Category Archives: the inventory problem: stockout vs. carrying costs

21st century retailing: my trip to Home Depot

August 22, 2017 By in internet, Inventory Cycle, Retail, the inventory problem: stockout vs. carrying costs, Uncategorized Tags: , , , , , , Leave a comment

This is another mountain-out-of-a molehill thing.

We have Toto toilets in our house.  Toto is the leading brand in Asia and has been making significant inroads in the US over close to two decades.  Yes, they’re the toilets that play music, heat the seat, double as a bidet and make fake urinating noises (a Japanese must)–but we just have plain old toilets.

The other day, I went to the local Home Depot, which, by the way, sells Toto toilets, to get a replacement part for one of ours.  A friendly employee showed me where the replacement parts were–all aftermarket brands, not Toto, but that was ok with me–and which was the right one. The replacement didn’t look much like the broken part, but the employee assured me that it would work.

It didn’t.  And, in fact, in looking back on my trip, the HD employee may, strictly speaking, have only told me that that was all they had.  If so, kind of embarrassing for me, since for most of my working life I was on the alert for verbal gymnastics aimed at papering over problems.

Rather than launch a telephone search for a plumbing supply store in the neighborhood that might carry the part I needed, I found it on Amazon.

 

Around the same time, I found I needed a replacement part for a Weber grill.  Same story.  HD sells Weber grills, but not replacement parts.  So, after a wasted trip to the local HD store, I ordered from AMZN.

 

What’s interesting about this?

In the early days of the internet, there was lots of speculation about the “long tail,” meaning that e-retailers like AMZN would make most of their money from selling obscure items that potential buyers couldn’t find in bricks-and-mortar stores.

A great story   …just not the case back then.  Just like bam, online exhibited the “heavy half” phenomenon, i.e., 80% of the business came from 20% of the items.

 

But maybe the long tail is beginning to come true.  It’s not because weird stuff that no one really wants has suddenly come into vogue.  Instead, I think computer-driven inventory control programs that eliminate slow-moving items from a store’s offerings may have gone too far.  Yes, carrying fewer items has the beneficial effect of requiring fewer employees and less floor space.  But at some point, the process begins to have negative consequences, as well.

For instance, it’s training me not to go to a physical DIY store, so I’m not passing by enticing end cap displays or being tempted by the sparkly high-margin junk arrayed along the checkout line.

 

My experience as an analyst has been that any cost-control measures always seem to go too far.  They work for a while, but the continual application of the same process somehow eventually ends up creating the opposite of the intended effect (yes, experience has made me a Hegelian, after all).  This may be what is starting to happen with inventory control programs that retailers use.

If I’m correct, this is another plus for AMZN.

 

auto inventories

December 5, 2013 By in Autos, economics, Industry Analysis, the inventory problem: stockout vs. carrying costs Tags: , , , , , 1 Comment

I’m not a big fan of the auto manufacturing industry.  It’s highly cyclical and capital-intensive.  It’s plagued by chronic overcapacity and generally terrible management.  Much of the technology involved in making cars has migrated over the years to component manufacturers, making it harder for brands to differentiate themselves from one another.  On top of that, the industry employs so many people that national politics can play a large role in how it fares.  Just look at GM.

Despite all this, the industry does have its moments.  I’ll confess to, at one time or another, having owned shares in Peugeot, Nissan, Toyota, Honda, Porsche, VW, Hyundai and BYD–plus bunches of parts manufacturers and the occasional regional Asian car distributor. Today I even own a tiny position in Tesla–thanks to the encouragement of my younger son and one of my brothers-in-law (I haven’t done any of the serious work, so this is not an endorsement of TSLA.  The Wall Street consensus for TSLA earnings in the year ahead is $1.50, meaning that the stock is trading at 100x.  That estimate is doubtless wildly wrong.  The investment issue is whether it’s too high or too low.)

Let me switch from incipient anti-commodity industry diatribery to the current auto inventory situation in the US.  I think I know what’s going on.

Take Ford (F).

During 3Q13, US wholesale (i.e., sales to car dealers) unit car volume was up by 16%, or about 216,00 cars, year-on-year for F.  That increase pushed operating profit from auto sales up by a whopping 61%, after subtracting special charges from this year’s figure (the relevant information is on page 51 of the 10-Q).

