Why? As business slows in a recession, companies shrink inventory and collect receivables creating a positive cash flow. While sales may struggle, there is cash to pay bills. As business picks up, sales, inventory and receivables grow and suck cash out of the company. All of a sudden there is no money to pay the bills even though business has improved.
Avoiding Cash Traps
Businesses need to watch out for common Cash Traps and one of the most common is inventory. As David Wootton said in his post last month "think of your inventory as a big box of dollar bills." Those dollars can be tied up in inventory too long if the purchasing decision is based on a faulty premise. Some premises may sound logical but they are not always good business thinking when the total cost of procurement is not taken into consideration.
• “If I buy the roll of vinyl flooring, I can sell it for less because my cost is less.”
• Or, “the margin in ceramic tile is twice that of carpet so I’ll sell ceramic and make more money.”
• And my all time favorite, “I’ll buy direct and save the 25% that a distributor would charge me.”
Think about the value of cash that is tied up in the roll of inventory. Factor in the cost of remnant write downs, style obsolescence, damage, insurance, labor to cut, inventory management and a host of other hidden expenses. A floor covering mill normally charges a 10 percent premium for a cut which is the exact size, color and style the customer wants now and is willing to pay for even before your payable is due! Isn’t that worth 10 percent?
Ceramic tile sells at higher margin because it costs more to handle and sell. Freight and damage are huge cost factors. Just ask all of those people who went out of business trying to sell ceramic at laminate margins. If you are not ceramic savvy, don’t go investing in ceramic inventory now.
Flooring distributors charge based on the services they provide and those services reduce the retailer’s cost of doing business. A distributor’s profit is not the 25 percent difference between the truckload mill direct cost and the distributor’s carton price. The average distributor’s bottom line profit is 2 or 3 percent. This is not enough of a return on investment to justify “cutting out the middle man” unless you have completely analyzed the cost of providing those lost services yourself. Acting on this premise without knowing the total investment can be a drain on cash that may be needed to fund a recovering business.
In all of these cases, determining the Total Procurement Cost must be part of the analysis before investing in inventory.
Consider freight, waste, insurance, obsolescence, inventory tax, claims, warehousing and handling, duty and tariffs, personnel to sell it and in some cases sampling. And don’t forget the cost of capital.
Another kind of Cash Trap
Another kind of Cash Trap is when the value of assets are under-utilized; trapping cash in a dormant state. There is a car dealer in St. Louis who has aggravated me for decades. He advertises, “We own our lot and building so we can sell to you for less.” What he is implying is that he does not have to pay a bank for a loan on his million dollar real estate investment so he can sell cars for less. What?
There are two things wrong with his thinking. First, he is ignoring the Cash Opportunity of his investment. If he has a million dollars tied up in his lot and building, it has a value whether he is paying the bank or not. He deserves a return on that investment the same as if the cash was in the bank, bonds or stocks. Secondly, he has discounted the value of these assets for his business. Should he consider borrowing on the lot and building so that he can fund a long term consumer credit program or buy more inventory? If these would produce more sales and more profit, it definitely is worth more than an advertising slogan. I am not suggesting that anyone overly leverage themselves in this economy; but I am saying that when cash is precious, its value should not be ignored.
There is no room for error now. Thoroughly understanding the cost of doing business is key to survival.
I am interested to receive your comments about hidden costs you've found and how you determine cost and profitability in your business.