The following is a transcript of Episode 37 of Return on Podcast, the show where we help e-commerce sellers improve their ROI in business and in life. For more episodes, subscribe to our YouTube channel or listen on Podbean, Apple Podcasts, Spotify, and Amazon/Audible.
All right. Hi there, Tyler Jefcoat here from Seller Accountant and from the Return On Podcast podcast. Thank you for joining us for today’s show. We’re in the middle of this series, getting close to the end here, called From Pain to Profit in 2023.
If you’ve been with us through all of the videos or podcast sessions so far, I wanna say thank you. Your time is valuable. I hope these sessions have been helpful. Leave me some comments and help me steer the future content of this show. Wanna dive into today’s topic related to understanding inventory turns and improving our inventory performance.
But before I do that, just a super quick announcement. We are going to be kind of landing the plane for season one of Return on Podcast as this particular series closes. So we’re gonna have another session after the one I’m recording right now, and then we’re gonna take a little bit of a break for kind of the busiest season of the accounting world here.
And I’d love to get some input from you as we launch season two very shortly. So we’ll go back to interviewing some of the great entrepreneurs in the space. I’m gonna do some additional mini-series like this, maybe in particular about cash flow. I’d really love to get your input, and I’d love to ask you a favor, if you don’t mind subscribing to the podcast or if you’re watching this on YouTube, go ahead and subscribe to the channel so that we don’t lose momentum and we can grab you back here in a couple months when we go live again.
But with that, let me dive into today’s episode. Session one was related to vision, session two, related to getting to your books in order. Sessions, I think three, four, and five were related to measuring profitability differently, better, more granularly so that we can understand and run our businesses by the numbers.
And the reason those sessions and the one we’re gonna talk about today are so important is that 2022 was a tough year. I don’t know, I don’t know how it was for you, but some of our – by the way, some of our customers here at Seller Accountant did great. It was an amazing year, best year ever, but that’s the exception.
I would say probably two thirds of our clients, and of my CFO clients, have more cash flow stress now than they had a year ago, had lower profit margins in 2022, are dealing with more headwinds related to demand and TACOS and these other key metrics. And so it’s never been more important.
It’s harder to sell a business right now, right? It’s never been more important to run our businesses by the numbers. And so that’s what this series is all about, From Pain to Profit in 2023. Today we’re gonna have an awkward conversation, maybe, if this is you, about your inventory performance, right?
We’ve been talking about, even last week we were talking about Return on Inventory Investment. That was a profit metric. That was your profit divided by the COGS that were needed to generate the profit. So PAG or post advertising gross profit divided by Cost of Goods Sold is gonna give you what’s called Return on Inventory Investment. ROII is like your batting average. How happy am I every time I turn my inventory? This week we need to talk about how do you define inventory turns, which is the same thing as saying inventory velocity. How many times per year do I sell through my inventory? The other metric that you hear a lot is days of inventory. Days of inventory is the algebraic inverse of annual inventory turns. I wanna talk quickly about how to measure it, and then I’m gonna tell you how to improve it if you’re not happy with yours.
First of all, lemme say what’s good and bad. More inventory turns is better, right? That may go without saying, but in case this is a new concept to you, some sellers get to rebuy their inventory every two months. That would be six times per year. If you get six inventory turns per year, that would be really good. If you buy a container and you sit on it for a full year where you’re only turning it once per year, that would be really poor. And then there’s the average is probably somewhere in between, you know where the average seller gets two to three turns per year.
But just know this, the higher you can push that, the more at bats you get per year, the better. And here’s why it’s better. If you’re trying to grow your business and you can increase your inventory velocity, in other words, get more “at bats” per year, you get to reuse that same dollar over and over again instead of having to borrow more money.
So if you’re one of those guys that came through 2022 where you made a profit on paper, but you still are outta cash, you’re having to borrow more money to keep this thing afloat, it’s probably because your inventory velocity or your inventory turns are too low.
Here’s how you calculate it. We already pulled our P&L up from our last few sessions. In the example that we had, by the way, Cost of Goods Sold for the year was $120,000 for the year. That’s COGS, that’s just the product COGS, what we paid to actually land the unit, get them into the warehouse, pay the factory. You may load inbound freight, that kind of thing into it. And now we wanna look on our balance sheet and see how much we have tied up in inventory.
