eyecare by the numbers

The Economics of Inventory

by Alan Cleinman

Most eyecare practitioners take a “cost-multiple” approach to the pricing of eyewear. This time-honored methodology is simple, for sure. But ECPs who use this approach generally rely upon their invoice cost or published wholesale price.

With margins eroding, the successful ECP must look for every opportunity to regain and retain profit margins. Understanding your true inventory carrying costs is a key to effective margin management.

FACTORING IN FREIGHT

Many practices include costs associated with the movement of product below the gross profit line in their income statements. The problem? Freight is not an overhead cost, but part of cost of goods.

This direct cost is exacerbated when products are ordered on a rush basis and a premium for shipping is paid, especially when this cost isn’t passed directly to the patient. It’s further increased when one considers the costs associated with shipping frames to the lab to have lenses cut and mounted.

The simplest way to calculate freight costs is to use an annualized approach to a per-unit factor. For example:

Using the above example, you would add 7.5 percent in order to determine the true the cost of every single frame you purchase for your practice.

INVESTMENT COSTS

Inventory is an investment. As with any investment, there should be an expected return. At the very least, the monies invested in inventory should be benchmarked against other investments so that your true costs are known.

Let’s assume that you have $40,000 invested in your inventory and that you turn it over three times a year. This means the average frame is “in house” for four months.

Regardless of whether you borrow the funds from a bank to purchase your inventory or get it from your own business, the fact remains that there’s a cost to this investment. Were you to borrow the $40,000 from your bank, you’d likely currently pay about seven percent for this type of working capital.

In the above example, the annual cost of maintaining your inventory investment is $2,800, and those monies must be added to cost of goods in order to recover the investment. You can do so in a variety of ways, but the easiest is to simply define a percentage factor.

Note that the turnover rate is arrived at by dividing your annual cost of goods by your average inventory value. Thus, in the example above, for every frame you purchase, you should add 2.3 percent to cover inventory carrying costs.

CALCULATING OBSOLESCENCE

Inventory has a useful life, just like a piece of equipment. If not sold, inventory becomes dated and obsolete. At the very least, the value of inventory declines over time.

While the textbooks have all kinds of methodologies, for businesses that have a rudimentary, at best, accounting system, measuring obsolescence is best done with an estimate.

Begin with addressing the age of inventory. This can be calculated over time by using a simple color-coding method. On the first day of any quarter, put a tiny green-colored dot on every frame in inventory.

During the coming quarter, put a red dot on every new frame that you add to inventory. For the following quarter, put a yellow one on all frames purchased, and so on.

Beginning with the first month of the next 12-month period, you’ll be able to easily understand which frames were purchased when. Plus, you can now count how many green-dot frames you have on your board and learn how many are more than a year old. Of course, if you use a perpetual computerized inventory system, you’ll be able to generate this aging from your computer.

By way of example, let’s assume you carry 800 frames. And at the beginning of the year, you know you have 100 frames that are a year old or more.

Assuming that you manage this inventory by marking the product down and selling it off (perhaps a 50 percent reduction if used for second pair or for sunwear, for example), you can calculate your obsolescence factor from this information.

In other words, add 6.3 percent to the cost of every frame you purchase to cover obsolescence.

SHRINKAGE COSTS

The retail industry reports that the average cost of shrinkage is 1.5 percent, and that 44 percent of shrinkage is from employee theft.

Every ECP has inventory shrinkage, but few know the cost. And, like other inventory costs, this expense should be recovered by including it in your pricing mechanics.

To measure shrinkage, start with a simple physical inventory count (which should be done monthly). Simply count the number of frames you currently have in inventory and any work in progress at your own lab or an outside one. This number represents your starting number. Now track the number of frames that you buy and sell, and you will arrive at your expected inventory.

The difference between actual inventory and expected inventory is the shrinkage factor. From this calculation, it’s easy to see that the practice in the above example has an overall shrinkage cost of 2.2 percent.

This process is most valuable when you actually price out your inventories and work with dollars versus units—especially because the value of the average frame stolen or lost likely may be higher than the average value of your inventory.

However, even a less precise unit count methodology will reveal a shrinkage problem. The sooner you know that, the sooner you can reduce or eliminate the problem.

Freight is not an overhead cost, but a part of cost of goods. The simplest way to calculate freight costs is to use an annualized approach to a per-unit factor.

CARRYING COSTS

Inventory carrying costs add substantially to your hard inventory cost and should be considered in whatever pricing mechanism you use. In the examples used here, those carrying costs total 23 percent:

With our original example of a practice with an average $100 frame cost, the ECP is under pricing by $23 per frame as a result of the unrecovered costs detailed above. These costs are currently being absorbed in other ways.

For example, they can be hidden in overhead expenses or reduced margins. But, unless you have an understanding of these costs and have controls in place to manage them, you’re fooling yourself if you think that the invoice cost of a product is your actual cost.

The practice in our example sells 2,400 units per year at an average wholesale cost of $100. The loss of inventory carrying costs represents more than $55,000 left “on the table.” That’s real money! EB

Alan Cleinman is the founder and CEO of Cleinman Performance Partners (cleinman.com), a business consultancy specializing in the development of high performance optometry practices. © 2012 Cleinman Performance Partners, Inc.