Tuesday, March 18, 2014

Leveraging Inventory (Tradecraft)

This post is a riff on using Open to Buy to leverage your inventory. I'm working on it for my ACD Games Day presentation. It may or may not go into that presentation, but it's been rattling around in my mind for a few days. It might be a bit too esoteric for the presentation. It might even be dangerous for beginners. It's certainly powerful.

If you are interested in this topic, but unfamiliar with the area, here are some links to read first:
If you know this area, skip down to Leveraging Open to Buy.

Open to Buy Basics
When you use Open to Buy, you are taking your powerful inventory budget and separating it from the rest of your expenses. This is difficult if you're not profitable or you don't have the cash flow. If you only order stock when circumstances permit, you're not ready for Open to Buy. My suggestion, before embarking on OTB, is to build up a cash buffer so you have room for an inventory budget. If you're coming off a good period, rather than spending on something, keep it in reserve so you have the flexibility to use this tool.

Open to Buy allows you to purchase what you need, when you need it, regardless of what's going on in your business. Just as regularly paying yourself a salary allows you to firewall business finance from personal finance, OTB allows you to firewall purchasing, the lifeblood of your business, from day to day business finance. This gets you into the Success Cycle with your inventory:
  1. Knowing what customers want
  2. Having the budget
  3. Receiving on time
  4. Satisfying demand
Leveraging Open to Buy
On its face, inventory seems a bit dismal and mechanical. You've got X amount of inventory and through diligence you can fine tune it to increase turn rates. Your inventory performance tends to improve in a relatively narrow band only after years of hard work. However, once you get the basics down, it's far more dynamic than this. An advanced technique, you can leverage this resource for your financial needs. Better yet, the stronger your inventory, the stronger the leverage.

Why would you want to do this? There are a couple reasons you would leverage your inventory, involving both drawing it up and drawing it down. First, through Open to Buy, you can draw up your inventory far beyond normal levels to take advantage of seasonal sales. Without OTB, this would be dangerous, as you wouldn't know where to stop or how to reverse the trend once it started. It's still a bit dangerous, but with good data, it's the usual risk management we do every day.

To give an example, during the holidays last year, my inventory peaked at $15,000 over my budget in mid December, to take advantage of holiday sales. By December 31st, two weeks later, I had a balanced budget, important since my excess inventory is subject to taxes. That $15,000 was leverage that allowed me to double sales in December from a normal month. Because I use Open to Buy and have sales data from previous years, I could forecast demand, budget inventory, and most importantly, draw it down in a condensed period. That's powerful leverage.

Inside Leverage joke
Drawing down inventory is usually an affliction, something that happens to people who don't track using Open to Buy. The dreaded Inventory Death Spiral is when a store is having trouble paying their bills, they use their purchasing money for expenses, which then results in poor sales because they have nothing to sell, which again starves their inventory budget, until they're standing in an empty store. Not spending your Open to Buy money is just as dangerous as overspending, but also just as powerful.

Through Open to Buy, you can carefully draw down your inventory budget during an off season, or perhaps for upcoming expenses where you would like to avoid a costly loan. That's something I did recently to pay taxes. Drawing down inventory over a longer period to pay temporary expenses, and then drawing inventory back up, again over a longer period. This leverage works far better with established stores with bigger inventories. That's because of how sales and inventory is structured, following the Pareto Principle

Pareto Principle
The Pareto Princple, also known as the 80/20 rule, applied to inventory says that 80% of your sales will come from 20% of your inventory. It's not an exact thing, but it mostly works. When you're a new or small store, inventory is relatively flat. You're an inch deep and a mile wide, with 80% of your inventory usually having just one item on the shelf. As your store and inventory grows, that begins to change. Sure, you add some inventory breadth, but the majority of your sales are still that 80% from before. Now you just have more safety stock, deeper amounts of those items in which you expect higher variation in demand or supply. That's opposed to current demand stock, items you have for right now, which is the other variable.

Safety stock is where you can find that draw down cash, which in a new or small store applies to only 20% of your inventory, but in a larger store, it's up to 80% of your inventory. A bigger budget means more leverage to draw down. The key is to only draw down safety stock so you can lean out your store, without adversely affecting sales.

You can draw up and draw down provided you've established your Open to Buy budget and provided you've got the financial leverage to make this happen, meaning terms or credit cards to pay for your inventory. Leveraging inventory  is a bit advanced, so I don't recommend it for everyone, but it's a tool in your toolbox.


  1. I don't quite get the connection between the Pareto principle and safety stock. You may want to expand a bit if you decide to add to your presentation.

    Suggestion - next time you do an ACD day, perhaps offer to do an Advanced Inventory seminar.

  2. Starting out, your safety stock is going to be about 20% of your inventory, with your current demand inventory at 80%. This means you've got limited flexibility, as you don't want to draw down your 80% of primarily one item SKUs.

    A more established store has a much higher percentage of safety stock. My safety stock is at 80%, which provides me a larger reserve to draw upon. 80% of my inventory has more than one item on hand, well beyond my current demand inventory. That 80/20 is what I was getting at with Pareto.

    Anyway, there's no way I'm going to go over this stuff for my presentation. Way too esoteric. It was fun to write though.