Inventory – the Death of e-Commerce Companies, Large and Small

A New Company

Let’s take, for example, a brand new company that’s getting into the blue widget business.  For fun, let’s call the owner Carlos. Widgets cost $50, and retail for $100.  For simplicity, we’ll assume that Carlos has to pay in cash up front (which is somewhat common when you just start out), that he orders once per month, and that he receives his inventory immediately (clearly, not very common).

Carlos has saved up and he has $5k to start out with, so he buys 100x widgets.  In the spreadsheet, Qty is the quantity that Carlos has in stock, COGS stands for cost of goods sold (Carlos’ cost on the items), and Retail is the retail value of the inventory.

inventory1

Now, 30 days later Carlos is doing pretty good.  He’s sold 75 out of his 100 blue widgets.

inventory2

Time to reorder!  Since demand is increasing, Carlos needs to spend all $7,500 in his bank account to buy 150x blue widgets. Now he has 175 in stock, but no cash.

inventory3

Things keep going well for Carlos.  In fact, he’s decided to expand his business into green widgets.  At day 60 he’s down to 50 blue widgets.  He orders 150x again, but also buys in to the green widgets with another investment of $5k for 100x.

inventory5

Wait a second.  Things are going pretty good, but Carlos keeps spinning his wheels when it comes to cash flow.  When he has a lot of cash on hand, he keeps having to spend it all on inventory to accommodate his growth.  When inventory looks good, he doesn’t have any cash.  He’s profiting, but there’s no profit to spend on anything other than inventory.

Us

Now multiply this over several product lines, with multiple vendors, all of which have different payment terms (cash, credit cards, Net 30), and all of which have various delivery times, and then factor in shipping damages, warehouse space, shelving units, packing material, employees, marketing, and probably 50 other factors, and you basically have us.  It’s easy to see how, despite really fast growth and  lots of cash coming in and out, there isn’t a whole lot left, even if you’re showing a large profit.

The situations that really kill us are vendors that we spend a lot of money with but also have slow lead times, forcing us to forecast out further than 30 days.  For example, we might place an order in July to cover us through September.  We get the products, have 30 days to pay for them, even though we won’t turn the inventory over for several more months.  At which time, we’ll be placing an even bigger order with the same company.  It’s a vicious cycle.

It’s a problem that we’ll probably never rid ourselves of completely.  The interesting thing is that this problem doesn’t stop as you grow.  If anything, it might get worse.  Take the case of Zappos.

The Super Duper Gigantic Company

In an excerpt from his new book, Delivering Happiness, in last month’s Inc Magazine, Tony Hsieh authored an article titled  Why I Sold Zappos.  Essentially, to sum it up for you, the reason was because of inventory:

At the time, Zappos relied on a revolving line of credit of $100 million to buy inventory. But our lending agreements required us to hit projected revenue and profitability targets each month. If we missed our numbers even by a small amount, the banks had the right to walk away from the loans, creating a possible cash-flow crisis that might theoretically bankrupt us. In early 2009, there weren’t a lot of banks eager to give out $100 million to a business in our situation.

That wasn’t our only potential cash-flow problem. Our line of credit was “asset backed,” meaning that we could borrow between 50 percent and 60 percent of the value of our inventory. But the value of our inventory wasn’t based on what we’d paid. It was based on the amount of money we could reasonably collect if the company were liquidated. As the economy deteriorated, the appraised value of our inventory began to fall, which meant that even if we hit our numbers, we might eventually find ourselves without enough cash to buy inventory.

These issues had nothing to do with the underlying performance of our business, but they increased tensions on our board of directors.

The fact that Zappos had these issues is both scary and reassuring at the same time.

Solutions?

We discuss this a lot. It’s probably our biggest growing pain, even more so than hiring, scaling our technology, or developing our warehouse operations. Now, most companies aren’t Zappos, they’re more like us. Is there any solution to this problem?

Yes, there is, and we personally know several e-commerce companies that no longer have this problem. Their solution: they have a shit load of cash. They don’t rely on bank lines to buy inventory. Somewhat of a necessity in the beginning, you can see from Zappos how bank lines can sour quickly based upon factors outside of your control. We’ve also experienced a TON of red tape trying to get new lines or increase existing ones. When the application process involves 10 meetings, personal credit checks, personal tax returns, the SBA’s backing, and a 100 page business plan, you have to question whether it’s worthwhile. Unfortunately for Zappos, they’re too big to solve the problem with cash. They’ve outgrown any potential “sweet spot.”

