CASE Linking Turns to Mountain Margin

This case is designed to let students explore the relationship between inventory turns and gross margin. In short, the higher a product$$s inventory turns, the less time it spends in inventory, so the less inventory holding costs it accumulates, which means it requires a smaller gross margin to be profitable. Through this analysis the student can better understand the connection between a firm$$s inventory and its overall profitability. Furthermore, the case illustrates that firms can differ in their operating strategies $$ there isn$$t a $$one size fits all$.$

Q$1.$ The first question merely asks if there is a pattern between turns and gross margin. Excluding Ace Hardware and Whole Foods, the pattern is clear $$ higher inventory turns is associated with lower gross margin.

Q$2.$ To get students to understand why there might be that relationship, ask them what it means to have higher inventory turns. Given that $...$

Turns $=$ R $/$ I $=1/$ T

higher turns means lower T$,$ i$.$e$.,$ a product that has a higher turns spends less time in the process.

Next ask the students why spending less time in the process might be related to profitability. It means less time with the capital tied up in inventory, less time spending money on rent to store the inventory and less risk of obsolescence, among other benefits. So in summary $...$

Higher turns $->$ Lower inventory related costs

The other key cost for an item is the cost to purchase it from a supplier. So the total cost of an item is

Purchase cost $+$ Inventory costs

Now ask to clarify what gross margin is$.$ It is the markup on the purchase cost that determines the selling price. So the difference between the selling price and the purchase cost increases as the gross margin increases. That difference is called gross profit. And that gross profit needs to be greater than inventory costs for the firm to make a final profit. Hence, a smaller gross margin is needed to be profitable if inventory costs are smaller, which occurs, all else being equal, when turns are higher.

Q$3.$ Ace Hardware has low turns and low gross margin. How can they survive if low turns means a product spends a long time in inventory, thereby accumulating inventory costs? The answer must be that the cost of holding inventory per unit of time is not as high for Ace Hardware as it would be for other retailers. For example, if their stores are not in locations with high rents, then the cost of storage might not be high for them. Or$,$ Ace might only stock items that don$$t face perishability or obsolescence. Given that they are a hardware store like Home Depot and Lowes, this is unlikely to be the explanation. Similarly, they might have a lower opportunity cost of capital, but again, this is not likely. The best explanation is probably the lower cost of rent means that they don$$t need as large a gross margin to remain profitable.