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First Thoughts
  By Dan Gilmore - Editor-in-Chief  
     
   
  November 5, 2009  
     
 

Supply Chain News: The Real Value of (Less) Inventory

 
 

OK, I better write this column before it becomes so common knowledge to everyone that it has little value.

 

The topic is the value of inventory – or more specifically, the value of less inventory.

 

I started to write this column earlier this summer, but began by talking about measures of inventory performance, such as inventory turns. I ran out of time before I got to the main point I was trying to make – but generated a tremendous amount of great reader response nevertheless (See Readers Respond – Measuring Inventory Performance).

 

It wasn’t that long ago that supply chain professionals and even some financial types did not well understand the role of inventory and free cash flow. Now, it seems like you can hardly read a corporate earnings report without seeing some connection between inventory and cash flow.

Gilmore Says:

Permanently reducing your level of inventories relative to sales and sales growth can have a dramatic impact on a company’s share price.


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Case in point: Goodyear announced last week that its inventory reduction program had generated a $1 billion in working capital reduction through Q3 2009.

 

Earlier this year, we reported on how Home Depot was striving to improve its inventory turns – meaning “reduce inventories relative to sales” – from 4 to 5. If it can do that, it also means $1 billion in annual cash flow improvement to the home improvement giant. A billion here, a billion there – it adds up.

 

So, for everyone’s benefit, let’s go through the basics.

It takes cash – capital – to produce or acquire inventory. That cash is tied up in that inventory, not usable by the corporation. It is called “working capital,”  and it is not available for other parts of the business. Since many companies turn to financing instruments to support their short-term working capital needs, this has a very real “cost” to the business.

 

So, for every dollar in inventory reduction, this leads to a dollar reduction in working capital requirements – and, therefore, to a dollar improvement in “free cash flow.”  Free cash flow is different than “profits” and “earnings per share,” – and is a critical metric for many financial analysts and investors. More on that in a minute.

 

The best way I know to illustrate this connection is to use a Walmart example.

 

In the middle part of this decade, Walmart actually let its inventories grow somewhat out of control – the growth of inventories versus growth in sales reached very high levels versus its historical ratios. It reached a level of as much as 90% inventory growth versus sales growth in 2005.

 

I think there is a direct connection between that period of poor inventory management and the fact that Walmart’s operating and stock price performance languished during the same period.

 

What followed? Several initiatives, such as Walmart’s Inventory DeLoad program, designed to get inventory growth back to historical norms.

 

The result? The graphic below says it all:

After Inventory DeLoad and the other programs, in fiscal 2007, Walmart was able to keep inventory growth in its US stores group to just 12% of sales growth (.7% inventory growth versus 5.7% sales growth).

 

That, in turn, drove a tremendous growth in free cash flow, which at 25% was not only substantially above sales growth, but about three times profit growth. And not surprisingly, Walmart’s fortunes and stock price were bolstered soon thereafter.

 

OK, this relationship of inventory to working capital to free cash flow was not well understood even just a few years ago, but certainly has gained much traction in the past few years. Those connections gained even more traction in the recession, when cash and cash flow became “king.”

 

In fact, a recent panel discussion of Wall Street types at the CSCMP conference in Chicago noted that many companies were looking to the supply chain as a new form of “financing.” As the credit market dried up, or borrowing rates moved to ridiculously high levels, CFOs realized that by squeezing inventories, their companies would generate cash that would supplement their needs for outside capital that was increasingly tough to come by.

 

But even if you know all this, here is something you may not know: permanently reducing your level of inventories relative to sales and sales growth can have a dramatic impact on a company’s share price.

 

Gerry Marsh, an independent financial consultant who has worked with many of the world’s leading companies, made that clear to me in a white paper that Gene Tyndall and I wrote a few years back on the value of global supply chain improvements. You can find the chart here that Marsh created that shows, based on his proprietary model, how increases in inventory turns/inventory capital reduction can directly impact share price. In this example, based on a composite apparel company we created for the report (Action Apparel), improving inventory turns from 6 to 7 would actually increase the company’s stock valuation by an incredible 13%.

 

Why? Because “buy side” Wall Street analysts see that the company can drive more cash flow from each sales dollar – and free cash flow generation is what they care about. In fact, Marsh can powerfully demonstrate how differences in free cash flow generation clearly explain the difference in stock price multiples for companies that on the surface have very similar earnings per share and earnings growth.

 

The bottom line: inventory management is perhaps the defining element of supply chain management – where supply and demand truly meet. Getting that right not only reduces operating costs, but has a dramatic impact on cash flow and shareholder value.

 

Those that well understand this have a real leg up on their peers and competition.

 

What is your reaction to Gilmore’s column on the value of inventory reduction? What would you add? Is this becoming well understood in business today? Let us know your thoughts at the Feedback button below.

 
 
     
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Feedback
2009-11-10
 
SC Digest`s thesis is absolutely correct.  There is one very powerful technique to permanently reduce inventory that many companies do not utilize.  The technique is Reducing Cumulative Lead Time.  I have written an article on the subject for those who are interested.
 
Herb Shields, CMC
HCS Consulting - Delivering results, not just reports

2009-11-06

The impact on inventory on business was recognized decades back. The issue seems to be that the models of Economic Order Quantity that taught optimization of Order quantities vis a vis conflicting costs of carrying inventory and the so called order processing cost (the Wilson Formula to the old timers) somehow became obsolete on the impact of MRP and Just in Time.  Currently very few people seem to be aware of the square root formula to calculate the Economic Order Quantity (EOQ). While batch size ordering based on the factors covered by the EOQ formula might be less relevent in today`s situations, the simple principle if taught in fundamentals of Supply Chain Management, will bring in the required emphasis on Inventory Carrying costs.
  
