It is generally known that operating to the same revenue with lower inventory is good for any business. Supply chain planning projects are often approved on the back of the promise of lower inventory levels. In a recent conversation, I was asked a more nuanced question: whether right-sizing inventory via better supply chain planning impacts earnings before interest, tax, depreciation, and amortization (EBITDA). This blog tries to address this question.
Per Investopedia, EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company’s overall financial performance and is used as an alternative to simple earnings or net income in some circumstances.
EBITDA can be calculated as follows:
Sales Revenue – Cost of Goods Sold (COGS) = Gross Earnings
Gross Earnings – Sales, General & Administrative (SG&A) Expenses = EBITDA
In an income (or P&L) statement, Sales Revenue, Gross Earnings, COGS and SG&A are typically reported above the EBITDA line.
Read more: ABC Segmentation for Inventory Management
Alternately, one can also calculate it as:
Net Earnings + Depreciation Expense (DE) + Amortization Expense (AE) = EBIT (Earnings before Interest and Taxes)
EBIT + Interest Expense (IE) + Tax Expense (TE) = EBITDA
In an income statement, DE, AE, IE, and TE are typically reported below the EBITDA line. Changing these therefore does not impact EBITDA.
In this light, the original question is easy to understand. To keep inventory, one needs to produce or buy it. This requires an investment of money. Assuming the money is borrowed, this results in interest being paid or interest expense. Since this is below EBITDA in the income statement, this should not impact EBITDA.
As the old saying goes, the devil is in the details. Let us then look at this in some detail.
Inventory is not reported on the company’s income statement. It is reported as an asset on the balance sheet.
Let us first talk about the two most obvious ways of getting rid of inventory. First is by selling it. Selling creates revenue, and this goes on the Income statement above EBITDA. So, it definitely impacts EBITDA. It also impacts the balance sheet and the cash flow statement.
The other obvious but extreme is that the inventory cannot be sold and has to be written off. In this case, we reduce the assets but do not create any revenue. Thus, this is accounted for as an expense to the company.
Now, let us imagine a situation where the inventory is right-sized (reduced and increased inappropriate places) through better supply chain planning. What then is the impact on the income statement?
Right-sizing means having the right inventory at the right place. If Product A is popular in Location 1, and Product B is popular in location 2, then the inventory of product A in location 2 is not really helping and vice versa. If one simply swaps the inventory between locations, the sales and therefore earnings increase. This will then impact EBITDA. The same can be said about the wrong package, wrong color, configuration, etc.
Inventory also triggers operational costs. So, reducing inventory does impact the EBITDA. The key question remains which operational costs are reduced if I lower my inventory. The starting point for a planner would be to think like this: If I halve my inventory, which costs will be reduced?
One typically has to consider the 3 R’s when it comes to inventory-related costs: Rent, Room, Risk.
- Rent is financial. It should be thought of as the costs associated with borrowing (or renting) money. Typically, to calculate this, one uses the Weighted Average Cost of Capital (WACC). On the one hand, it accounts for the interest paid on loans (which is below the EBIT line), on the other hand, it accounts for dividends paid to the shareholders (which is even below the net profit line). Therefore, this does not impact EBITDA.
- Room is operational: if one halves their inventory, the question is which operational costs are reduced. Here is one way to think of it. If a company has a warehouse, and because of too much inventory, they have had to pitch a tent in the parking lot or rent extra space. If through better planning, a lot of the inventory is no longer needed, then one would not have to spend the money on this tent or this short-term warehouse.
- If the warehouse is outsourced the impact may be immediate as one needs to rent less space. Therefore, this impacts EBITDA.
- If one has their own warehouse, a large part of the cost can be fixed and hits the P&L as depreciation. This does not impact EBITDA.
- In this case, only a small part (such as inventory counting) may be a variable cost. These costs are above the EBITDA line and do impact EBITDA.
- Risk can be operational.
- If one halves their inventory, they can also expect to reduce/halve the write-offs.
- Small Inventory write-offs are typically expensed as COGS and therefore will negatively impact the EBITDA.
- Large Inventory write-offs are typically expensed as a special expense and may or may not impact the EBITDA.
- Risk typically also accounts for insurance, theft, damage, etc. In general, these costs are operational, above the EBITDA line and will be decreased if one decreases their inventory. This does impact EBITDA positively.
In addition to above, a business will incur direct costs when as a result of better planning, they identify slow-moving and obsolete inventory. To get rid of these inventories, one might have to indulge in any of these activities. All of these impact EBITDA negatively as they are costs to the business.
- Moving or Rebalancing across locations
Conclusion: To the very specific question about whether or not the right-sizing impacts EBITDA, the answer is that it does so both positively and negatively. The overall effect should, therefore, be measured very carefully.