Are You Crazy? The Stock-Out Will Probably Kill You!

"Jimmy, what's the markup on that Belgian Ale anyway?" Colin Davies, an affable Scot, mischievously inquired of the bartender. Jimmy fake squirmed at the question as he placed a second martini in front of Davies' drinking partner, a weary-looking businessman who had been a frequent visitor to the brew pub this week. Bill Pike, CFO of a locally based supermarket retailer, smiled at the banter between the two men, grateful for a brief respite from his day job woes.

"Not enough obviously" replied Jimmy with a chuckle, tucking Bill's bar tab into a glass in front of him . "I'm still working here aren't I?"

"Anyway it's not like the price puts the punters off" Jimmy continued. "I can't keep it in stock. That why you're drinking Bud - I never run out of that." Jimmy winked conspiratorially at Bill, moving away to tend to another customer.

"You see, it's like I was saying" Colin said, turning to face Bill. "Jimmy's situation's no different to what I see with many of my customers. Even with the economy falling down around their ears I have clients who repeatedly run out of the very products that their customers most want. And on top of that, many of those same products are their most profitable as well. There are literally thousands of companies in the United States today that could go out of business because their supply chains are unable to deliver products that their customers are ready and willing to buy."

"Reminds me of our Operations meeting this past Monday" remarked Bill. "Same store sales down 12% last quarter and we still had stockouts for six of our top ten products."

"Top ten products in what?" asked Colin.

"Well, top ten in sales of course" replied Bill.

"Ah, of course" Colin said in a mock-knowing tone. "Tell me - did you have any stockouts for your top ten most popular and most profitable products as well?"

"Well I don't know. I'm not even sure we know what those are" admitted Bill.

Colin inched his barstool closer to the CFO, looked around and leaned in as if about to impart critical information to a fellow undercover operative. Bill smiled at the Scot's melodramatics but bought in to the role-play, cocking his head slightly toward Colin to receive the incoming intelligence.

"What were your net sales and gross profit last quarter?" Colin asked, almost in a whisper.

"Four hundred million sales" Bill replied. "Gross profit a hundred million, give or take a buck."

"Okay, so 25% gross margin. And you've already told me you made a ten million operating loss so your operating expenses were about $110 million. I can give you some ideas for attacking the operating expenses later, but let's focus on the gross margin first. What if I said you could increase your gross margin from 25% to 30% in six months and generate an additional twenty million dollars in operating income on the same quarterly sales? And what if all you had to do to achieve that was avoid Jimmy's mistake?"

"You mean buy more Belgian Ale?"

"Exactly!" Colin laughed. "In your case it would mean ensuring that your most popular and most profitable products are always on your store shelves for customers to purchase. I guarantee if you achieve this you will be in the top quartile of your industry for gross margin. You'll regain profitability and stay profitable even if your sales were to drop a bit further, too. And one more thing - if you address this by transforming your supply chain today you'll remain several steps ahead of your competitors long after this recession has ended. Your above average profitability for your industry will enable you to make heavier investments than your competitors in all aspects of your business, thereby allowing you to maintain a permanent competitive advantage."

"It sounds so obvious - getting customers the products they need. Why aren't more companies doing this today?" asked Bill.

"I'd say one reason is because when the economy was good a company could hide a poorly performing supply chain with sheer volume throughput of products. If you're selling a billion dollars of product at 20% gross margin you can swan along quite happily feeding an operating expense base of nearly $200 million, all that time leaving millions of customers wanting stuff you've run out of and with millions of dollars of stuff they don't want sitting on store shelves or in the warehouse. The problem comes when the downturn hits, your sales nosedive and your 20% gross margin is now trying to satisfy pretty much the same operating expense base. Hello red ink."

"Okay, so I'm biting. How do I achieve 30% gross margin?". The CFO took a furtive, hurried sip from his cocktail, fidgeting a little on his barstool as the other man continued.

"Well, it's not easy but it is straightforward" the Scot started. "First you ask your merchandise operations group to provide you with a report showing stock turnover and profit contribution for each merchandise stock keeping unit - or "SKU" for short - over the last twelve months. What are those? Well, think of stock turnover for a SKU as the number of times that SKU gets replenished in inventory during a year as a result of customer sales. Quite simply, think of a SKU with a high stock turnover as being in frequent demand. And that's completely irrespective of how much this SKU sells for or how profitable it is. It's just a popular SKU, the lucky chappy.

As for the profit contribution of a SKU, this is equal to the dollar profit that an individual SKU makes to a company's total gross profit. To a first approximation it is simply the difference between the wholesale price your company pays the manufacturer and the retail price paid by the customer in a store. A detailed calculation would take into account several other factors such as volume discounts and process costs but for our purposes the simple definition is perfectly adequate."