T A Krishnan
General Manager-Supply Chain Management
Larsen & Toubro Limited
India

2009-11-06


From the International perspective, setting regional distribution centers in strategic areas of the world is the key to reducing the local inventory levels.  As you may know, countries like Hong Kong, Dubai, Uruguay in South America and Panama with strong Free Trade Zones give the multinationals the chance to have regional inventories (with no real property of the goods for the countries of those particular regions). This is huge value for the companies that do business using the model, and it also has a tremendous logistical advantage reaching the markets with very good lead times so the time from warehouse to the market is not affected. We do this for many multinationals (one mentioned in your article) in the Colon Free Zone of Panama, so I believe that it`s a very interesting topic to touch on more deeply and share with the supply chain community that follows Supply Chain Digest .

Demostenes Perez C.
General Manager
Logistics Services (Panama)
Colon Free Zone
Republic of Panama


2009-11-05

Nice article covering the basics. I saw one thing missing though from the cost of inventory – the carrying cost. This is a savings on top of the “cost of capital”. The carrying cost is typically in the range of 10% to 15%. Some of the carrying cost is variable, like labor which is almost directly proportional to the unit of inventory reduced, whereas, certain carrying cost, like storage warehouse require a certain minimum level of inventory reduction before they can be taken off.

I also wanted to point out a small clarification on the concept of “free cash flow”. Free cash flow can be generated either by reducing inventory or turning it around fast (i.e. increasing inventory turns by selling fast) – it’s the latter that creates the “useful” free cash flow that adds value to the company and not the former. Let me explain a little more. Typically companies pay for the inventory through short term loans. If there was no need for the inventory they would not have taken the loan, and hence, there would not be any free cash flow. The only case where free cash flow becomes important is when a company uses its own cash to invest in the inventory. In that case, reducing inventory and hence, freeing up the cash would help invest the capital somewhere else (with higher returns). So in other words, generally, when the inventory is reduced, it’s really the “cost of the capital” and not the capital itself that’s saved.

So then the key question becomes if it costs to carry inventory (carrying cost + cost of capital) then why not reduce it as much as possible. That begs the next question - how much inventory can and should a company reduce? There are two steps to this analysis – first companies need to look from market perspective, essentially their competitors and see what’s the inventory turn of the best in class (BIC). If the BIC is 10, as an example, then that determines how much inventory the company is entitled to keep, to meet a certain sales level. Second step in the process is look at internal processes – specifically cycle time of operations, inventory policies, stranded & excess inventory, obsolescence, etc, to determine how much can the inventory be reduced to meet the entitled level. There are a few other side variations to this problem as well. Sometimes, inventory cost  - the cost of capital or the capital tied itself is not the biggest of all concerns for the company –  particularly those that are in high margin business. For them any stock-out can have a significant revenue and margin loss. In those cases, it’s OK to maintain a high level of inventory to ensure near 99.99% fill rate. The inventory cost is offset significantly by the revenue and margin upside.

Manoj K. Singh
Associate Partner,
IBM Global Business Services

2009-11-05

Obviously, any reduction in inventory can have a direct impact on "working capital."  In addition, inventory reduction has an indirect and quite possibly a direct impact on distribution center and/or store space requirements.  Depending how a corporation accounts for the fixed costs associated with distribution centers and/or stores, the net effect of inventory reduction can thus have a positive impact on current and future real estate costs.
 
Larry Zwakenberg
Blue Spruce Consulting

2009-11-05

Thanks for another great article. “Amen” is all I have to say!
 
Just one other thought. “Inventory embodies the set of decisions made in the past from forecasts and operational plans, and casts them in concrete. The further in the past the decisions were made, the less useful they become. Inventory freezes decisions”. (Adapted from “Lean Distribution”, Kirk D. Zylstra).
 
Mario Carniato 
Manager, E-Supply Chain
Kimberly-Clark Australia

2009-11-05

I believe most people understand the value of lowering the inventory levels so the real challenge becomes how do we get people (Sales, Marketing, Purchasing, etc.) to change their behaviors. Everyone is all for lowering the inventory so long as they don’t have to change their behaviors, processes, etc.
 
Dwayne A Wildhagen C.P.I.M.
Manager Demand Forecasting, Planning & Product Configuration
Springs Window Fashions LLC

2009-11-05

The other "real value" is it requires less space and less risk of obsolescence.  
 
Robert Jones
Caterpillar 

2009-11-05

As a consultant to the Fulfillment Industry, it makes perfect sense in times when the other major access to cash flow is cutting expenses and firing personnel.

A few years ago, firms found that when it was difficult to expand sales, and just as difficult to get even expensive financing, cash was more important than even profits to survive until better times arrived.

Even though you do not want to run out of salable merchandise, improving inventory turn, reducing theft, damage, and storage, all increase efficiency.

Mark Kaplan
InternetMarketingInc of San Diego


2009-11-05

Your Real Value of Less Inventory is a really well done piece. Glad you did it.
 
And you did another piece last week on "The 50% problem." That too was very good. So good, in fact, that I wrote a column on that (giving appropriate credit, of course) for the next issue of OCH.
 
Gary Forger
Senior Vice President of Professional Development
Material Handling Industry of America



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