Cheat Sheet: Inventory Questions for Uncertain Times (Part 2)

If you read my earlier essay on the questions a business’ leadership team needs to be answering to understand how inflationary pressures are affecting it, you know that we are seeking data, avoiding anecdotes, and trying to look ahead to identify the specific sources of rising costs. Once you have these answers, it’s time to take actions – but there are also more questions you need to answer in this phase.

Just as we did in the first essay, I’ll outline the kinds of answers that will help you make good decisions and point out the problematic responses that should make alarms ring.

At this point we know that costs have gone up for a particular business, but has management passed on any of those price increases to the customer and to what percentage of customers?

The answer should be that the business recognized the increased costs as soon as they were imposed and immediately passed on. If management argues that customers will resist increased prices because they were raised last year or some similar excuse, this is a warning sign. Prices are continuously going up, and a business needs to be able to adapt in real-time to these changes quickly. A quick note: even if there is a recession, costs can increase – that is the definition of stagflation. While it is a completely different topic, inventory cost answers illustrate an awareness of what is happening around management and how that impacts their goods.

If management has not increased prices for the entirety of their business but has done it on a subset of customers for a subset of items, management should be able to isolate the channel or customers affected. “I don’t know,” or just the channel name without specific numbers is not a satisfactory response.

Has the price change been incremental? How many increases have been made?

This is a question you want to repeat for each instance, and what you want to hear is that price increases have increased as they have received the market changes. You do not want to hear that they are waiting for some arbitrary end-of-year date before raising prices. This is about market timing, not social/industry norms – likely set by customers in times gone by.

What is the acceptance rate of these changes?

It is a fact that some customers will not accept price increases, and then they will take their business elsewhere. This is how you determine the elasticity of demand for your product or service. A good proactive business should know who is and isn't accepting increases and how that relationship affects profitability. If they do not know the impact, it’s a warning sign that the business is vulnerable to being resourced, and margin erosion is on the horizon.

But losing a customer who is only marginally profitable isn’t necessarily a bad thing. It allows the business to focus its energy and resources on more profitable customers. There may be non-monetary reasons to keep a customer, such as personal relationships, the prestige associated with a certain brand, or the assessment of long-term or tangential benefits. But you can’t do that for many customers and can’t do it for very long. Loyalty to a customer without profitability is deadly.

What about price changes that are permanent or semi-permanent?

Maybe there's just a small surcharge or a spot price change. This question is like the one we posed about how vendors have affected or been affected. But this question concerns how vendors have been passing along their cost increases and whether they are permanent or temporary. As in the other cases, the management team must know this answer. If they don’t, it can wreak havoc on data and collections.

What is the competition doing?

If they increased prices, how did they do it? Who was involved in the decision? Have they changed standard costs? These questions and more are best handled by a senior executive team that has a description of these measures in a war-room manner. If they do not have this, can you be sure that the senior executive team is paying attention to the market?

How have price increases have affected credit terms payment processes or collection realizations?

A good answer will have a detailed analysis of receivables, and it is measured in DSO as a trend line over months. A business that has not managed this properly might have run out of capital.

This is also the time to ascertain if the funds from the government assistant programs increased demand in the market and if so, does management anticipate a reduction in demand as the programs wind down? If so, when?

A good business owner or management team will know that these programs were temporary, seeing the bubble in the market, or they know what changes are going to be permanent. A bad management team will have doubled down on inventory or expects the market to continue to grow exponentially but cannot justify why beyond a few deflecting anecdotes.

Finally, do we know what the return-on-investment assumptions and calculations management has made and where that capital will be deployed?

You want to see a detailed budget with managerial analysis relative to permanent market changes versus bubbles. If a business has become, so top line focused that any order is a good order, or if it is using market capital to buy up goods to hoard or have for supply chain issues, it may be in trouble.

Have you asked any of these questions recently?

Did you get good or bad answers? How a business answers these questions is imperative to judging whether it is prepared to address an increasingly volatile environment. A lot of the weak answers indicate that a business is at the precipice of going downward but may not necessarily have begun that descent.

Now is the time to take a clear-eyed look at the cost side of the business and make sure management sees the whole field. As we said at the beginning of these articles, no living businessperson has experienced the range of factors business faces today. So, if you don’t like the answers, it may be time to bring in a set of outside eyes to help.