Last month, we discussed turn, as it relates to your used-vehicle inventory, and the flexibility a good turn affords you in terms of liquid capital. This month, let's expand on used- vehicle management by discussing holding cost.
A reminder: holding cost (a.k.a. carrying cost) and turn are elements that apply to all inventories, not just used vehicles, although used will be our focus here. You will find these elements closely related for one reason; the quicker you turn inventory, the less your holding cost.
We buy and accumulate inventories in anticipation of a sale, gross profit and, ultimately, net profit.
To establish your holding cost, you will need to know:
- Your average month's used-vehicle inventory.
- Your used-vehicle floor plan rate. If you don't floor plan your used vehicles, apply your new-vehicle interest rate. Why? There is either a real or an implied cost of funds. You could apply the funds dedicated to used-vehicle inventory to pay down your new-vehicle line.
- The average number of used vehicles (retail and wholesale) in inventory.
- Your average monthly fixed overhead, i.e., your total used-vehicle departmental expenses excluding variable expenses.
- The average number of days a used vehicle remains in inventory prior to sale.
Now that we have this information, we need to perform the calculation to determine holding cost.
Here's an example:
Average monthly inventory equals $1,759,502 multiplied by 5% floor plan cost equals $87,975.10 annual interest cost.
$87,975.10 divided by 365 days equals $241.01 daily interest cost.
$241.01 divided by 178 units in inventory equals $1.35 per unit.
Average monthly fixed overhead equals $86,424 divided by 30 days equals $2,880.80 divided by 178 units equals $16.18.
Daily fixed overhead cost equals $16.18 plus $1.35 interest cost equals $17.53 daily holding cost.
For our example, let's assume the average vehicle remains in inventory 52 days at $17.53 per day holding cost. That equals a $911.78 average used-vehicle unit retail holding cost.
If we subtract this from a front-end gross per used-vehicle retail of $1,683 in this example, we are left with a real gross of $771.22 from which we must still pay our variable expenses. The other “unknown” cost includes items such as inventory damage, pilferage and lost opportunity cost.
What can we do to reduce and control the holding cost?
As is the case with our fixed coverage, we must either raise our grosses, reduce expenses, or a combination of both. One key part of this formula is the average aging of the vehicles being sold. If we reduce our average days a unit remains in stock, we reduce our holding cost. If we turn our inventory dollars more quickly, our cost of money is reduced.
It's been a challenging year. The near-term outlook is for more of the same. As we've discussed many times, education is key to superior performance. If you take the time to educate your personnel on items such as inventory turn and inventory holding cost, you will see their performance improve.
Remember, the example here is for used vehicles. I would recommend you apply this same exercise to your new-vehicle inventory and parts inventory.
If you have questions regarding the calculations, or want a form to better help you calculate your holding cost, please feel free to contact me.
Tony Noland ([email protected]) is the president and CEO of NCM Associates, Inc.