There are really only two ways for a retail business to get a shit load of cash. 1) You start out with it because you’re rich. 2) You slowly but surely build it up over years and years of profits.

Since #1 doesn’t apply to us, #2 is what we’re shooting for. #2 is how we’ve seen other successful e-commerce companies do it. This isn’t a one or two year thing, it’s a 5-15 year thing. It means absolutely minimizing other expenses (most notably, new product lines, employees and warehouse costs) until that revolving cash flow cycle eventually starts to turn in your favor. If you’re profiting, it will (and if you’re not, well, you’ll be out of business). We see it slowly getting better. The difficult part is controlling expansion – expand too slow and you lose market share, expand too fast and you hit the reset button and start that bad cash flow cycle all over again.

It’s a fascinating topic, one that I think is often taken for granted when starting a retail venture. At first glance, you just wrongly assume that if you’re profiting you’ll have no cash flow problems, which definitely isn’t the case.

Side note: as I’m about to hit “post” I realize that this is my 400th post since switching to WordPress and moving this blog from SportsLizard, where I had another 296. It kind of blows my mind to think that I’ve written almost 700 posts over the last five years. If anything, I suppose it shows I’m consistent when I apply myself to something. Thank you to everyone who has ever read, commented, or emailed!

31 comments on Inventory – the Death of e-Commerce Companies, Large and Small

  1. Aaron says:

    Adam thank you for sharing your business journey. I personally enjoy reading your blog over many other business magazines or blogs because you share the everyday activities, worries and strategies that encounter as a small business. Not as a fictional business in a magazine or a large business out of touch with the daily struggles of a small business owner. Keep it up.

  2. Jakob says:

    Really interesting post. Have you looked into raising private funds from individuals? Selling bonds?

    • Adam McFarland says:

      Good question Jakob. Without writing an entire essay, I’ll just say that yes we have several interested private investors and if we were to take on any funding we’d almost certainly go that direction. Still, everything comes with strings attached so we’d like to avoid it if possible. For the most part, we’re in a pretty good situation so long as we don’t have some drastic unforeseen expenses.

  3. Tim says:

    First of all, Congratulations on hitting the 400 post milestone on this blog! It takes a lot more dedication than most realize to have a quality blog that continues. Not every post can be life(or business) changing an establishing a following takes FAR longer than most people are willing to wait.

    As for the content of this post, wow does it hit close to where home used to be! As you know, I previously owned a brick and mortar(it really was brick and mortar) establishment that was a retail sales and service type business. This death spiral was a constant problem and as we grew it only became worse because the numbers just kept getting larger. We may have been purchasing $175k in products every month, but I was not making more than when we were purchasing $50k in products every month – most people just assume, bigger numbers means your take increases – WRONG! We were in business for 15 years, and even though we sold nearly 3 years ago now, had we stayed with it our accountant didn’t project this cycle ending for at least 10 years from when we sold, in other words, it would have taken our business 25 years to reap the rewards of our hard effort if nothing catastrophic went wrong, and it was a rapidly changing industry. Selling became the wise option if I wanted any chance of change in my life, thankfully there was a serious national company who was trying to penetrate our market and we fit into their puzzle too perfectly for them to pass up. They’re happy and I was happy!

    Fast forward today and I would NEVER put myself in a position like that again, and I know you feel the same way. Both of us ended up in our business by chance, not quite by accident but I’m sure neither of us thought this is where we were going to end up if you asked us when we graduated high school.

  4. Dave says:

    Really great post Adam. Something we’re surely dealing with. It has been a mixture of being able to work with some vendors for drop shipping and growing slowly (aka using profits to expand inventory and going back to square 1). Luckily (at least for now) the vendors/suppliers/dealers/distributors we work with have been fairly easy in terms of buying smaller amounts of inventory where we can try and manage having a small number of items or working with 30 day (or less) turnover.

