If your business deals with inventory and you are going to try to optimize your inventory investment, you will need to be able to identify your good from your bad inventory, and you will certainly want to know about your really ugly inventory. But in order to do that, you need to know some other factors about your own business operations first.

Your NIREP -- Non-Inventory Related Expenses as a Percent (of Revenues)

To calculate your NIREP, you need to gather up (say from your last fiscal year) all of the expenses your organization incurred and separate them into two groups:

  • Inventory-related Expenses: That is, those expenses that are related to purchasing, receiving and warehousing inventory. Include all the expenses related to owning or leasing your warehouse space, the expenses related to lease-hold or ownership improvements in the warehouse, the expenses related to leasing or owning warehouse equipment (e.g., racking, lift trucks, conveyors, dock equipment), the expenses related to wages paid to warehouse personnel (prorated, if necessary, when warehouse personnel may serve other purposes -- like manufacturing), and the expenses related to technologies supporting warehouse activities. (A good way to think about this is to ask yourself this question: "If I did not have to carry any inventory -- if I could drop-ship all my products from another vendor or manufacturer -- what expenses could I eliminate entirely?" The resulting list of expenses are your "Inventory-related Expenses".)
  • Non-Inventory Related Expenses: Once you've come up with the list of Inventory-related Expenses, the expenses (not cost of goods sold) you have left on your profit-and-loss statement are "Non-Inventory Related Expenses".
NOTE: It would be possible to create a custom FRx report that would
separate your Inventory-Related Expenses (based on prorata calculations, too)
and then calculate your Non-Inventory Related Expenses for you.

Now, to calculate your NIREP, take that Non-Inventory Related Expense value we calculated above and divide that by sales revenues over the same period. For example, if your Non-Inventory Related Expenses are $3.77 million for last year and your Revenues for last year were $26 million, then your NIREP is $3.77 million divided by $26 million or 14.5%.

Your Adjusted Gross Margin

Many organizations believe that they make the same amount of "margin" on a product regardless of the amount of inventory they are required to keep on hand in support of the sales. However, those that believe this are fooling themselves. Consider the following example:

Product A:

  • Annual Sales = $12,500
  • Annual Cost of Goods Sold (COGS) = $9,500
  • Gross Margin: $12,500 - $9,500 = $3,000/$12,500 (Sales) = 24%

Product B:

  • Annual Sales = $12,500
  • Annual COGS = $10,000
  • Gross Margin: $12,500 - $10,000 = $2,500/$12,500 (Sales) = 20%

Wow! We make a 4% greater margin on Product A than Product B, right?

When we calculate Adjusted Gross Margin, we take into account the expenses incurred for carrying inventory (by product or by product line). The formula is:

(Annual Sales Dollars - Annual COGS - (Average Inventory Value * Carrying Cost %)) / Annual Sales Dollars

The difference between the traditional Gross Margin formula and the Adjusted Gross Margin formula is in red above.

Let's say that for our product examples above, we are driven to carry the following inventories:

Product A:

  • Average Inventory = $5,000
  • Annual Carrying Cost = 25%

Product B:

  • Average Inventory = $2,500
  • Annual Carrying Cost = 25%

Now, if you calculate the Adjusted Gross Margin for our Products A and B above, you should come up with the following values:

  • Product A's Adjusted Gross Margin = 14%
  • Product B's Adjusted Gross Margin = 15%

Now we can separate "The Good" from "The Bad" and "The Ugly"

Once you have calculated both your NIREP and your Adjusted Gross Margins by product or product line, you are in a position to separate your inventory into "The Good", "The Bad" and "The Ugly". Simply establish some simple rules such as the following:

  • "The Good" have Adjusted Gross Margins at least N% greater than your NIREP.
  • "The Bad" have Adjusted Gross Margins less than N% greater than your NIREP but greater than your NIREP.
  • "The Ugly" have Adjusted Gross Margins less than or equal to your NIREP.

Since we calculated a NIREP (by example above) of 14.5%, in our example maybe our rules would look like this:

  • "The Good": Adjusted Gross Margins greater than 24.5% (NIREP + 10%)
  • "The Bad": Adjusted Gross Margins greater than 14.5% (NIREP) but less than 24.5% (NIREP + 10%)
  • "The Ugly": Adjusted Gross Margins less than 14.5% (NIREP)

Please note that there may be valid reasons for keeping some of "The Bad" or even "The Ugly" around in inventory, but the reasons should be carefully considered. For example, some of these less than desirable items may function as loss leaders to attract business for more profitable items. Other items may be necessary to "support" the sales of items in "The Good" category.

With these calculations in your hand, however, at least you are not making decisions with your eyes closed.

(c)2008 Richard D. Cushing