For this particular seller that I’m using as the example, they have $60,000 tied up in inventory. And so all you have to do is take that annual Cost of Goods Sold of $120,000, divided by the amount of inventory you have. COGS divided by inventory equals turns. In other words, we burned through $120k in inventory in the form of Cost of Goods Sold, and we have $60k on the shelf. And so that means we burned through it twice. That’s two turns per year. If we were gonna convert that as we talked about a minute ago into days of inventory, we would just take 365 days divided by our turns, right? So if we turn the inventory twice per year, that’s about 180 days of inventory.
If you were to do this math, and here’s the problem is that we need to get a little bit more granular ’cause what I just did as a math problem, you can do on your P&L, balance sheet. Let’s just pull Costs of Goods Sold for 12 months. That’s the numerator. Let’s get our inventory balance. That’s the denominator. Let’s use a calculator to do the math, and we have returns.
But we actually need to do it on a SKU by SKU level also. Because almost every seller that we help here at Seller Accountant, one of the recurring conversations that I’m having is, wow, we have three years of inventory for the blue one. The blue one has three years. That’s amazing. That’s too much inventory for the blue one. But for the red one, we’re selling through it really quickly. We sell it every two months. And so understanding if you have SKUs that are killing you is a really important part of this as well.
So let’s say that you calculate your inventory turns per year, and you’re not happy, you wanna find ways to improve it. I wanna give you five ideas that I have here that you could potentially employ to improve that inventory performance. The first one and the most important one is payment terms. So if I can go to my vendors, my suppliers, my partners, and develop actual partnerships with them and get to where I can pay them later, pay them after the product arrives or pay them with a smaller deposit up front.
The highest leverage tactic that any seller has to improve cash flow and therefore increase the inventory velocity, take money outta the supply chain, is to develop tight, great relationships with your suppliers. As the market continues to open up, post Covid here, flight to China, shake hands, kiss babies. Do whatever you need to do. Send emails, send Loom videos. Do whatever you can do to develop relationships with your key suppliers so that when cash gets tighter, when you’re trying to extend your dollar further and pull money outta your supply chain, which is the same thing – when I say improve inventory turns, you can do that by just pulling money outta your supply chain. So getting better vendor payment terms is a crucial tactic that everyone should be trying.
Liquidating bad products is a second tactic. Have I looked and realized, oh, dang it, I’ve got three years of inventory for the green one. This is not a viable product maybe. I might just need to sell through it and get out and not keep my cash tied up in that one. Simplifying variants is connected to that. Sometimes we launch the red one and it does really well, so then we launch the blue one, the green one, the purple one, the pink one, right. And what we realize is that almost all of our sales are through the red one, but every once in a while someone picks the pink one. What we may want to choose to do is just take one of the choices away from our customers. That doesn’t feel good. We don’t like having to remove choices, but if we simplify the variance, sometimes that allows us to pull money out of the supply chain and increase our inventory turns.
Obviously, we can try to negotiate lower MOQs. That’s really frustrating when you have to buy a thousand of a product that you only sell five a day of, right? That can be really difficult. But again, developing those relationships with our suppliers where they will give us relief, not just in payment terms, but also in negotiating lower MOQs, minimum order quantities, is really good.
And then the final thing I’ll say is just imagine you’re the captain of a huge ship and you’re trying to get into a harbor. The better your visibility is, the better your navigation equipment, the closer you can afford to get to the shore. In other words, when you think about this from inventory, if I have really good inventory management, if I have a VA team or a good piece of inventory management software, if I have really good processes for inventory, then in general, I can afford to have less inventory in my system. I can afford to wait later to make purchases.
But if I have crappy navigation, if I have crappy visibility, I have no choice but to way overorder my products so that I don’t stock out and have the opportunity cost of stocking out. And so just investing in better inventory processes, better inventory software, better inventory people, if you need to hire someone, can be another way to really radically improve your inventory turns.
But just wanna say this. As a KPI, you must be measuring inventory velocity. If you want to frame it as days of inventory or if you wanna frame it as annual inventory terms, same metric, just in an inverse fashion. You’ve gotta measure it, and you’ve gotta find ways to improve that metric over time. And here’s why: because every time you improve inventory terms, you’re getting more of your dollars back quickly to reinvest so that you don’t have to borrow as much.
In our, I think, final session of this particular series, next time, I’m gonna put these two concepts together in what I call the Holy Grail of KPIs. We’re gonna talk about how to combine inventory velocity with the profitability per turn to really grade each and every one of your products. Hope to see you next time for that session. Have a fantastic day. Take care.