    By the way, Delivering Happiness is a great book, I’m about 90% done…easy read and extremely interesting (especially the first half).

    • Adam McFarland says:

      Good to hear. I’ll definitely pick it up soon. I’ve been looking forward to reading it ever since he announced it.

  5. Jakob says:

    BTW, any idea how Dell managed to avoid this problem, growing from a dorm room into the PC giant?

    • Dave says:

      I don’t have insight to this, but weren’t they made-to-order PC’s? I would think that could somewhat help…worst case, make the wait a little longer while you wait for inventory to arrive.

    • Tim says:

      Dell received an infusion of capital from his family circa 1985 of $300k roughly 3 years later the company went public raising mid 8 figures. Without that initial infusion I think it’s safe to say dell would not have experienced the success they have to this day, some would call that a wise investment!

      • Adam McFarland says:

        Good question Jakob. Even though they received a lot of money as Tim pointed out, I do think that Dave also makes a good point. You have a little extra leeway when you’re making everything custom to order.

        About 2 years ago we toyed around with getting into the PC business, making small, cheap, energy efficient “green PCs” and we planned to start out just ordering everything from Newegg after the customer placed an order (Newegg is only 1 day away from us with standard shipping). George has been making custom PCs for people since he was a kid, and he worked for many years in college at CompUSA so we had some basis to get started. Inevitably we were too busy with DI and TD at the time, but it would have been interesting to get in to. Now I think everyone is focused on energy consumption, however a few years ago that wasn’t much of a focus in the PC world at all.

  6. Rob says:

    The inventory problem is a tough one to crack.

    It seems to me that what you need is more cash than you need to spend on inventory, to put it another way – if you spent all your cash on inventory, it’d be more than you could sell before having enough cash to replace it.

    Being in a much more service oriented business (where product costs are tiny compared to staff, travel, equipment etc)we don’t have quite the same problem. We do have a ton of different problems though.

    The closest I’ve come to experiencing the inventory-cashflow cycle is playing online trading games, like EVE. You start off trading some low value commodity, then, when you have a bit more money, you move into a higher value market. Before you know it you’re spending thousands of times more on inventory than you were initially but you’re not really much better off.

    To build up cash reserves over time I suppose that you’ve got to take money out of the cycle on purpose, perhaps by allowing yourself only to spend 90% of your available cash on inventory. This would reduce short term growth but make you more stable for the future.

    @Tim – why were you making no more money at $175k than at $50k. I don’t understand – was your margin reducing, or were you growing at a faster rate than before?

    Overall, I think the main thing we learn from this tale is that Carlos isn’t very original. Every business book I’ve ever read talks about selling widgets and the millions you can make – I’d have thought the market was massively oversaturated by now!

    • Adam McFarland says:

      Haha yes there probably isn’t much of a market for widgets these days

      I don’t want to talk for Tim, but I think what he means is that the rate of growth was too fast to keep up with. Despite the increased profit, the increased costs of more inventory (both new products and existing products) essentially ate up the extra available cash on hand.

      You’re definitely right about taking money out of the cycle. That’s what we try to do. Still, when you’re stocking out of items or when your competitor has a product that sells that you don’t, it’s hard to remain disciplined and slow your growth to let the cash flow cycle catch up.

    • Dave says:

      Tell us a little more about some of the problems you saw in the service industry in comparison to this problem when selling product.

      • Adam McFarland says:

        I’ll second that request. When we did web development and SEO service we were very small, much much smaller than you are Rob, so we didn’t encounter many of the growing pains I’m sure you have with staffing and training and whatnot. I’m very interested to hear what struggles a big service business runs in to.

  7. Tim says:

    Rob, the company was making more money with the increase in business, but that increased profit went to increased expenses to cover the growth, more employees, more space, more equipment, more accounting fees, higher insurance, and the list goes on and on. Then you factor in the inventory problem it was a constant rat race, I’d have to pump 4 months of my pay into the business to keep it afloat. I should have been more clear. And it’s not that I made literally no more money, I saw small raises over time, but those increases had no direct correlation to the increase in business.

  8. Rob says:

    First, a disclaimer. As you probably know, I’m predominantly in the service industry. The questions I ask are because I genuinely want to know and don’t understand – please don’t confuse my stupidity with me questioning your business skills and choices, or trying to tell you how you should run your business; I’m just trying to understand :).

