Supply Chain and Finance-How important is my inventory?

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Editor’s Note: Part one of this series discussed just how important stockouts, new product speed-to-market, and asset utilization are to your supply chain. Today’s post is going to focus on the last key driver: Inventory.

The impact of better supply chain management on inventory has been well documented. Research by FinListics reveals that for North American department store retailers, each 1-day reduction in inventory generates almost $2 million in cash flow. But how does a reduction in inventory help grow the top line? The obvious answer is that the freed-up cash from the inventory reduction provides funding for growth through things like market expansion, new stores, expanded product offering, etc. There’s an answer, though, that’s more strategic…but very real.

Gross margin return on investment (GMROI) is a commonly used metric that provides insights into revenue and inventory management. It’s measured as gross profit expressed as a percentage of inventory investment. The average GMROI for retailers in North America is 175% – $350 million in gross profit as a percentage of a $200 million investment in inventory for each $1 billion in revenue. GMROI is also often expressed as gross profit margin multiplied by inventory turnover. Our example industry has a gross profit margin of 35% ($350 / $1,000) multiplied by inventory turnover of 5 times ($1,000 / $200), so we magically have the same GMROI of 175% (35% x 5).

Let’s say SCM initiatives reduce inventory by 10% to $180 million while maintaining the same service levels. GMROI is now almost 195% (35% x 5.55) holding all else the same. But what if the GMROI of 175% is already acceptable? In this case the improved inventory turns would allow the same GMROI to be achieved on a lower profit margin…31.5% vs. 35.0% to be exact. How could this help increase revenue? For one, merchandise could be sold at a lower price. New merchandise could be offered that had a lower gross profit margin than the average. Or, prices could stay the same and more money put into promotions, loyalty programs, and other value added services.

Figure 1 shows various combinations of Gross Profit Margin and Inventory Turnover that result in a 175% GMROI. For example, increasing inventory turns 30% from the base of 5.0 results in a breakeven gross profit margin of around 27% compared to a breakeven of 35% with turns of 5.0. Think of the greater flexibility this provides your client in growing the top line and managing ROA.

Better managing SCM has the potential to improve many areas of financial performance besides traditional areas of transportation, warehousing, and inventory management. These are important but the impact to revenue often can be even more important. It’s critical that you make the financial-SCM connection. If I’m talking to the VP of Transportation, it’s a very simple conversation – reduce costs, reduce costs, reduce costs. But the conversation with a CFO or CEO is much different.

This is post is excerpted from a longer article by Finlistic’s solutions.

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Aaron Pittman

Aaron is former Corporate Counsel/Director of Marketing at One Network Enterprises,A lawyer by training, heprovides practical advice regarding regulatory, compliance, and transactional matters, and also leads global marketing and communications activities including content, messaging, and analyst and press relations. He holds degrees from Vanderbilt University and the University of Michigan Law School.