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SOUTHERN TORO DISTRIBUTOR, INC.

Teaching Notes

Synopsis
This case describes a conversation between Joe Melaney, the owner
of the Toro distributorship in Galveston, Texas, and his son, Joe Jr. The
immediate subject of the conversation is to decide on the spring season
order for the entire irrigation line. In the course of the conversation, other
issues emerge, ranging from the proper inventory level for specific parts to
the future ownership of the distributorship.

Purpose
This case can be used at two levels. At the first level, the case is an
exercise in the development of an effective system for managing
independent demand inventory, taking into account the particular problems
faced by a distributorship. At the second level, the case can be used to
demonstrate the importance of inventory management as a policy variable.
Since Southern Toro is a distributorship, profitability depends heavily on
inventory management.
Discussion Questions
1. What would you recommend that Joe Jr. do, assuming he takes
control of Southern Toro?
2. Evaluate the importance of inventory and inventory management of
Southern Toro Distributorship, both for irrigation products and spare
parts. Should the inventory be cut back?
3. Evaluate the current inventory management system at Southern Toro.
What inventory management system would you recommend?

Analysis
Joe Jr.'s course of action if he takes control of Southern Toro
certainly depends on a financial analysis of the company. Exhibit TN-1
shows some of the common financial ratios for the fiscal years 2000, 2001
and 2002.
Southern Toro Distributorship has been steadily increasing in net
worth over these years but the return on invested capital has been low.
Furthermore, the future outlook is potentially disturbing. As Exhibit TN-1
shows, the distributorship is highly leveraged, with a sharp increase in
2002. This will increase the cost of any future financing. Liquidity is
decreasing, particularly quick liquidity, suggesting that the company may
be forced to seek additional financing unless other action is taken. The
company's activity is decreasing also; this is particularly noticeable in
inventory turnover. As might be expected, the ROA of the distributorship,
never very high, has been steadily declining over the last three years.
The return may be improved with better management, but will
probably never become extremely high. It is for Joe Jr. to decide whether
or not the return can be enough to satisfy him. However, based on the
above analysis, it appears that the distributorship is likely to encounter
difficulties if present trends are allowed to continue. Since the sale of
irrigation equipment is heavily dependent on the weather, the company
must plan to be flexible to accommodate irregular sales patterns. Liquidity,
particularly quick liquidity, must be re-established and maintained to
ensure Southern Toro's ability to pay off its short-term obligations without
relying on the sales of inventories.
Future plans for Southern Toro must be based on good inventory
management. The majority of Southern Toro's assets are in inventory, yet
inventory levels do not reflect sales levels. From FY 2000 to 2001, sales
declined 10.3% while ending inventory was reduced only 3.2%. Between
FY 2001 and 2002, sales increased 20%, but ending inventory increased by
67%. This was an increase of $400,000 in ending inventory. It was
necessary to increase notes payable by $371,000 to finance this increase.
Inventories need to be reduced to improve the turnover ratio and to increase
liquidity once again.
A rough idea of the amount of inventory required to support this
business can be calculated by using the relationship:
average inventory = Q/2 + safety stock
where Q is the order size
In this case the order size (Q) will be four months of sales, since orders are
placed three times a year. The average inventory will therefore be 2
months + safety stock. If there is no safety stock, the inventory will turn
12/2 = 6 times per year. Safety stock will merely reduce this turn rate. For
example, one month of safety stock results in 4 turns.
Since the current turns are 4.0, it is clear that it will be difficult to
reduce inventories while meeting current demand, lead time, and safety
stock assumptions -- the most critical constraint being the supply lead time
imposed by Toro. The Southern Toro Distributorship must seek to reduce
this supply lead time or seek additional sources of funds, preferably from
Toro in the form of notes or accounts payable to support larger inventories.
Assuming this can be done, we turn to the next problem of designing an
inventory control system.
The new inventory computer system does not appear to be
successful. The system was installed in October of 2001. In FY 2002, an
abnormally dry year, the company "stocked out of most goods" yet had
ending inventories of $1,000,000 in June of 2002.
The software package, as described, is completely unsuited to
Southern Toro's situation. The following points should be raised:
(1) Southern Toro has three preset ordering and delivery times
each year. A reorder point for each item is therefore
inappropriate.
(2) Southern Toro must order at the set times sufficient inventory
to last until the next period's delivery. An EOQ is irrelevant.
(3) Demand for irrigation equipment is seasonal. A forecast of
usage based on average monthly demand is insufficient.
(4) Large turf orders, from golf courses and other commercial
installations, cause irregular demand "peaks". A mechanical
forecast of the affected products is inappropriate.
Development of an appropriate inventory system for Southern Toro
must begin by examining the specific circumstances. There are three
separate ordering cycles each year. Although the periods and lead times are
irregular, sufficient inventory must be ordered to cover the order period
plus the lead time. Based on Exhibit 6 of the case, the following coverage
times can be determined:
Order Period
Order Placement Coverage Until Plus Lead Time
Oct. 15 - Oct. 30 May and June 7 - 8 months
Feb. 15 - Feb. 30 August and Sept. 6 - 7 months
June 15 - June 30 December and Jan. 6 - 7 months
For the approaching October order, demand must be forecast for the
period until May and June, when February's orders will be received. It may
be appropriate to adjust the forecast based on weather predictions for the
period. The forecasts for individual items, where larger orders are
expected, may be adjusted manually.
An ABC analysis is needed to center attention on crucial inventory
items. Exhibit TN-2 shows such an analysis for the irrigation products.
The exhibit also shows the current inventory as a percentage of FY 2002
sales. As can be seen, the products are unequally stocked with stocks
ranging from 9% to 80% of sales. In general, the A and B items are less
heavily stocked than the C items. This suggests that the inventory
investment is overly weighted with C items and that the inventory turns,
with the resulting risk of stock out, primarily come from A and B items.
This is borne out by the case, where concern is shown for possible
overstock of a Monitor Controller, a C item, and possible understock of a B
item valve.
Although an exact inventory system cannot be suggested, a new
software package should be developed which is carefully tailored for
Southern Toro. The software package should be used to automatically
manage C items, both products and spare parts. A items, and to some
extent B items, should be carefully monitored and the computerized system
adjusted based on experience and knowledge.
The new system should be based on the following principles:
1. A forecast for each item should be produced from analysis of
past data. One of several different models could be used
provided that seasonal factors and trends are included in the
model. For A items, and possibly some of the critical B or C
items, the forecast should be carefully examined and adjusted,
based on marketing information available. The average
demand and standard deviation should be forecasted through
the lead time plus review period.
2. A service level should be established for A, B, and C items.
Based on the service level, forecasted average demand and
standard deviation, a target inventory level can then be
established for each item.
3. Order sizes should be determined to bring the inventory up to
the desired target levels.
4. The order sizes should be converted to dollars and the resulting
inventory levels projected on a monthly basis into the future.
The total purchasing dollars required and the future projected
inventory levels should be examined for business feasibility on
a total dollar basis. If these expenditures and inventory levels
cannot be financed or are considered excessive, then service
levels should be revised or other assumptions modified (lead
time) to achieve the total aggregate financial levels desired.
If this system is followed, it may be possible to bring the inventory
levels into overall conformance with business goals. At this point it will
become apparent how inventory levels can be reduced, liquidity improved,
and return on capital invested increased. If the desired service levels are
ultimately incompatible with investment and sales goals, then perhaps Joe
Jr. should consider looking for other business opportunities.
EXHIBIT TN-1
FINANCIAL RATIOS