    @Adam

    Regarding the discipline, I guess that’s a really hard part – you’re probably going to have products go out of stock and lose some sales, so you need to weigh up whether the short term losses of doing that will be offset by longer term strength/growth/positives etc, right? If this is the case, and you have a business plan, or know what the “Adam” in the cold-light-of-day-pure-business-head-on, not the swept-up-in-the-moment “Adam” would do, how hard is it to do that and see those short term losses? Does it terrify you, is that why it’s so hard, knowing that you’re losing money you could have, or perhaps even losing customers to a competitor? Is it possible to simply concentrate on fewer products for a while and only add the extra ones when it’s not going to be at the expense of keeping inventory of the things you’re already selling?

    @Tim

    It sounds like a case of the business growing faster than you were comfortable with again, is that right? Is the general consensus here that people feel unwilling to (artificially?) slow the rate of growth of the business because that would mean lower profits on in the short term (as the profits would be eaten up by increased inventory). I think perhaps we need a good definition between “increasing profits” and “increased cash profits” (that which is not spent on inventory). A business fails when it runs out of cash, so knowing that, is it not prudent to ensure that cash is kept in reserve at all times, even if at the expense of growth? Is that hard? (I mean it, I’m really asking. Please don’t mistake this for a patronising comment. Gah, tone is so hard to get right in writing!)

    @Dave&@Adam (please pardon the length)

    Our niche is portrait photography at formal student events. We work with tons of big schools and universities right across the country. We’ve got all the usual supplier issues as everyone else – Isaac spent most of last week dealing with a couple of companies that SUCK at customer service. One of them delivered mounts that we needed at short notice to an incorrect address that we didn’t have time to get to. The other took one of our printers for repair (minor fault) and then returned it in a totally unusable state. Nobody in business to business sales in this industry seems to care about customer service and the unfortunate thing is that there are very few companies providing the products we need (printers, specialist ink & paper, embossed mounts at a reasonable price), so you can’t really take your business elsewhere. Anyway, although resolving their mistakes (which we’ve ended up having to pay for) has taken most of our time the last week, the problems that we face mainly relate to staffing and equipment.

    The events that we cover fall in a few short seasons every year. This means for a good portion of the year we can work a 9-5 doing general admin, marketing and perhaps investigating side ventures. Then, all of a sudden we change gear completely and we’re covering multiple events simultaneously across the country, using a mixture of part time staff, freelancers and subcontractors. These events used to be very profitable. They’re not any more. The bottom has somewhat fallen out of the market. We’re working harder than ever but generally making less per event than we were 5 years ago. It’s probably a dying industry. Anyway, enough of that…

    So, we’ve gone from 1-2 events per week to 5, 10, 20 or more. This means we’ve got to find incredible numbers of staff (last count was 36) to cover some weeks, but others we don’t need anyone. We’ve got to ensure these people are all trained in our workflows, make sure they’ve built our trust, are in the right area, answer their phones/email (seriously, who doesn’t someone back when they’re offering work??) which takes a lot of time. We’ve also got to allocate equipment to them (which needs to be insured, serviced, and most importantly, stored and transported…).

    Because there’s only two of us and sometimes we’re covering many more than two events in a night, that means some of these staff need to work entirely independently of us. We’ll assemble a team of people who have gained our trust, will work well together, and are capable of working completely unsupervised, representing our company and brand, and whom we have to trust entirely with our equipment, reputation and any cash they may take. Oh yes, one other minor point. They need to be available! As this is part time work, they’re mostly students, or this is their second job, so they’re not always available when we need them, even more so at short notice.
    The next step is transporting equipment to them (a horrible task, making sure the right bits are at the right end of the country at the right time). On the day they need to travel to the venue (usually a hotel, conference centre etc.), do the setup without any assistance at all and deal with the organisers, drunk students, rudeness, venue managers, con-artists and somehow take enough photos to cover the cost of paying for themselves, bonuses, equipment and everything else. They then return, usually with one or two bits of equipment damaged or missing, which we often need to get replaced within 12 hours. Money needs to be paid in, photos processed and uploaded to our servers, equipment checked and repaired as necessary, people contacted to thank them etc. and equipment transported to another team as required. Now, imagine this going on every day for a fortnight, but it’s 5 teams you’re managing in addition to events you’re leading yourself, ongoing general admin, correcting any mistakes, dealing with accounts, and any other bookings that come in. The fun part happens when staff bail on you and you’ve got to scramble to find someone else so as not to break contract with the client…

