This article was written by NCM Institute instructor, Steve Hall, and was originally published on the Up to Speed blog. 

Today’s article is intended as a wakeup call to General Managers and a profitability lesson to Parts Managers.  So, I’m going to lay it on the line…

It amazes me when I see parts departments with obsolescence that has been in their inventories for 12 months, 24 months and many times even 36 months or longer. Parts obsolescence is a large financial drain on any parts department. Controlling this negative revenue part of your inventory is a necessity for any parts department that wants to be highly profitable. In order to do this, people must look at obsolescence for what it is – idle capital at best, and “junk” at worst.  Either way, it is not pretty!

Let me define what I mean by each term:

Idle capital

This is the portion of your obsolescence that is returnable to the manufacturer. For one of several reasons, these parts were brought into your parts department, either through phase in, speculation or special orders, and have had no sales over the prior nine months. These dollars are just sitting on your shelves doing nothing for you. The parts are still in returnable condition, but either you haven’t sent them back to the manufacturer or you don’t have enough return allowance to send them back.

Let me take this one step further; stock parts are considered idle capital after nine months of no sales, but special order parts are considered idle capital after one month of no sales. After all, special order parts were already sold when they were ordered and if they are still there after one month, you have a problem.

Junk

Sometimes you get stuck with a part that is non-returnable. This could be from many causes, such as, open or damaged packaging, mis-ordered parts that are not eligible for return, partial quantity packages, left over inventory from a buy-sell, and many other reasons. I consider these parts “junk” because you only have one way to get your investment back, and that is to sell the part.  Unfortunately, the chance of ever selling any obsolete part is less than 85% and the chance of selling a “junk” part are even lower.  I don’t like those odds, especially when you start calculating the holding costs on the parts.

Let me explain the mathematics of the problem. There are three types of costs associated with parts inventory.

1. Cost of sale: This is what you actually paid for the part when you purchased it. This is also the amount you should receive back if you return the part, minus a small restocking charge.
   
   
2. Holding cost:  This is actual tangible expenses that you incur when a part is in stock. These expenses include items like taxes, insurance, space and interest. These costs equate to about 2% to 3% of the part cost per month. If you have an average size inventory of $300,000 and control your obsolescence at only 5% of your inventory value, you would have $15,000 in obsolescence.  This $15,000 alone would cost you about $3,600 to $5,400 a year in actual carrying costs. You can never get this money back and it comes straight out of net profit.
   
   
3. Intangible costs, also considered lost opportunity costs: These include lost revenue (gross profit), lost return allowance and lost purchase discounts that could have been earned on the $15,000 if it was turned into good inventory. This is a much larger number. If you only have five inventory turns a year, the $15,000 of obsolescence could be costing you upwards of $37,500 a year in intangible costs and that is in addition to your holding costs! Here is how I came up with these numbers:

With all of this in mind, do you know what makes up your obsolescence? Is it returnable? If so, you must get it returned and put that money to use. Is it junk? If so, get rid of it! Take the loss, free up the space and quit paying taxes, insurance and other real costs. Take the write off and turn the money into something that will make you a profit. After all, this is really just “water” in your inventory.

It’s a hard pill to swallow, but don’t continue to pay for something that has no value. Pay attention and increase your profitability.

Top level parts profitability doesn’t just happen by accident. It takes understanding and planning. If you would like to have a better understanding of how to turn your parts department into a net profit machine, I invite you to join me for NCM Institute’s Principles of Parts Management training courses. Whether you are a General Manager that wants to understand every profit center within the dealership, a veteran parts manager or a rookie manager, we will help you realize the profit that you deserve!