the inventory problem: holding costs vs. stockout risks

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.


(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.






retailers and inventories

I want to write about prospects for retail during the upcoming holiday selling season in the United States.  I’m going to do it in two posts.

In today’s I’ll cover the general issue–how retailers figure out how much inventory to have on the shelves.  In Sunday’s I’ll cover what activity at the major ports in China and on the west coast of the US is saying about what retailers are doing this year.

the inventory problem

In its simplest form, the ground-level decision retailers make about how much stuff to buy to stock their shelves can be framed in terms of the two possible unfavorable outcomes.

They are:

–stock-out costs, meaning the opportunity loss a retailer suffers if a potential customer comes in to buy a specific item and is willing to pay full price, only to find that the store has run out.

This is a tragedy.

There’s some chance a good salesperson can persuade the customer to buy a substitute item that is available.  More likely, the customer goes elsewhere and the chance to grab a 100% markup over cost of goods is lost.

On top of that, the rival that makes the sale has a shot at becoming the customer’s first stop from that point on.  Also, too many empty shelves can create a “don’t go there” atmosphere akin to walking down a dark street in a bad neighborhood at night.  And a thoughtful shopper might construe the absence of certain product lines as a statement by their manufacturer about the retailer’s (low) status or creditworthiness.


The other side of the coin is:

excess inventory, especially of seasonal items.  In this case, the retailer has the problem of how to dispose of the extra merchandise.

Three reasons for this:

the value of the inventory is eroding as time passes,

the merchant wants to recover the cash he sunk into buying the merchandise, and

he wants to create shelf space for more salable items.

Some things may be returnable to the manufacturer, whether the sales agreement, strictly speaking, allows this possibility or not.  Most, though, will go through a process of markdowns in the store, followed by sale (maybe even at a loss) into the extensive closeout network that crisscrosses the US.

Although the reality is that few retail purchases in the US are at full price, customers are put off if a store always looks like a fire sale is happening.  Branded goods manufacturers may also become very upset if retailers sell their wares at a discount or if they find their merchandise floating around in closeoutland.

True, some manufacturers are vertically integrated.  That is, they maintain retail doors themselves, as well as wholesale warehouses to serve both affiliated and non-affiliated customers.  In such cases, retailers can operate just-in-time by ordering periodically from local distribution centers.  This doesn’t eliminate the inventory planning issue, however; it just shifts it from the retailer to the distributor.  The tradeoff for the retailer is that he doesn’t capture the full markup from the factory door (as a rough rule of thumb, maybe half the total markup on any item goes to the wholesaler).

Over the past couple of decades, department stores, which still serve many of the needs of average Americans, have increasingly turned to house brands, with merchandise ordered more or less directly from the (usually Asian) manufacturer.  They may use an intermediary like Hong Kong-based Li and Fung for ordering or for design services, or they may go straight to the factory themselves.  In either case, their decision has been to increase their inventory-related risk in order to generate higher margins.

taking retail’s temperature

Generally speaking, small, lightweight, high-value items like laptops, tablets or cellphones, are delivered from Asia to the US by air. For most merchandise, however, speed isn’t essential and airfreight costs from Asia would take too big a chunk out of profits.  So this stuff travels by ship from, say, Hong Kong to California, and then by truck or rail to a distribution center.

Anyone can get a reasonable idea–with some caveats–of how retailers see the holiday season shaping up by monitoring the publicly available data on activity in the major import-export ports.

The message the ports are delivering is that despite relatively robust retail sales in recent months in the US, retailers are planning on at best a flattish holiday selling season.

More about this on Sunday.