Strong inventory controls are essential, whether you are gearing up for growth or resisting a recession

Six years ago Howard Skolnik bought a sleepy, middle-aged company in Chicago that manufactured steel containers for use in the storage and disposal of hazardous materials. He had big plans for growth but knew his newly renamed Skolnik Industries Inc. lacked the financial systems to support expansion. "No one in the old company understood how the costs associated with excessive inventory and warehousing were hurting profits," he says.

Growing companies typically tie up more unnecessary cash in their inventories than in any other part of their business, with the exception of accounts receivable. "If you can free up the cash from inventory," Skolnik says, "you can spend it on growth instead." That strategy becomes even more compelling in recessionary times, when strong cash buildups become a company's best line of defense against order slowdowns and credit freezes.

Today $10-million Skolnik Industries maintains one of the best-controlled inventory operations in its industry, enabling the company to ship most products to customers within 24 to 48 hours of orders. At the same time, inventory levels are leaner than they were when the company was half its size.

To get there, the company switched from the quarterly inventory updates the previous owner had used to a computerized inventory-control system that continually updates warehousing records on a product-by-product basis. Then, with the help of Cecil Levy, a principal at the Chicago accounting firm of Miller, Cooper & Co., Skolnik set up a financial-reporting system that tracks trends in five different kinds of financial relationships within his company. Together, these function as an early-warning system against potential inventory problems. The reporting system monitors the following:

* Gross margin return on investment. Calculating this ratio is simple. Manufacturers subtract the costs of a product's raw materials, direct labor, and factory overhead (including warehousing costs) from their selling prices and divide that by the selling prices; administrative expenses should be left out of the equation. According to Levy, manufacturers should be able to demonstrate a 15% to 25% rate of return on each product line. For distributors, who lack production expenses, the ratio is calculated simply by subtracting the costs of goods bought from goods sold and dividing that by selling prices; their goal should be a 25% rate of return.

For Skolnik, those statistics were revelatory: "Some of my biggest selling lines were not profitable. So I eliminated some and looked for ways to reduce costs on others." One solution: instead of offering customers containers in 15 different shades of blue, all of which had to be stocked in inventory, he reduced the choices to 2 -- and since the customers were in a position to buy the 2 colors in larger quantities, they were able to get a better price.

* Inventory turnover. An effective inventory-tracking system can tell a CEO how often every product in inventory is used and replaced. An efficiently managed inventory turns over as frequently as possible to minimize the amount of cash that is tied up in the warehouse. To calculate your turnover rate by product, divide the total number of units sold during that year by the average number of units on hand during the year (the beginning number plus the ending number divided by two).

"Order cycles vary by company, but as a good rule of thumb, manufacturers' inventories by product line should turn over six to eight times a year," recommends Levy, "and distributors' inventories should turn over four times a year." The cost of slower inventory turnover is simple to calculate: a manufacturer whose inventory turns over just three times a year has tied up twice as much cash in the warehouse as necessary, at a cost of whatever interest that money could have been earning in an investment account.

If products begin to show turnover rates slower than Levy's suggested levels, that's a sign that too much cash is being tied up by them in the warehouse. Skolnik prefers to keep his turnover rates at the high end of the manufacturing spectrum -- aiming for a turnover rate of about eight times annually -- but he's willing to occasionally stock up on a raw material like specialty steel or paint if he finds a great deal. "Before I'll agree to a deal, I run through the numbers to make sure that my cost savings outweigh the additional expenses attached to a slow inventory turnover," he explains. (He calculates those costs as the price of warehouse overhead, including labor, plus the interest lost on money that is tied up in inventory.)

Since inventory levels are constantly changing as order levels shift, it's vital to monitor the turnover rate frequently. Skolnik tracks finished and "on-line" goods on a weekly basis, reserving monthly reports for raw materials only.

* Percentage of orders shipped on time. There's a risk attached to quick inventory turnover, attractive as the notion is. Quite simply, lean companies may not be able to fill orders as promptly as they would like. Percentage of orders shipped on time is the statistic to watch to make certain inventory management doesn't go too far at your company. "Aim for a 98% success rate at fulfilling orders by whatever delivery terms you promise your customers," advises Levy. Companies need to monitor this ratio on a product-by-product basis every two to four weeks. If the percentage of successes begins to drop below the mid-90s, it may be a sign that certain inventory levels need to be pumped up.

* Length of time to fill back orders. Skolnik dreads the potentially detrimental effect of backlogged orders on his business base so much that he pays extra to do business with suppliers who can make emergency deliveries of raw materials when he receives unexpectedly large orders.

For companies unwilling to pay that extra cost, Levy advises, "On a weekly basis, watch the number of days it takes to fill back orders and make it a major goal not to tolerate any type of worsening, because it will ultimately hurt sales." One way to reduce backlogs is to increase inventory, at least on certain products. "If you know you're going to sell 5 items a week, and it takes you two weeks to make those 5 items, then you'd better keep at least 10 in stock," he says. "If your salespeople start selling 7 a week, respond immediately by pushing up production so that inventory can keep up with demand."

* Percentage of customer complaints to shipped orders. Customer complaints often represent a company's earliest warning about problems in inventory and warehouse systems. A complaint ratio (complaints divided by all orders shipped) higher than 2% could signal real problems. At that point it's essential to analyze each complaint for what it could reveal about underlying operational problems. Incorrectly shipped items, for example, may indicate a poor product-tracking system, mislabeled storage bins, or badly trained warehouse personnel.

Consistently late shipments may also signal computer overload. In just six years Skolnik Industries has already been forced to upgrade its computerized inventory system four times. After all, the company's orders -- if not its inventory -- just keep swelling. "It all ties together," Skolnik says with a smile. "When your inventory is well maintained, you can keep your customers happy and still afford to pay for your growth."


Get the right reports

Effective inventory management depends on the right kind of financial reports. Here's how to get them and use them:

* Computerize. You'll need an inventory-updating system that instantaneously records every product movement in and out of your warehouse. Growth companies usually require software that is specially adapted to fit their product lines, sales cycles, and so on. Howard Skolnik, owner of Skolnik Industries Inc., investigated over-the-counter models and ultimately chose software that was modified for him by his accounting firm.

* Analyze results frequently. Inventory reports are just as important as any other type of management information. It makes sense to analyze them every two to four weeks. During periods of either strong sales growth or flagging orders, review them weekly.

* Circulate reports to all key managers. A well-maintained inventory base can be a profit center that frees up cash as needed. The key is to keep salespeople, financial staffers, production managers, and other aware of the company's current cash-flow goals and inventory realities.


Stock in trade

Most books about inventory management are dry, technical, and absolutely unreadable. But Jan B. Young's book, Modern Inventory Operations (Van Nostrand Reinhold, 1991), is a welcome exception: a comprehensible text that focuses on such issues as which types of specialized inventory reports can be useful, how to keep inventory records 100% accurate, and how to evaluate new warehouse technology. At $44.95, it's a bargain compared with the rates consultants charge to design specialized inventory-control systems.