It all starts with demand…
The goal of an enterprise is to answer and fulfil some kind of demand, be it in return for financial compensation, aka a payment, or not. When this is done for profit, we call it a business.
Let’s start by defining demand as the willingness to invest (time, money, or effort) in order to be able to get and use a specific product (or service). Since we are in retail e-commerce, let’s stick to physical products that are paid for with money.
Of course, any time someone is willing to pay for a product, someone else will be willing to sell that product – this is the supply. Actually, if the price is right, it won’t be just one someone, more suppliers will enter the market to try and enjoy this opportunity. We see this clearly on Amazon’s marketplace, once a product or category shows high demand, many FBA and FBM sellers join the market, sometimes even Amazon itself.
Once there are enough suppliers in the marketplace, the demand generators (let’s call them customers) start facing a choice. They have to choose which supplier will best satisfy their demand, and, presto, competition has entered the building.
Now, each unit of demand sparks its own “winner takes it all” competition. One supplier (such as an Amazon seller) wins the opportunity to fulfil this demand unit and the rest lose the sale. So, the suppliers do all they can to be the winners at each and every demand “race”.
Demand drives inventory
If you think about it, before you can even try to win the race, you have to be in it. For the demand race, this means the sellers have to be able to supply the demanded item. Once the race is on, the customer takes into account all relevant parameters for this demand, like how fast the fulfilment will be, how much money must be spent, and other emotional and practical considerations.
The speed of fulfilment is one of the top criteria in the race to win a sale, even trumping price as the most important. That’s one of the biggest powers of Amazon Prime. Of course, fulfilment speed has a limit – fulfilment can be immediate and not faster. Demand can only be fulfilled from the moment it is formed or acted upon.
In order to be able to come as close as possible to this limit, the products must be available at the very moment the demand is exposed. In brick-and-mortar situations, this means the item must be in the shop, preferably on the shelf, when the customer arrives with the demand. For Amazon sellers, this means there is enough inventory in FBA or the external warehouse and the listing is alive and active.
The only way the item will be “on the shelf” when the demand hits the store is if it has arrived there beforehand. These items that are available before the demand arrives are the heart of retail (in-store or eCommerce) business and they are called – Inventory.
Inventory costs money
Of course, there is a downside to holding inventory – it costs money.
Here are some sources of inventory costs:
- The cost of the goods themselves – often sellers pay 100% of cost before a single unit is sold for profit.
- The cost of the money – the interest on the investment, be it out-of-pocket or loaned.
- Storage costs – the space and services the inventory occupies until sold.
- Handling fees – inventory has to be received, checked, placed, pulled, counted, and the list goes on.
- Inventory aging costs – the longer an item sits and waits to be sold, the higher the chances it will get lost, break, be spoilt somehow, be stolen, and all that jazz. And most of the items that survive all this, turn out to be dead-weights, inventory that just doesn’t sell and nobody wants.
- Elimination costs – finally there comes a time when you have to take it as a business owner and write off that inventory. Then you have to pay to get rid of it.
So, cash moves from your bank account to the warehouse
As we have shown, the goods have to arrive to our shelves, or be available through FBA, before the demand arrives to make the sale.
Unfortunately, this also means that we have to purchase this inventory before we have (all) the required information about the market demand. Far too often we have to make that call a lot of time before we have that required information.
So, what should we do? Guess? No. We use forecasts.
Forecasts appear to be a good solution – an algorithm that uses the data we do have to create a calculated estimation of the future. It works really well for the weather, after all.
Well, retail is not the weather. Due to several different factors, it turns out that it is mathematically impossible to predict how many units of a specific SKU or ASIN will sell at a specific location 12 weeks down the road, without an error margin of at least 50%.
It’s important to note that this forecast isn’t uniformly inaccurate. It’s actually pretty good at the aggregated top level. This means that the forecast for the total demand for all SKUs in family A and market B for the entire quarter, will probably be pretty close to the actual demand. At this level forecasts are quite useful.
