sales as a stratification method. No matter how many times you explain that a ‘D’ item has no profits, almost never gets picked, and generates almost no sales, people will get concerned. The stratification needs to combine techniques and all parties must be educated on how it works.

So What’s the Impact?

Even with a combination technique, the average distributor has about 20 to 40% of their inventory in ‘A’ and ‘B’ items (great contribution to shareholder value) and 60 to 80% in ‘C’ and ‘D’ (negative contribution to shareholder value). Firms that execute inventory stratification connected to purchasing processes are able reduce or redeploy 20 to 50% of inventory in cases we have observed. The following exhibit describes the link between stratification and shareholder value.



When “cash is king” as it is now, inventory reduction takes center stage. One distributor faced a crisis last year when their sales were flat and inventories were expanding due to canceled customer orders with the onset of the recession (numbers have been simplified and somewhat disguised for confidentiality). Inventories ballooned from $8 million to $10 million in a few months. The expansion led to an increased financing need of nearly $2 million since supplier funds were maxed out.

A further problem was Accounts Receivable. As the economy worsened, customer Days Sales Outstanding increased from 30 to 40 days resulting in a need for another $1 million in credit just to stay afloat. So with no change in sales, the firm suddenly had to come up with an extra $3 million in credit.

Then the loan covenants kicked in. The distributor had been granted a line of credit up to 50% on good quality inventory. The economic slowdown and pressure on banks caused them to decrease it to 45% and disallow more inventory as potentially obsolete. The net effect was that even with a $2 million increase in inventory, there was effectively no increase in the line of credit.

The bank also gave 90% on Accounts Receivable (A/R) of less than 90 days. Due to reevaluating the distributor as more risky, they reduced the covenant to 80%. In addition, a greater percentage of customers went beyond 90 days as the economy trended downward. The net effect was almost no increase in credit to cover the increase in A/R. So the company found itself with nearly a $3 million shortfall, a potential death sentence for an otherwise profitable firm.

The firm was fortunate to have started an inventory stratification process before the storm hit. After analysis, they had $2 million in ‘A’ items, $2 million in ‘B’ items, $4 million in ‘C’, and $2 million in ‘D’. They set out to reduce ‘A’ and ‘B’ by $500,000 each(relatively easy to do), ‘C’ by $2 million (discounting would bring a 5% loss in value), and ‘D’ by $1 million (discounting 30%).

The firm freed up $3.6 million in cash to help get them through the crisis. They also “righted” the ship by improving their inventory quality and bringing it down to a manageable financing level. Loan covenants on inventory were restored to the previous 50% level by the bank.

What If Cash Flow Wasn’t the Problem?

The firm could have gone after the other shareholder objectives if they weren’t facing a cash crisis. Instead of only reducing inventory, they could have redeployed it to fast movers or into new products or markets spurring growth. The impact would have been higher profitability on increased sales with greater asset efficiency since the investment would be in ‘A’ and ‘B’ items.


About this Blog
“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in Comments and email this blog to other interested parties.

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