Unit profit per car averaged $1,354 during 3Q12, $1,877 per car in 3Q13.  Yes, a difference  …but what’s $500?  Where’s the operating leverage?

Look at the data in a different way.  If we ask what the unit profit was on the incremental volume in 2013, the answer is $5,100 a pop.  In other words, once F’s sales covered fixed costs and reached 2012 production levels, the unit profit on anything above that was about 4x the average.  This is where the operating leverage is.

This implies

…the loss incurred if a customer leaves a Ford dealership without buying because the car he wants isn’t in stock is much higher than normal for F today.  That customer isn’t going to come back; he’s probably going to buy a Honda instead.  Given that the cost of financing dealer inventory is basically zero, it makes no sense, either for F or for the dealer, to skimp on what’s on the dealers’ lots.  Especially as early in the model year as we are now.

Yes, there may be trouble down the road from too-large inventories at some point.  But if the industry dials back production from the current 90% of capacity to, say, 80%, maybe there won’t be.  For F at least, the cost of some manufacturing downtime early next year will likely be dwarfed by the extra profits being achieved at present.

That’s what the media is missing.  On the other hand, that information isn’t sound-byty, and it’s on page 51 of a 79-page, small-print 10-Q.  No reporter or academic is going to bother looking that deeply.

the inventory problem: holding costs vs. stockout risks

December 4, 2013 By in Inventory Cycle, inventory days, operating leverage, the inventory problem: stockout vs. carrying costs, working capital Tags: , , , , 1 Comment

The domestic auto industry reported November vehicle sales yesterday.  The numbers were very good.  But most of the (negative) media attention centered on the elevated level of inventories–about three months worth of sales–on dealer lots. Yes, that may eventually be a worry, but I don’t think it’s the right way to look at the current situation.

The auto news also gives me the occasion to write about the balancing act every manufacturer and retailer faces in deciding how much inventory to have.

the simplified story

There’s an often convoluted dance between supplier and distributor/end user about return policy, payment terms, co-op advertising…in negotiating over how much of a product to buy and at what price.  Nevertheless, the decision about how much inventory to hold ultimately comes down to weighing two opposing risks:

—stockout costs.  This is when your brilliant national advertising campaign, your sterling reputation for high quality and service–or sometimes just random factors–prompt a potential customer to either go online or enter a physical store with the intention of buying an item.

You’re out of stock.  You try to interest him in a substitute, or promise to have the item tomorrow.  He says thanks, leaves and buys the item somewhere else.

You’ve lost a sale.  And the person you’ve disappointed is at least marginally less likely to have you first on his list next time he’s shopping.

That’s stockout costs.

—inventory holding costs are much more straightforwardly quantifiable.

There are three main factors:

-financing costs, which in today’s world are negligible;

-liquidity risk of having your capital tied up in inventory rather than in cash during the time it tales you to make a sale; and

-the possibility that the items either become obsolete, go out of style, or–like fresh food–exceed their shelf life before they can be sold.  Then your asset has become a wirtedown.

complications

(In the stock market, there are always complications.)

In good times, companies want to hold more inventory (because they see stockout as a greater risk than holding costs); in bad times sentiment reverses and everyone wants to hold as little as possible.

If prices are rising, procurement managers see the chance to make windfall profits and order more than they need; if prices are falling–as is chronically the case in industries like consumer electronics–inventories are kept trimmed to the bone (except in really good times, when everyone throws caution to the winds).

In industries with low fixed, high variable costs, manufacturers see no percentage in upping production volumes.  In industries like autos, with high fixed costs and therefore tons of potential operating leverage, there’s a tremendous incentive to make extra units once a firm reaches breakeven.

The competitive structure of an industry doesn’t change the nature of inventory risk, but it can change who it is who’s assuming them.  This may not always be obvious from even a detailed study of the working capital sections of the balance sheet.  If a manufacturer were to have a policy of unlimited returns (that would be crazy, but let’s just suppose), then it–not anyone farther down the distribution chain–would ultimately be responsible for any unsold goods.

 

More tomorrow.