Kevin Morris

Vendor managed inventory (VMI) is a recycled buzz phrase making its way through the HVACR distribution industry again. The overall concept transfers inventory costs away from the wholesale distributor requiring the vendor to have available inventory that can be shipped to either the distributor or its customer on demand. Larger distributorships that are able to absorb more inventory costs are not the typical adopters of VMI, but rather the mid- to smaller-sized companies. This large distributor-large inventory trend, however, is beginning to shift, and currently some of the largest wholesale distributors are cutting their inventory to unprecedented new lows.

To some degree, these occurrences were predictable. As the marketplace has become hyper-competitive, distributors continue to seek cost-reduction strategies. Many have cut staff and/or implemented salary cutbacks. Others continue to expect manufacturers to continue to shorten lead times that were once acceptable merely five years ago. Now, with cash truly being king, many distributors — both large and small — expect same-day shipments, sometimes regardless of the order size. Because of this, manufacturers continue to see an increase in drop shipments and next-day orders.

The majority of manufacturers are often willing to carry more inventories, especially if they feel that distributors will value them more highly as a supplier. When there is no acknowledgement or reciprocation, however, this willingness can become strained. Distributors will likely find that using manufacturers as an instrument to help maintain a competitive advantage is acceptable, if they are treated as a partner. When distributors share their business plans it allows the manufacturer to better provide for the company’s needs. Open communication helps both sides of this relationship remain profitable and satisfied.

PROCEED WITH CAUTION

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Lowering stock and leaning on manufacturer vendors to remain competitive can be a beneficial strategy. Distributors can’t forget, however, that one of the principal purposes of maintaining distribution through wholesalers is to ensure that product is readily available to the trade at the local level as needs arise. If the OEMs were required to maintain the major burden of readily available inventory, and were capable of doing so, there would not be a place in the distribution network for the wholesaler. In some respects, wholesalers owe their very existence to their willingness to maintain adequate levels of readily available inventory. It is understandable that distributors desire to seasonally adjust the levels of the various types of products that they supply. Distributors, however, owe it to their customers, the contracting trade, and their vendors to strive to have sufficient quantities of the right product mix at the right times in order to support the industry.

It is nearly impossible to place a cost on being out of stock. It takes years to build the reputation of being the go-to place. It only takes a few times to destroy that reputation and replace it with one of being a distributor that never has what contractors need when they need it.

Inventory is a cost of doing business, but it is also the main reason distributors are able to earn a profit from the overall distribution of goods in this business.

PROTECTING ASSET LEVELS

In the midst of tough economic times, distributors have begun to focus on asset reduction strategies that could be dangerous to their overall survival. Most of the focus has been on inventory reduction and for the most part, has not yielded the desired effects. The foremost concern among distributors is cash. A low-cash position almost automatically brings investment reduction to the forefront of management’s thinking. If cash generation is the distributor’s goal, two things come first — inventory reduction and accounts receivable.

For most distributors, inventory and accounts receivable generally range between 60 percent and 80 percent of the distributor’s total assets. There is a very distinct possibility that by lowering inventory levels, a distributor could and most likely will reduce sales. Reduced sales lead to lowered profits, and in turn lower profits lead to reduced cash flow, and the vicious cycle continues. What is the effect of inventory reduction on return on assets (ROA)? Suppose that the inventory reduction is around 25 percent, and that the inventory is sold, but not all of it replenished.

At first the distributor would see a proportionate increase in cash, at a 25 percent decrease in inventory levels the distributor will inevitably be faced with a sales decline. The level of inventory is decreased and the distributor’s ROA increases modestly from anywhere between 7 and 9.5 percent. Granted, it lowers expenses and in so doing raises profits, but it also lowers the distributor’s overall level of asset investment.

INVENTORY ADJUSTMENT

When setting profit goals in a tight economy, it is easy for distribution managers to overestimate the cost of carrying inventory and underestimate the cost of being out of stock. Most branch managers are taught that the cost of carrying inventory is tremendously high, 30 to 36 percent. Taking the distributor’s interest rate and adding 5 percent can generally determine inventory-carrying cost. For this scenario, use 12 percent. Reductions in inventory of 25 percent would only cause ROA to increase 9.5 percent. Reductions in inventory have only a humble effect on both the ROA and the dollar profit.

The best way to avoid a cash flow problem is not to lower inventory and accounts receivable, risking a decline in sales. Instead, improve cash flow by covering it with lots of profit and focusing on the ROA. Unless someone in the supply chain is willing to bite the bullet and be successful at managing inventory, the HVAC distribution industry may be required to adopt a new set of business rules and accept longer lead times as the norm. The days of instant inventory gratification may end up needing to be adjusted.

Publication date: 10/26/2009