Inventory Variances: Does the Net Tell the Truth?

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Across our six locations, our physical inventory variance was zero and we’re proud of it.

This tells you exactly nothing.

A Tale of Jack and the Pride of It All…

Jack is the owner of an industrial products supplier with five sales/inventory warehouses including one large distribution center. Jack called me and asked if I could spend a few days with him and review the overall business. I could tell he had something on his mind.

I arrived, we talked, and I suggested a tour of the company. Met a lot of nice and hardworking people—and I mean working so hard that I could feel the stress. It doesn’t take long to see that something’s not quite right. There was a chaotic feeling about the organization; a sense of nervousness.

Jack turned to me with that deer in the headlights look and said, “We lost near $300,000 last year.”

I said, “Jack, you have my attention.”  I asked for more details and that he keep the conversation at a macro level.

He said he couldn’t give me much other than that at the end of the year, the company’s sales looked good and inventory looked better than ever. I said, “Let’s focus on the inventory. What portion of that $300,000 loss was related to inventory?”

He said, “The company was up 10% in sales volume, so we guess it was from the operations side of the business.”

I said, “So your sales were up and your operating expense increased by no more than 2%, right?”

He said, “No—actually, operating expense increased much more than that.” Jack’s team looks at Sales, Operating Expense, Inventory.

I’ve been at this long enough to know what’s going on. I asked, “So what was your physical inventory variance?”

Grinning ear-to-ear and proud as a peacock, he said, “We don’t even have to look at that, as it was almost zero. That’s why we’re sure it came from the operating expense side.”

“Jack, what were your pickup and shrink percentages?”

He then said that it doesn’t matter.  (Well, my family will tell you that when I’m curious, I just don’t stop.)

I said, “It does matter, Jack; it matters a great deal. Case in point: If you had an inventory shrink (loss) of $200,000 and a pickup (increase) of $200,000, that would be a net variance of…?”

Jack said zero. I said sure enough and that would look pretty good—so good that it would make a business owner happier than a fish in water. Jack smiled.

I posed this question: “If the $200,000 shrink related to 1,000 part numbers, and the $200,000 pickup related to 10 part numbers, would that be cause for alarm?”

He said, “Nope. It’s still a zero variance.”

I posed this thought: “I’m afraid I can’t agree on that one, Jack. If I had errors for twelve months on 1,000 of my part numbers, I would suspect that a whole lot of bad is going on and that for sure the operating costs were very high. Errors on 1,000 items clearly trumps errors on 10 items—that is, if you place your focus on what inventory is really about—quantity. In fact, the human resource and financial outlay to manage that type of discrepancy would scare the dickens out of a guy.

“Your challenge is that you are focused on the dollars and not the quantity. The net variance of quantity is an alarming number where the variance of dollars is not. You’re hearing what you want to hear.”

I then said: “When dealing with inventory, focus on the pieces—not the dollars. You do not sell dollars. You do not order dollars. You do not warehouse dollars. You manage quantities of consumable assets.”

“If you focus on the quantities, the dollars will follow along.”

When is the last time one of your sales staff walked into the warehouse and asked, “Hey Charlie, did my $10,000 of nail guns come in yet?” Instead, it would be much more likely that the salesperson asked if her order of 10 Ramset nail guns has arrived. When is the last time your customer called and said, “I’d like to order $10 of utility knives”? My guess is that they said, “I’d like to order 10 utility knives—what’s your price?” or “I’d like to order 10 utility knives at $10 apiece.”

Jack said, “Dan, I get it and agree. We just never looked at things that way. Heck, even everyone in my peer group places focus on the dollars.”

Then Jack said, “Do you have some time to talk about my operating expense?”

The moral of the story is that you need to:

Look past what you want to see for what you need to see… which is the truth and not the average.

Remove your blinders of desired bliss.

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