Inventory Management Is Really Cash Management

Most dealers think of their inventory as the number of vehicles they have in stock on their lot, sitting at the auction, at repair shops and in transit to their store. To me, inventory is another form of cash. Think of each vehicle as a pile of cash in each space on your sales lot instead of a hunk of metal and rubber.

Most dealers are somewhat limited on the number of vehicles they can stock by their checking account balances, lines of credit or floor plan lines. Since most dealers borrow money to purchase vehicles, it doesn’t seem like cash was used. This is not true. Cash is cash whether you have it in the bank or borrow it. To think of it otherwise doesn’t make much economic sense.

Inventory is also a current asset on your balance sheet. Current assets are meant to be short-lived, as in less than one year. This means you shouldn’t have any inventory over one year old.

If you are only reviewing units over 60 days old, you are too late. You need to start at the 15-day mark and find out why no one has been demoing the vehicle or even inquiring about it. If you start at 15 days, you’ll quickly identify when you have purchased too many of the same vehicles or vehicles people aren’t currently interested in.

Everyone knows “fresh” vehicles sell faster with higher average gross profits. If your inventory turns slow down, your total and average gross will normally decrease. The amount of floor plan interest paid per vehicle will increase, lowering your overall profitability. You may even be asked to pay down or pay off your floor plan as your vehicles age, using up the available operating cash in your checking account.

This makes it even more important to manage your inventories constantly and make the necessary adjustments timely instead of waiting and not achieving your expected rate of return on your investment.

Let’s look at the cash management aspect of inventory. If you have invested $10,000 to purchase, transport, clean-up and recondition a vehicle, you have effectively spent $10,000, whether you took it out of your bank account or borrowed the money. Now your goal is to sell the vehicle and make a profit. Let’s say your gross profit should be $2,000. If that is the case, the selling price is $12,000. To calculate your gross profit percentage, you would take the $2,000 profit and divide it by the $12,000 sale price. You have just made a 16.67-percent gross profit on the sale. Not bad.

Now the goal is to reinvest the $10,000 in another vehicle and make the $2,000 gross profit again. The question is how many times can you take the same $10,000, purchase a vehicle and sell it within a year? If you do this six times in a year, you have just made $12,000, or a 120-percent return, on an investment of $10,000. With interest savings rates at an all-time low of approximately 0.50 to 1 percent, the 120-percent return looks very appealing.

Do you watch and calculate how many times your inventory turns each year? Do you know what your return on inventory investment is? Do you know how many vehicles to stock? Do you know how many dollars you should have in inventory for current sales level? Without this information, you may not be maximizing the capital you have invested in the largest asset on your balance sheet.

The place to start is to calculate your average monthly cost of sales. Include total cost of sales, including reconditioning, transportation and clean-up. Then, take your total inventory cost from your balance sheet and divide it by the average monthly cost of sales. This will give you the months of supply of sales you have in vehicle inventory. You can then divide the months of supply into 12 months to arrive at how many turns per year you are achieving. An example is as follows:

Year-to-date cost of sales through June                         $1,200,000
Divided by the number of months YTD                                    6
Equals average cost of sales per month                        $200,000
Inventory cost from balance sheet                                   $500,000
Divided by the average cost of sales per month           $200,000
Equals months of supply                                                         2.5
Number of months in a year                                                  12.0
Divided by the months of supply                                             2.5
Equals estimated number of turns per year                        4.8

The above example reveals you will only turn your inventory 4.8 times per year. Now, assume each time you turn your inventory you make 16.67 percent gross profit. Total sales would be arrived at by dividing the estimated total cost of sales by 83.33 percent (100 percent less the 16.67 percent gross profit).

In the above example you would have a $2,400,000 total cost of sales divided by 83.33 percent, arriving at $2,880,115 in total sales and $480,115 in total annual gross profit. This averages $100,024 of gross profit per turn of your $500,000 of inventory ($480,115 gross profit divided by 4.8 turns). This equates to a 96-percent return on your investment of $500,000 ($480,115 gross profit divided by $500,000 inventory).

Now, let’s assume you only have $400,000 of inventory and sell the same number of vehicles. Your return on investment is 120 percent ($480,115 gross profit divided by $400,000 inventory). You made the same gross profit with less capital invested. Isn’t a 120-percent return on your investment better than a 96-percent return? It definitely is. Which rate of return would you rather?

Now let’s take another scenario. Assume you have the same $500,000 of inventory and turn it six times per year instead of the 4.8 turns. If you achieved the six turns, you would generate a $3,000,000 cost of sales and $3,600,144 in sales, leaving a $600,144 gross profit. Your rate of return is now 120 percent and you have generated $120,009 in additional gross profit using the same amount of capital.

To achieve the 120-percent return on your investment you will have to work at it every day. Yes, every day. If you don’t constantly review your inventory and deal with the overage units, you will not achieve your expected rate of return on your investment. Why not work the same amount of hours and make more money by working smarter?