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Inventory is Evil

CPisHere

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Uh, yeah. When I say growth, I mean growth in net income -- and that's EXACTLY what I pay my bills with.
The context was that there was no Net Income because it was reinvested for growth.
 
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blackbrich

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Just because it's Evil doesn't mean you shouldn't invest in it. Obviously you should if your business requires it.

But let's take an information marketing business from a few years ago as an example. They have $100,000 in DVD's for inventory, which they believe is a competitive advantage and necessary for getting sales. Suddenly the internet allows them to make all that revenue without holding inventory. Their business is infinitely better off as a result. Oh, and that $100k of inventory is now worthless - years of "reinvested profits" that weren't taken from the business become nothing but a write-off.

The difference is whether it restricts your ability to take profits from the business and if you can re-adjust the investment.

In that particular example though, it seems like the information was what was valuable not the DVD.
Whereas when selling a physical product the actual product provides the value.
 

CPisHere

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You do realize that the period of no income is only as long as it takes to turnover the inventory? It's not as if I growing my business means I'll never make another penny. If you turnover inventory quickly, the period of no income could be (should be) relatively meaningless.

I'm starting to feel like you're arguing just to argue. Either that, or I'm completely missing your point.
Maybe I'm not being clear...

If you have an inventory-based business with 50% margins, and you double your growth - to achieve that you either massively increased debt or didn't take out profits (depending on other costs, maybe both).

True enough, as soon as you stop growing, that profit becomes "accessible". But that's assuming nothing happens to degrade the value of that inventory. If your distributor knocks it off, you've now reinvested all your profits into a worthless asset. And who wants to stop growing?

I am NOT saying you shouldn't invest in inventory, just that if you are pursuing an inventory-based business you have to recognize the issues.
 

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This could be the thread that never ends.

For the record, everything that @JScott has said in this thread is correct.

Some of the other points that have been raised in the thread are marginally correct also, but superseded by the fundamental points that @JScott has made.

With that, I will exit stage left and let the Millennials continue to argue against the experienced.

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CPisHere

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Okay, I think I see the disconnect here...

Investing in inventory doesn't change your income; it simply changes your cash flow histogram. If you're running a business where you need the monthly profits to survive, then I agree that you shouldn't pursue a business that relies on inventory. If you can't live without the profits from your business for whatever your inventory turnover period is, your not properly capitalized to run an inventory-based business, as growth will cause you to starve.

This goes back to my earlier point about inventory being a barrier-to-entry. Because it requires an investment and (if you're successful) the ability to reinvest income back into the business, there are a lot of people who aren't in a position to start these types of businesses. That's one of the reason I love these types of businesses -- unlike drop-shipping businesses or IM/affiliate type businesses, I don't have to worry about every wannabe entrepreneur competing with me.

So, again, if you're in a position where you can't afford not to take money out of your business for a couple inventory cycles, I'd recommend not getting into an inventory-based business. This happens not to be an issue for me -- I don't mind not being able to take profits from the business, as my goal is an eventual exit strategy, not living off the business income in the short-term.
Correct. I agree completely. The problem is most people going into inventory-based businesses do not realize this, which unfortunately included me. Luckily I've been able to stick it out but it's been a painful learning curve.

Btw, in your example above, the only way I find myself not earning any profits is if I'm doubling sales during every inventory-turnover period -- if I can realistically do that, I'd be a billion dollar business within 18 months. If that's my biggest risk, I'll take it... :)
What do you consider a very healthy growth rate for an inventory-based business?
 

ZCP

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My attempted add to the thread was that lowering the required WCR was one good place to optimize that is sometimes overlooked. Smart inventory controls that maximize turnover. If you are looking for money in the business, sometimes that is a good first place to go. Attack cost. Attack WCR. Do that internally while pushing sales externally.
 

Walter Hay

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Maybe I'm not being clear...

If you have an inventory-based business with 50% margins, and you double your growth - to achieve that you either massively increased debt or didn't take out profits (depending on other costs, maybe both).

True enough, as soon as you stop growing, that profit becomes "accessible". But that's assuming nothing happens to degrade the value of that inventory. If your distributor knocks it off, you've now reinvested all your profits into a worthless asset. And who wants to stop growing?