    The issue is that when we grow, that means we’re getting more bookings. Because the seasons are so short, these often fall on the same few days. To be able to cover these events we need to stock up on equipment, train staff, prepare inventory (ink, paper etc.) and coordinate everything I mentioned above. This, of course, all needs to be paid for BEFORE actually covering the event and seeing any cash (apart from staff, who are paid afterwards). During the short seasons the work is so intense – I’m often away from home for 7-14 days at a time, working on admin stuff (generally coordinating equipment, staff, immediate problems etc.) from about 10 am until 3-4pm, then going to an event and working until 1 or 2, getting home and processing images for upload, leaving them on overnight and starting again the next day.

    The obvious solution is franchising. It doesn’t work in this industry, because the franchisees need a lot of skill and the same equipment. If they had that anyway, it’s not a huge step to being a competitor. No matter how great your contract wording, people will be people.

    Once we find a way to clone our best staff and ensure infinite equipment durability we’ll be sorted. Until that time… this is not a scalable business.

    • Adam McFarland says:

      Wow Rob. I think I’ll nominate that for blog comment of the century 🙂 Great insight into your business. It just goes to show that all businesses have their problems, service or retail. Many times one side wishes they were the other, but in reality they’ve both got some very big positives and some very big negatives. I think for both of us, the pros outweigh the cons, otherwise we wouldn’t be in business.

      To answer your questions, I usually am for a slower growth and a slow down in the new products we acquire, however there is some fear that if we don’t keep up with the competition that eventually our customers will go elsewhere. Also, there are four of us and I’m probably 3rd or 4th on the list in terms of who is making the purchasing decisions. We talk strategy at our Monday meetings, but during the week Greg and George make those calls. I’m a bit more removed from the process than it would sound by reading this post. I trust that they know how to balance adding a new product vs losing a few new customers. It’s tough because sometimes we’ll get “first dibs” on a new product with a lot of hype and you don’t want to get the reputation for turning that down. It’s a constant balancing act.

  9. Nev says:

    Inventory is the devil.

    • Adam McFarland says:

      Why yes Nev, I suppose that would be this entire post and comments, summed up nicely in 4 words 🙂

  10. Tim says:

    Rob, I get what you’re saying, and I do agree, but the gray area is enormous. In order to grow you often take leaps rather than small steps, my old business was a retail tire shop and automotive repair shop. It started at with one bay, then we added another, effectively doubling our potential output. Due to a number of reasons we then added 3 more bays, again more then doubling our potential output. We had an enormous demand, we weren’t actively seeking new business it was literally walking in the door on its own, short of telling someone to “Get out!” there wasn’t much we could do but try to accommodate them. We were perpetually playing the take 1 step forward and then 3 steps back – yes we had more business but we were in a low margin business with high over head, so it was tough to ever really get ahead. Eventually we were just too busy we couldn’t produce any more from our current location, this was probably the best financial position we were in, we were making money and booked weeks in advanced, but we were still bottle necked by our facilities. So we purchased land, and built a brand new state-of-the-art facility with 9 bays – what is frustrating side note, I acknowledge that we were in a high over head, high liability and low margin field yet banks were lining up to throw us money, yet successful tech companies can’t get the time of day from traditional banks, I digress..

    In any case, as you can see our growth was impossible to make incremental, it was large leaps which took years to recoup from and there was just nothing we could do. Factor in incredibly poorly estimated taxes and other unforeseen expenses the new location was a disaster from a financial standpoint. We also had to play the continually bank game, spending an alarming amount of our time showing the banks that we were making progress, we were making money and paying our bills, but that wasn’t enough, they wanted to know we were moving forward in a direction to continue to be able to pay our bills – so counterproductive and frustrating all so a mid-level bank employee can justify their inflated salary.