The problem starts as we break up this demand into smaller, more granular pieces of data, as we try to turn this pretty accurate forecast into the actionable data. After all, you can’t order at the aggregated level. As you break down the forecast the error margin grows and some items will be over-forecasted, ending up with units that don’t sell and some will be under-forecasted ending up with lost sales.
As a result, slowly but surely, cash is migrating from the bank account to the inventory. Even if you have deep pockets and no shortage of cash, this is not a direction you want for your money.
How inventory affects profits.
Wait, why is this migration a problem? Isn’t it just part of business? Let me ask you back – did you include this in your financial planning?
If you planned your business deterministically, with the logic of ‘I’ll buy, they’ll pay’, then you haven’t accounted for the inventory build-up. Let’s explore this quickly:
Assume net profitability is 10% on a X5 mark-up. This means that for each $1 invested to buy a product, you expect to sell for $5 of which you expect 50¢ to reach your bottom line. If you sell only 80% of the units you buy, each $5 revenue represents $1.25 of inventory spend, instead of the original $1, and your actual profit is HALF of what you thought it was.
This type of discrepancy is like road ice. If you know it’s coming and you prep your vehicle with snow chains, no problem. If it takes you by surprise, you go into a tailspin. How does this tailspin manifest itself in business? Your costs are up, your risk level is up, your ability to react to surprises (good or bad) is limited and you lose sales. You are fragile and exposed.
BTW, did you know that lost sales are the #1 killer of profits and profitability?
 In actual profit, as opposed to the accounting profit, we refer to your total revenue vs. total expenses. Accounting profit doesn’t include unsold inventory, that is considered an asset.
When profitability goes down, the pressure goes up
Let’s look at the process we charted out so far:
Purchasing to forecast leads to lost sales and inventory build-up. This means revenues decline as costs go up, eroding profitability.
As profitability declines, a pressure starts to do something about it. Now, what feels like the most important contributor to the bottom line? Usually it’s the top line – the revenue. This is because it’s hard to reduce the expenses and revenue is both highly visible and extremely measurable, giving off the false notion of control.
The pressure to bring in more revenue is translated to short term actions such as promotions and price discounts, to move the inventory that isn’t selling. And to longer term efforts to bring in new inventory that will, hopefully, sell better.
The short-term efforts further erode profitability, adding to the pressure even when they are successful.
The longer-term efforts drive to another forecast based order that will restart the cycle. While it may appear to lift the pressure for a while, soon the good sellers are gone, again, and the situation keeps going south.
If you are running most of your sales through the Amazon marketplace, you know this negative feedback loop first hand. Actually, you know things are much worse for Amazon sellers, FBA or FBM. This is because Amazon’s knee jerk reaction to both options, stock outs and over stocks, is to overshoot and make you pay for it.
Unless we have the tools to control it
We just saw that the source of this feedback loop is the fact we are buying to forecast.
This is the key to changing the loop, then. We need to stop using the forecast as the inventory plan and find a new tool that allows us to balance inventory to actual demand.
The goal is to create a flow of inventory in and out of your warehouse, Amazon FBA account, or anywhere you hold inventory. Never stock out, never build too much stock.
As you create a balanced flow you will immediately reduce the burden on your cash flow, allowing you to be prepared the next time opportunity comes knocking.
Next, you will be able to cash the money you have tied up in inventory and finally, you’ll start seeing your revenue rise because your best sellers stay in stock, without giving up sales.
This combination will allow your profitability to improve as well, driving a new, positive feedback loop.
Now, this is why we stay in business.
Storfund accelerates your marketplace payouts across multiple geographies and allows you to manage your finances in one place. Storfund helps e-commerce sellers drive sales and increase profitability by shortening their cash cycle, thus allowing them to purchase additional inventory and never run the risk of being out of stock. Our clients receive their sales the same day, irrespective of the marketplaces’ actions, be it rolling reserves or 14- or 30-day payment cycles. Storfund is available in 17 Amazon marketplaces and in the French marketplace Cdiscount. We work with companies registered in the European Economic Area (EEA), the United Kingdom, the United States, Canada, Australia and New Zealand.