Assessing true inventory value

Editor’s Note: Throughout 2009, inventory management became more and more critical to survival for marine dealers. In the heyday of boat sales, inventory strategies simply sought to question how much more a dealer could finance. But as the recession taught us financial prudence, dealers and builders alike have begun scrutinizing past strategies. Of all the discussions our team here at Boating Industry has heard and facilitated, few have offered the concrete methodology of the inventory valuation tool outlined in the following article. While we typically don’t publish product-oriented guest columns, our hope is that this tool will become a solution that can help the industry better manage its inventory and help you better manage your financial future. The author is Bob Reich, vice president, customer and dealer support, Sea Ray & Meridian Boat Group, who co-developed this tool with The AVALA Marketing Group.

I’ve spent most of my career working with marine retailers who carry a lot of high-dollar inventory, primarily boats and motors. All too often I’ve seen large and small dealers alike turn down offers on inventoried products, waiting for a predetermined profit margin, while the value of that unused asset depreciates.
In fact, one dealer I visited last year complained he was paying $10,000 annually in interest on a trio of 3-year-old boats — and that he had to turn down several low-ball offers. What was he holding out for? Chances are he didn’t know that his holding costs had probably already exceeded any profit he could hope to make off the boats.

Especially in these challenging times, it is vitally important we work a sale properly and see what the deal really presents us. In other words: What is the actual cost of old inventory? At what point is product not worth holding? Could a sale at a loss be fully recouped by rolling that money into a quick-turning, profitable asset?

To make such decisions, we must be aware of all associated costs. That’s where an “inventory valuation model” comes in. This tool assists dealers in determining when an asset is no longer providing a profit opportunity and should be liquidated. It will also help forecast when a skinny offer should be considered, or when to hold out, regardless of whether or not the clock is ticking.

For years, many dealers have trusted their intuition and deal-making experience to manage their inventories. All too often that art has cost them far more money than they realized. An inventory valuation model takes the emotion out of the decision and provides a more analytical approach to inventory turns.

So, how does it work? Inventory management systems exist in other industries, and most of them incorporate similar buy-hold-sell models of inventory control. The difference is in the data collected and analyzed. The inventory valuation model used by The AVALA Marketing Group, a full-service firm specializing in the luxury goods market, starts with the invoiced cost of the product and then factors in the following:

• Inventory financing costs may or may not be capitalized into the cost of the inventory.

1. Provisions can be taken for subsidized flooring by simply putting $0 in the supported month and starting the interest rate in the appropriate month (as shown in the table on page 8).

2. Interest is usually a factor of a base rate at or around Prime Interest Rate, and the increase of the interest rate as a factor of time the product is held can be factored in.

3. Should a dealer prefer not to capitalize the interest, simply put $0 in the interest payments, but this is not recommended for true, fully loaded cost/valuations models.

• The product mark-up as a percentage; this is an input for competitive market pricing that subsequently reports the gross profit margin based on the building cost of interest capitalized into the cost of the asset.

• Cost of sales, a dealer input that can be limited to commissions or include prep and marketing costs allocations.

• And finally, the anticipated market depreciation associated with time held, seasonality and model life. This is not arbitrary, but requires dealer input to accommodate seasonality, geographic and market conditions, and competitive considerations.

As AVALA President Steve Pizzolato points out, this tool removes the emotional impact of accepting a low or no-margin offer by telling dealers when an asset is no longer providing a profit opportunity and should be liquidated.

Expense or Capitalize?
Inventory carrying costs, and how you account for them, are also critically important in determining efficient inventory levels. Many dealers expense their inventory finance interest payment in the period it is incurred. The rationale is to lower net profits of the business in that period upon which taxes are assessed (gross sales – expenses = net profit).

The alternative is to “capitalize” the interest expense, allocating it to the specific asset and then deducting the interest from the gross profit as an element of cost of goods sold. This is commonly done with big-ticket items such as cars, boats, RVs and farm equipment. By doing so, the business takes the expense of the particular asset in the period in which the asset is liquidated or converted from hard asset to cash. The tax benefits are simply recognized in the same period as the sale rather than in the period of interest incurred.

Capitalizing expenses can also have a financing benefit, as many lending institutions view the value of capitalized expenses as gross assets upon which credit facilities are evaluated. In addition, understanding the total cost of a sellable asset is a valuable management tool to determine true profit and to make inventory decisions at the dealership.

Inventory interest expense should ultimately be considered a cost of goods. If you pay cash for your inventory, what you paid is your base cost. If you incurred carrying costs, such as warehousing, inventory movement or finance charges, those expenses are also and appropriate cost of goods.

Still, that is not a requirement for interest expense capitalization. Generally Accepted Accounting Practices guidelines allow interest expense to be capitalized for any asset that can generate future economic benefit and allow for the expense to be taken in the period in which the economic benefit is recognized (converted to cash). An accounting period may be monthly, quarterly or fiscal year, but generally does not exceed 12 months. Due to the recent downturn in the marine industry, we are all too aware of the reality that not all of our purchased inventory will convert to cash in 12 months.

A report on inventory carrying costs in the Institute of Management and Administration’s Controllers Report concluded that, “A valuable tool for lowering inventory costs is underused. This is the finding of a joint survey by the Institute of Management and Administration and Harding Associates, which shows only 54 percent of companies calculate their carrying costs when making inventory management decisions. The higher the number used to calculate carrying costs, the more potent it is in reducing inventory.”

Bottom line: Recognizing the full cost or the real margin contribution becomes all the more difficult, or at least less obvious when, carrying costs such as finance charges are expensed in the period it occurs rather than at the time of sale.