Inventory is a Bet
Originally published: 08.01.06 by Ruth King
You put that part in your warehouse. You pay for that part with profits from other jobs. You hope that it is sold to a customer. You celebrate when it is put on a technician's truck and hope that it doesn't get damaged before it is sold. And, unfortunately many bets are still sitting on your shelves at the end of the year. That part was a bad bet.
Your employees don't help. They think, "He can afford it...so what if I damage this part or forget to write it down on an invoice or material sheet?" Your employees don't have to pay for the damaged parts. They don't see the waste. They do't see the bad bets.
One of the saddest experiences I've had in the past 20+ years was with a company that hadn't taken inventory for two years. I knew just by watching that materials and equipment were disappearing. They didn't want to take inventory... there was no time. They were busy. I insisted. They finally did. Long story short: when the inventory was counted there was about $250,000 less than the balance sheet said there should be. That company lost a quarter of a million dollars net worth in one day. What a shock to the owners.
Can you lose $250,000? Easily. Here's how:
If you divide the $250,000 into two years, that is $125,000 per year or about $2,400 per week. There were about 30 different crews or service technicians who handled inventory. This means $80 per week per crew or $16 per day. Leave a box of flex on the job, damage a few grills, leave off a part used on the job, take two parts and use one, etc.
Sixteen dollars per day is easy to lose. And yes, it does add up.
Did we fix the situation? Of course. Here are some of the "absolutes" of inventory management that I used:
1. Education is critical. We explained how easy it is to lose and damage inventory and gave them an example of a $10,000 loss (using the same rationale as above). The field labor could relate to $10,000. We asked them to be careful and told them that paperwork and lockup was going to occur.
2. Do not run a warehouse supermarket. Lock up your warehouse and do not give crews or technicians free access. If they have access they will go through the warehouse before a job and take two parts instead of the one needed... just in case. Of course, they never bring back the extra part.
3. Count your inventory and be accurate! If you haven't taken it for a few years you will likely encounter a nightmare the first time you count it. After that first time it becomes easier because you've set up a system to count it. Many companies shut down for a morning or afternoon to count inventory. Everyone counts and everyone calculates the value of the inventory. Technicians are paired. Each technician counts the truck of his partner while the driver of the truck records the information. Using this system you can get inventory counted in a day. It lessens the agony!
4. Be clear about identifying shop materials. You don't count shop materials. You don't add shop materials to inventory. When you get shop materials in the door, they are expensed immediately. Otherwise you will have inflated inventory at the end of the year.
From a service perspective, I don't expect you to count hand cleaner, rags, wire nuts, sheet metal screws, etc. From a construction perspective, count whole boxes and whole boxes should be expensed to jobs as they are opened.
Here's the difference between shop materials and inventory--shop materials are difficult to account for in their usage. Do you relieve inventory by one wire nut? It costs more to do the accounting than that wire nut is worth!
To make it easy, when you order shop materials they are expensed immediately into a shop materials category in cost of goods sold. Watch the total shop materials expense. Make sure that the total revenues you receive from the shop materials charges on your service tickets at least equals the expense. If not, raise your shop materials charge on your service tickets.
5. Track your inventory by looking in two areas of your financial statements. Looking at these ratios assumes that you have counted inventory and are adding and relieving inventory each month. The first place to look is the ratio between current ratio and acid test. If your current ratio is 2, your acid test should be one or better. In other words, the acid test should be more than half of the current ratio. If it isn't then you probably have too much of your cash tied up in inventory. This ratio is no good if the inventory value on your balance sheet doesn't change each month...or ever.
The second area to look is your inventory days. If your inventory days are excessive (over 60 days), then you probably have too much cash tied up in inventory.
If your ratios are in line you want to keep them in line. Make sure that you aren't counting obsolete inventory. This consists of parts, equipment, etc. that has been sitting in your warehouse for two to three years or more and you probably will never use them. If you want to keep obsolete inventory, fine (there are a few pack rats among us). Put whatever you can't bear to part with in a special place in your warehouse just in case that customer calls two years from now and needs that special motor. Otherwise, have a garage sale and get rid of it or donate it to a technical school.
6. Create and use material sheets. One sheet is used for each job. All materials and equipment needed for that job are listed (including the box of screws). When a job is sold, the sales person creates this sheet. It is given to the warehouse and someone pulls the equipment and materials needed for the job. It is placed in a specific location in your warehouse. The day that the job is scheduled to be performed, the equipment and materials are loaded onto the truck and the crew leader signs off that he has received all the materials. At the end of the job, any unused parts are brought back and signed in.
Remember, inventory is a bet. I hope that you make prudent bets!
Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and become more profitable. She is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. Ruth has written two books: The Ugly Truth About Small Business and The Ugly Truth About Managing People. Contact Ruth at firstname.lastname@example.org or 770.729.0258.