I am NOT saying you shouldn't invest in inventory, just that if you are pursuing an inventory-based business you have to recognize the issues.
If a business is operating on a small margin like 50%, growth can be disastrous. I have seen many businesses fail because they have grown faster than they can fund.

This is why I have always looked for high margin products to sell. The result has been that I have been able to fund growing inventory out of profits, not from borrowing, while leaving me a very comfortable and highly satisfactory income as well.

My former importing business grew at a phenomenal rate, and I could afford to restock with ever increasing order sizes, and also pay family members to work for me. As sales continued to grow I still had no problem funding inventory from profits, but I had run out of family members to employ, and did not want to employ strangers, so I began selling franchises. Eventually those franchisees in four countries, following my methods, and reinvesting some of the profits, also built large businesses.

Not one of them had to borrow to buy inventory. All of them were earning at least 4 times the average wage (except one who only made 3x).

Profits begin with buying. Some people are happy with volume. I'm happy with profit and that profit had to give me a big ROI in relation to investment of my time.

Walter Hay
 
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theag

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If a business is operating on a small margin like 50%, growth can be disastrous. I have seen many businesses fail because they have grown faster than they can fund.

This is why I have always looked for high margin products to sell. The result has been that I have been able to fund growing inventory out of profits, not from borrowing, while leaving me a very comfortable and highly satisfactory income as well.

My former importing business grew at a phenomenal rate, and I could afford to restock with ever increasing order sizes, and also pay family members to work for me. As sales continued to grow I still had no problem funding inventory from profits, but I had run out of family members to employ, and did not want to employ strangers, so I began selling franchises. Eventually those franchisees in four countries, following my methods, and reinvesting some of the profits, also built large businesses.

Not one of them had to borrow to buy inventory. All of them were earning at least 4 times the average wage (except one who only made 3x).

Profits begin with buying. Some people are happy with volume. I'm happy with profit and that profit had to give me a big ROI in relation to investment of my time.

Walter Hay
I'm curious because I never considered a 50% margin to be low. What are high margins in your opinion? 80-90%? Are we talking gross margin, net margin? I honestly can't even imagine such high margins, since right now my advertising cost alone is usually 30-40% of revenue and COGS another 25%. Seems like I have to change my mindset regarding this.
 

CPisHere

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If a business is operating on a small margin like 50%, growth can be disastrous. I have seen many businesses fail because they have grown faster than they can fund.
Many businesses operate on 25-30% margins.

How do you manage growth with moderate margins?

Profits begin with buying. Some people are happy with volume. I'm happy with profit and that profit had to give me a big ROI in relation to investment of my time.
Is this primarily based on choosing the right type of business? Or can it be substantially affected within a business?
 

CPisHere

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Ran across this story from Warren Buffett & it seemed appropriate here.

"We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million.
This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth—and somewhat immodest financial growth—of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire."

I don't understand how Working Capital went from 1.6x EBITDA to 0.5x - this summary seems to make it seem like it was just a great business, but clearly once Warren bought it something changed.

Read the rest here-
http://fourhourworkweek.com/2012/06...ett-a-few-lessons-for-investors-and-managers/
 
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Walter Hay

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I'm curious because I never considered a 50% margin to be low. What are high margins in your opinion? 80-90%? Are we talking gross margin, net margin? I honestly can't even imagine such high margins, since right now my advertising cost alone is usually 30-40% of revenue and COGS another 25%. Seems like I have to change my mindset regarding this.
I am talking about gross margin after taking into account all landed costs. I have always operated my businesses on low overheads because they can eat up profits.

Yes I agree that 80-90% would be a high margin. I think it is more readily achievable in B2B sales than online consumer sales, but it is certainly possible even there.

My two previous business were both B2B. With the first I was making so much money as a one person operation that after becoming well established I didn't look for new business. It came to me by referrals, but I would only accept new customers if I could maintain that high margin.

