With the era of low interest rates and low inflation consigned to history – and the costs of holding stock soaring – resolving the problem of excess inventory has become a major headache for retailers.
On the one hand, there are the obvious, visible costs of being over-inventoried. Prices of goods themselves are rising, along with warehouse rent and labour costs. But there are also a range of hidden costs. First and foremost, the ‘opportunity cost’ of capital tied up in inventory that cannot be used elsewhere. In addition, there is the risk that excess stock may not sell, either because of obsolescence (think of goods that benefit from novelty – such as toys and electronics – that may depreciate in value while gathering dust on the shelves of a warehouse or store) or because it passes its due date (think of perishable food in supermarkets that may be thrown to waste).
When we think about ways to fix the problem of excess stock, our minds typically go to the operational levers we can pull, as explained in another recent article, The hidden costs of excess inventory.
What’s often overlooked, however, is the impact that upstream commercial decisions can have on inventory levels. Imagine, for example, a retailer wants to position itself as a market leader in terms of customer choice. It takes advantage of the extra capacity of its larger stores and ‘ranges to space’ – i.e., it fills their shelves with the highest possible number of SKUs to deliver greater variety and choice for customers.
However, we often see no correlation between increased range and sales volume (as shown by the example below of a grocery retailer’s alcoholic drinks range). The actual customer demand for less popular ranges frequently fails to match the retailer’s perception of the value of ‘choice’.
Beyond the best-selling SKUs, items often spend far longer on shelves than is desirable from the retailers’ perspective, as the graph below from a different retailer (general merchandise) illustrates.
Decisions about overall range require a balancing act between the breadth of the assortments and the cost and complexity of carrying more SKUs.
Industry best practices show that new governance approaches are required to ensure commercial decisions consider working capital implications. In particular, organisations need to break down siloes between different business functions and make buying and sourcing decisions collaboratively and rethink the KPIs in use to evaluate sourcing decisions.
For example, if buyers are targeted on sales and gross margin, then the incentive of that function is to source at the lowest cost. Goods sourced cheaply, for example from China, can deliver the targeted margins, satisfying the KPI. Even greater margins may be achieved by buying in greater volumes.
But what about the working capital costs of that inventory, such as potentially lengthy lead times and the increased risk and complexity of holding more stock over a longer period? This is where the use of metrics like GMROI or the introduction of Net Working Capital charges helps consider the end-to-end implications of those decisions and ensure better trade-offs.
During times of low inflation and low interest rates (not to mention the absence of global tariffs) these concerns mattered far less. But the picture is very different today, and there needs to be a radical shift in how retailers think about working capital in stock, and their governance when it comes to buying decisions. Retailers might be able to reduce their stock by addressing operational issues, but they will find it hard to sustain those gains without tackling the more fundamental drivers of excess stock that lie with ‘upstream’ commercial decisions.