    • Adam McFarland says:

      Great info Tim. Your situation with the tire shop was several degrees more complex than our situation, which is hard to imagine lol. You bring up a very good point about the jumps being big and not incremental. On a much smaller level, when we pick up a new brand it might cost us $10k – $30k, which requires a big influx of cash that, per my example, doesn’t turn over for a while. It’s not just one product at a time, it’s one manufacturer/distributor, and we’re always handcuffed by minimum orders, or a minimum amount we have to spend yearly, or a minimum amount to get free shipping (which, for freight products is a big deal).

      Clearly though, we can “control” things a little more than Tim could. He had a lot of labor to deal with, a lot more customer service nightmares I’m sure, and probably way more insurance/liability type of stuff with the service side of his business.

      PS – I hate banks and just about every thing about the way they operate when it comes to handling small business. Yo government, want to start to fix the economy and encourage business growth? Give us more tax breaks, and give us banks that understand how businesses started after WWII operate. I don’t care if it’s through better SBA programs or something different, just less red tape and more logic. I’m not asking for you to throw money at any new venture (that’s a bad idea), but if someone like us comes along that has shown large growth for years and is profitable in a crappy economy, it seems counterproductive not to give us access to gobs of capital that we can use to grow and create jobs. We might not always want it, but for it not to be there is a joke. /end rant

      • Rob says:

        Yeah – sorry about the length, took over a bit there. feel free to delete/trim if you like.

        @Tim – I think I understand better now, with the large leaps required it’s not so easy to slowly transition up – it’s got to be done slowly or not at all. As for turning customers away, could you perhaps charge more until you’ve got the right number of customers? That’s what most business books tell us to do, but I know that if the market is price sensitive it can be a fine balancing act.

        @Nev – very concise!

        @Adam – $10 – $30k eh? So how did you go from nothing to the first supplier? Was it a different deal then, or were you paying consumer prices, or was it just a certain supplier who didn’t have crazy restrictions?

        • Adam McFarland says:

          I wasn’t working with Greg and George in the very early days, but what they did was buy some products directly (the ones that had low buy-ins, say less than $1k) and then buy the rest from a distributor (middle man). When buying from a distributor, you might have a minimum order of a few thousand dollars, but with that you can pick up small quantities of a lot of different brands. Over time, we’ve gotten to the point where we go direct for almost all of our products. There are only a few that we still buy from someone in the middle, but that’s because they are both a distributor and a manufacturer, and we’re ordering from them anyway because they manufacture products directly. Most of these people also sell online themselves, so one company might be a direct competitor, manufacturer of multiple product lines that we carry, and also distributor of many more. Makes for some interesting relationships 🙂

  11. Adam Holland says:

    Two words: Information Products

    No warehouse/inventory/shipping/lead times/etc.. Oh, and if its a digital product you’re talking 96% profit (only cc fees and hosting and other little bs expenses).

    I’m still waiting for your car detailing DVD! 😉

    Adam Holland

    • Adam McFarland says:

      Information products do have great margins 🙂

      The production costs of a good auto detailing DVD are through the roof though. You’re talking tens of thousands of dollars to do anything decent. You need a super expensive car, a lot of supplies, a detailing bay with A+ lighting, a pro quality HD camera, a pro detailer who can talk to the camera, someone to edit it all, somewhere to produce the dvd, etc etc…and you still have inventory if you distribute a physical copy, which we would in addition to selling it online. With detailing you have to have perfect lighting and perfect camera work to be able to see the minor imperfections you’re working on and how much you improve them. It’s much more complex than it initially sounds. Our pro-detailers who write for us are continuously working to improve their garages, and one in particular may have a brand new one being built with the capabilities of really doing it right. When that happens we’ll revisit the idea of shooting a DVD.

      Much more realistic for us is the continued growth and success of SportsLizard and LockerPulse, which obviously have no inventory.

  12. Rob says:

    Found this series of articles and thought people might find it useful:

    http://www.effectiveinventory.com/articles.html

  13. […] written before about how the cash flow cycle of inventory can be the death of e-commerce companies of all sizes. One of the things we’ve done this year with surprising success is pre-selling […]

  14. […] that inventory cash flow post I always link to? You know, the one where I basically concluded: Is there any solution to this […]

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