The second, importing, was also highly profitable and having a great USP and very effective marketing, sales grew at a phenomenal rate. It was easy to franchise because I could confidently promise franchisees a high ROI. One wrote: "It was nice to make that occasional $50,000 for half a days work". He was talking about a series of repeat orders for which his landed cost was only $5,700. My best profit percentage didn't equal his. I sold 1,000 items to a customer for $21,000. My landed cost was $3,000.

My best marketing tool in both businesses was direct mail. In the first one, my letter offered for a nominal charge a sample large enough for a small production run. In the case of the importing business, many of the products were very small, so partly to demonstrate quality, but mainly to ensure that the mailing received attention, the letter had a sample attached. Conversion rates were above direct mail industry average.

I explain this because effective advertising can cut your costs.

If advertising costs are high and are badly affecting net profit, it could be necessary to think laterally and consider other marketing methods. By way of example: If you sell generic type products, what outlets are there beside online?

It might be necessary to review your purchasing. Having bought a large variety of products from China, Taiwan, Malaysia, Vietnam and other countries I know that some manufacturers have become westernised in their outlook, and as a result they look for bigger profit margins. Try to find the more traditional Asian business people who are happy to work on very low margins. This difference in outlook is often the explanation for the huge discrepancies in quoted prices.

Walter
 

Walter Hay

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Many businesses operate on 25-30% margins.

How do you manage growth with moderate margins?

Is this primarily based on choosing the right type of business? Or can it be substantially affected within a business?
Managing growth on moderate margins becomes a juggling act. Some people are good at it - I'm not. I know that managing cash flow is vital.

The best suggestion I can offer is to factor in a discount for COD, or payment within 7 days. I had no option but to do that in my first business because I had virtually no capital.

Choosing the right type of business can make all the difference. In my first business I had unique products, a number of which were my own invention. Once a customer started using them, they were hooked. To illustrate: I once passed through a picket line, wearing my suit and driving my expensive car, with the trunk loaded with product without which the entire production line in that large factory would have shut down. When a customer knows they need you that much, price is no object.

The customer loyalty throughout that industry was so great that when a potential competitor offered an alternative product at half my price, customers called to tell me about it and asked if I would like them to obtain a sample so that I could evaluate it. I lost one customer nationwide, and they came back to me cap in hand a few months later.

In my second business (importing) I chose a market segment (niche) that was very poorly served. I started off selling at double the competitors' prices, and had no trouble defeating their ineffective marketing. Several competitors went out of business, unable to get the sales even at their much lower prices.

Walter
 
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CPisHere

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Something did change...management. That's what Buffett is known for, implementing good management.

I don't know anything about this business specifically, but my guess is that he was able to increase margins, decrease overhead and just generally make the business more efficient by implementing a good management team and good management practices.

There are generally no secret formulas with him...just putting smart people in charge..
It did mention raising prices (which would mean higher margins).

The article also mentions Buffett's two retail investments & says one of the keys to their success is much lower prices & margins than the rest of the industry, which I found very surprising because it they are inventory-heavy businesses (furniture & jewelry) so it seems like that would make taking cash out difficult.
 

jazb

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Obviously its something to consider if you want to expand rapidly (cash tied up in inventory)

you could: sell a digital product/ pre-sales/ organize your biz so you get paid before you spend the money on product (multiple ways to do it).


If you really think it's evil then perhaps consider a service based business. but then you have the burden of delivering a stellar service every time as opposed to merely shipping out a product.

upside is that you can start a service based biz really cheap and expand quickly. your main expense is sales/marketing, not much else.
 

Walter Hay

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It did mention raising prices (which would mean higher margins).

The article also mentions Buffett's two retail investments & says one of the keys to their success is much lower prices & margins than the rest of the industry, which I found very surprising because it they are inventory-heavy businesses (furniture & jewelry) so it seems like that would make taking cash out difficult.
I don't know about the furniture industry, but I do know that the retail jewelry industry works on massive margins, so selling at below the usual margins in the industry could still provide big margins.

Walter
 
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CPisHere

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If you really think it's evil then perhaps consider a service based business. but then you have the burden of delivering a stellar service every time as opposed to merely shipping out a product.
Exactly why I just bought a service business.
 

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