FOR most of the last decade, distributors have taken a strong cash-flow orientation to their operations. The rallying cry has been "Profit is fine, but cash is king." There is now strong evidence that the king is in exile.
A proponent of the cash-flow perspective would argue that both inventory and accounts receivable are cash traps that must be drained. However, reducing these onerous investment factors has the potential to lower sales volume. Let's examine the implications of lowering the investment in inventory and accounts receivable, from two different perspectives:
• The Investment Versus Sales Trade-off: An examination of how investment reduction programs have the potential to either increase or decrease profitability.
• Having Cake and Eating It Too: A review of the opportunities for investment reduction that can be undertaken without risking sales decline.
The Investment vs. Sales Trade-Off
To understand how investment and sales reductions work their way through the business, it is necessary to have a precise understanding of the financial structure of firms in the industry. The chart at lower left provides financial results for a representative distribution firm.
This typical firm generates $40 million in sales volume, operates on a gross margin of 20% of sales and produces a pre-tax profit of $1.2 million or 3% of sales. The firm is also assumed to have variable expenses (commission and the like) of 4% of sales.
The key investment issue is that the firm requires $12 million in total assets in order to generate this level of sales and profit. Of this amount, $5.5 million is in inventory and $5.1 million is in accounts receivable. These results are shown in the first column of the exhibit.
The second and third columns examine the impact of an investment reduction, but do so under very different circumstances. The second column assumes that both inventory and accounts receivable can be reduced without impacting sales volume. The final column looks at the consequences of an investment reduction that result in a modest sales decline.
In both of the "what if" columns the investment in inventory and accounts receivable has been reduced by 10%. It is also assumed that the cost of carrying inventory and accounts receivable is around 20%. That is, for every dollar of investment reduction, profits would increase by 20 cents due to less interest, a reduction in insurance on inventory, fewer bad debts, and the like.
A 20% factor for inventory is about what most inventory consultants suggest should be used for inventory. For accounts receivable, a 20% factor overstates the carrying costs by a large extent since the only carrying cost items are interest and bad debts. Consequently, the cost reduction factors in the exhibit are slightly over-stating the profit impact of an investment reduction.
As can be seen, if there is no sales decline, the cost reduction (line item "Reduction in Carrying Costs" in the exhibit) is significant. Costs decline and profits increase by $212,000. At the same time, the reduction in investment is also significant. When the investment reduction and the profit improvement are combined, ROA increases sharply, from 10% to 12.9%.
The problem in distribution is that investment reductions are almost always associated with reductions in sales activity. This is due to out-of-stock conditions on inventory and the reluctance to provide credit to marginal customers on accounts receivable.
In the final column of the exhibit, it is assumed that sales decline by 10%. This is not meant to imply that a 10% investment reduction will automatically result in a 10% sales decline. It is merely a pro forma set of results. The actual sales decline may be more or less than 10%.
In any event, the sales decline destroys the financial structure of the firm. With a sales decline, it is impossible to shed fixed expenses. The result is that profit declines from $1.2 million to $772,000. Even though the asset investment is reduced, ROA actually falls from 10% to 7.1%. Simply put, sales are much more important than investment levels in determining the financial success of the firm for BSA members.
This profit impact of "sales not made" is not well understood as traditional information systems simply can't provide pro forma income statements that add back sales that were lost. Since the profit impact of investment reductions are highly visible and those of lost sales are not, there is a natural tendency to move toward an investment reduction approach.
Having Cake and Eating It Too
Few distributors have as much cash as they desire. The instinctive reaction is to lower investment levels. However, such actions are likely to lower profits, which make the investment challenge that much harder. There are two solutions to this challenge-drive profits higher or eliminate marginal investments.
• Driving Profits Higher: For most firms it is absolutely essential to place more emphasis on increasing profits and less on lowering investment levels. This means avoiding investment myopia, which results in blanket reductions in either inventory or accounts receivable.
If the firm can generate an adequate level of sales volume and a realistic gross margin on those sales, profits tend to increase almost exponentially. The key to this strategy is to have the right product in stock when customers want it and to be willing to finance those purchases. There is no other realistic approach to profit improvement.
• Eliminating Marginal Invest-ments: The key to investment reduction success is focusing on where the investment is doing little to help the firm generate sales and profits. In inventory planning this is easy; for accounts receivable planning it is much more difficult.
In inventory, the problem investments are easy to identify. They are items that have not sold during the last year. Monitoring systems must be in place to highlight these problems and management must deal with them on an on-going basis. Dead inventory never returns to life.
For accounts receivable, the issue is more complex as it is not just the slow-paying accounts, but those which are slow paying and also generate low levels of sales and gross margin. This requires a system to evaluate the overall profitability of accounts and commensurate ability to make pricing adjustments where the return does not justify the investment.
- Dr. Albert D. Bates is founder and president of distribution research firm Profit Planning Group, Boulder, Co. The article is adapted from his new book Profit Myths in Wholesale Distribution: The Truth about Sales, Margins, Inventory, and Expenses, offered by the NAW Institute for Distribution Excellence, (202) 872-0885, www.naw.org/profitmyths.