Bill paused here to sip on his beer, the CFO regarding him somewhat impatiently. Grimacing obvious disapproval at the blandness of his beverage, the Scot continued.

"Now at this point you will need the services of a management consultant" Colin stated in a serious tone.

"A consultant? Why?" asked Bill, suddenly confused.

"To draw a two by two graph" Colin replied. Poker-faced for a couple of seconds, a teasing grin then broke across his features. "Just joking - you will need to draw a two by two but internal resources should suffice." Bill rolled his eyes at the Scot's witticism.

"Funny. Anyway I was Big 6 consultant myself a few years back. I'm a two by two Subject Matter Expert" Bill jested back. "And like any SME I always bring the right toolkit. Here - have a napkin!" The CFO grabbed a paper napkin from a pile on the bar and proffered it towards his drinking partner who received it gratefully, laughing.

"Funny yourself" said Colin, pulling a pen from his jacket pocket and starting to draw on the napkin. "Okay, so here you go.... this two by two has stock turnover by SKU on the y-axis and profit contribution by SKU on the x-axis. Each axis is simply low/high. Using the report from your merchandise group you plot all the SKUs on this graph - it's the top right quadrant we're most interested in. The SKUs in this quadrant are the most frequently demanded and they are also contributing the greatest amount of dollar profits to gross margin."

Colin then peppered the graph's top right quadrant with about half a dozen rapidly penned crosses, each of them representing data points from the merchandise group's report. He then fenced all the crosses with a heavily drawn circle.

"Read my lips" Colin stated, point of his pen in the center of the circle - "MAXIMIZE LINE ITEM FILL RATE FOR THESE SKU's IN YOUR STORES."

"Line item fill rate?" questioned Bill.

"The line item fill rate for a SKU in your store is the percentage of times over some period - usually a year but it can be any time period, say a quarter - that a customer can walk in and purchase that SKU from your store shelf." Colin replied. "For all the SKU's in the top right quadrant of our two by two here you need the line item fill rate to be a close to 100% as possible. If you do this you will be ensuring that those products that contribute the most dollar profits to your gross margin - and operating income as well - are always available to, well, do just that. By actually being there for a customer to buy."

"This is all sounds so simple" said Bill.

"Well, there are a few devils in the detail like deciding exactly how many SKUs should be in the top right quadrant" replied Colin. "And after that, setting a realistic percentage for the line item fill rate target for each SKU that balances the cost of a stockout against the increased inventory holding costs. Plus there are strategies for the other three quadrants that we should also talk about some time that will lower your overall cost of doing business even further. But conceptually, yes it's simple. It will certainly need some dedicated effort from some of your best and brightest folks in your merchandise operations and inventory management areas but the return will be worth it."

"I agree, and quite frankly I've got nothing to lose. If I can't pull things around this quarter I'm probably history."

"Look at it like this, Bill. This recession may be a positive thing for your company. Today, like most of your retail competitors, you've got an underachieving 25% gross margin supply chain that's served you adequately in good times. Now the recession has exposed your supply chain's limitations and you need a 30% gross margin supply chain to get you out of trouble. Move smartly to put the new supply chain in place and you may never be in trouble again. In fact, if as I suspect you end up being one of the first companies to move on this you will end up being one of your industry's highest performers both financially and operationally on an ongoing basis."

"Well I'm intrigued enough to put this to my COO" said Bill, settling his tab and rising to leave. Perhaps I could even loop you in for a conference call if Sarah wants to dive into any of the detail?"

"Sure, I'd be happy to. You've got my card." Colin replied. He stayed seated, obviously settling in for the long haul. The two men shook hands. Bill turned to leave but stopped suddenly and looked back at the still seated Scot."Colin...you mentioned giving me some ideas about attacking operating expenses as well? I'd be interested in hearing about that as well sometime."

"No problem. Just over a hundred million dollars of operating expenses last quarter, right? That's an even easier area to find rapid savings, even though an English buddy of mine treats it like rocket science. If you're around next week I'll tell you how to get another ten million cost savings out of indirect procurement. Oh, and without any seven-step strategic sourcing methodologies or transition management programs either."

"Excellent" said Bill with a slightly puzzled expression. "Without those. Look forward to it!" Shaking Colin's hand again he turned and exited the bar, decidedly more spring in his step than when he had entered two hours before.

"Hey, Jimmy!" Colin called, dismissively pushing his unfinished Bud away from him. The bartender broke away from conversation with another customer, turning towards the Scot. "When you get a moment, let's discuss supply chain strategy for your Belgian Ale."