Death by Inventory Part 2

“It’s always the same story. The company accumulates too much slow moving inventory, then suddenly goes bankrupt.”

In my post Death by Inventory Part 1, I discussed 3 common reasons companies accumulate too much inventory and die and their warning signs. And In previous posts I have talked about

• the importance of reducing Days Inventory Outstanding in order to decrease your Cash Conversion Cycle and increase your capital cycling (link)
• how your capital cycling impacts your Net Working Capital and that determines your max organic growth rate (link)
• why brand leaders allow inventory to accumulate until it kills them (link)

In this post, I talk about what to do to prevent death by inventory. You must:

1. Change your mindset
2. Change your analysis
3. Change your incentives

Our goal is to improve our inventory ordering process because when we do we make more money faster.

The Mindset

You are a trader.

Inventory purchases are investments. They are bets.

And every invoice is paid using borrowed money.

Most brands are borrowing money to fund inventory. But even if you are debt free, you are using organic cash and that cash can have other uses such as marketing or distributions. The point to hammer home is that capital is not free. And if you are going to invest it, then your returns better be greater than your cost of capital.

With your personal investments you wouldn’t borrow money at 30% in order to invest it at 10%. So why are you doing this in your company?

You are a trader. You are making choices. You capital is not infinite and comes with a cost.

The Analysis

Now that we have the mindset of a trader, we need the right framework and analysis to make our choices and decisions. We need to answer three questions:

1. Am I satisfying known demand or am I creating new demand?
2. How much money can I make?
3. How quickly do I make it?

Am I satisfying known demand or am I creating new demand?

Let’s say we have a hero product or category. We have strong repeat purchasing. To grow, we can seek out new customers who also want our hero product. But depending on our market, this can get expensive. We have plucked the low hanging, easy to convert fruit and now CAC’s are rising.

So we look to introduce a new product with the hopes to sell more to a different set of customers and hopefully cross sell and achieve new growth.

In my experience, everyone in the company is excited about the new new. But rarely are people accurately understanding the costs of the new new and the tradeoffs they are making by putting dollars behind the new product as opposed to the hero. How much ad spend is anticipated for the new product? Are we spinning up new suppliers? Did we have to hire new people? Onboard new software? How does the new product impact packaging and fulfillment? How much attention will it require in merchandizing? How much of everyone’s time is focused on the new product as opposed to trying to make more money from our hero product?

To answer the core question of known or new demand, the purchasing decision should force a prediction of the percentage of units ordered that will be bought by our High Value Customers (HVC’s), our total current customer base (including the HVC’s) and new customers. These are SWAG’s and we are looking for the 10 second, quick, gut feel and not an in-depth analysis.

Units to new customers → units per new customer orders → orders → new customers needed → CAC - ad spend needed.

We don’t need to go down the rabbit hole of all the other costs outlined above. We can eyeball the investment required. Or if it’s a big enough decision and we have the resources, we can develop a more thorough analysis.

How much money can I make?

This is simply expected post CAC Contribution Profit per unit multiplied by units in the PO. This should include our guess of ad spend needed to support the product sales.

We can get fancy here with actual units that pass QA, returns, breakage etc but we don’t have to. We are looking to quickly understand the magnitude of the potential Contribution Profit from the order.

How quickly do I make it?

IRR is our tool here.

IRR is expressed annually so it allows us to compare our investment decisions, our trades, to our cost of capital. And it allows us to compare our investment decisions to each other.

Many inventory purchasing frameworks use static days of inventory e.g. this group of products will have 90 days, this will have 60 days and this will have 30 days. But this doesn’t enable a comparison to our cost of capital and it makes decisions between choices difficult. It also ignores the sales velocity. A product that sells out within 2 days of being launched is treated the same as the product that sells more evenly to 60 days.

I suggest starting simply here and then adding refinement as the teams get up the curve. For example, a simple prediction of percent of units sold by week in the first 52 weeks works. If you are buying what you expect to be 60 days or 8 weeks of inventory, then input percentages for those first 8 weeks and zeroes thereafter.

The Incentives

We have a trader’s mindset and we have some new metrics to weigh in our purchasing decisions. But nothing will change if we don’t change our incentive structure. People respond to their incentives, so we need to make sure we adjust our incentives in our purchasing decisions.

Our goal is to create a better machine, not simply generate more money. When we create a better machine, we will more consistently generate cash in both up and down cycles. Therefore, the right incentive structure should focus on improving the accuracy of the predictions we used in our decision making as opposed to the results.

It’s of little long term value to us if we make a ton of money from a PO decision, but our predictions on who bought and how quickly they bought were wildly off. We threw darts blindfolded and happened to hit a bullseye.

So spend your time assessing the accuracy of past predictions and thinking through what is needed to improve that accuracy.

And align your bonus structure to accuracy of predictions.

Common Pitfalls

I have seen companies and leaders make these mistakes.

1. Punishing stock outs. Stock outs can be painful and we don’t want to always be stocking out. But if the message becomes stock outs will be punished directly or indirectly by leadership or other team members, the inventory planners will avoid this by over ordering. This continues as inventory balances balloon and the company chews up cash.
2. Ordering to unrealistic goals. The board demands growth. The CEO demands growth. The planning team develops ordering plans to satisfy that growth. People may whisper about how unrealistic the growth is, how marketing can’t support it, how finance can’t finance it. But no one stops it.
3. Past trend analysis is unquestioned. YoY and trailing trends are helpful. But they are often unquestioned. The biggest source of error is the YoY multiplier. What is this multiplier based on? Is it just the growth rate the CEO wants to see?
4. Ignoring past mistakes. Dead stock, broken sizes, slow moving inventory is ignored. Out of sight, out of mind. The planning team and leadership are acting like traders who are ignoring all their losses and just focusing on their wins. It’s like talking to the gambler who never seems to lose.
5. Over ordering the new new. This product is going to kill it. We need something big. We need it in 15 colors. It’s easy to get optimistic and when that optimism radiates from the CEO, it will get translated into big order. Of course we still need the hero products. So PO’s increase.
6. Capriciousness disguised as process. The CEO asks for analysis after analysis. But the process really just comes down to what they want to do. So either they wear down the planning team or the planning team just starts giving them what they want to hear. But in either case process is replaced by the whims of the CEO. What makes this especially hard to correct is that the CEO is often the founder and this method has worked for them in the past. The correction is to force the CEO to make their predictions known in advance (using the above) and then evaluating their gut against reality.

Conclusion

All companies die because they run out of cash. And the key culprit to that cash drain is bad inventory decisions. Our goal is to improve our inventory purchasing process and the key to that is changing our mindset, setting up the right analytical framework and aligning incentives.

If inventory is getting away from you and you are experiencing the common pitfalls, it’s time to make a change. If you have questions or if adding this structure to your inventory planning sounds exciting and you want help, reach out.