Ratio 2000 2001


2002
Liquidity:
Current: current assets 4.87 3.54
2.26
current liabilities
Quick: current - inventory 2.14 1.82
.88
current liabilities
Leverage:
Debt to equity .49 .59
.98
Activity:
Inventory turnover: 4.5 4.4
4.0
Cost of Goods Sold
average inventory
Day's Receivables: 44 days 62 days
54 days
A/R x 365
sales
Total asset turnover 3.33 2.83
2.8
sales
average assets
Profitability:
Return on Assets (ROA) .03 .03
.02
net profit
total assets
Return on net worth .05 .04
.05
net profit
net worth
EXHIBIT TN-2
AN ABC ANALYSIS
FY 2002 FY 2002 Item % Sales in
Product Description $ Sales % Sales Class
Inventory
Free Controllers
Series 150 - 4 + 8 15 2 C
80
Custom Controllers
Series 123 - 8 + 11 12 1 C
67
Monitor Controllers
Series 176 - 11 + 23 26 3 C
58
3/4" + 1" Valve
Glove/angle in-line 78 8 B
59
1-1/2" + 2" Valve
Glove/angle in-line 62 7 B
10
Brass Valve
Glove/angel in-line 7 1 C
57
Pop-up Bodies 77 8 B
26
570 Series Nozzles 68 7 B
20
Stream Rotors
Series 300 144 15 A
9
Rain Pro
Series 320 26 3 C
46
Gear Driven Rotary
Series 600 22 2 C
45
Gear Driven Rotary
Series 620 39 4 C
54
Gear Driven Rotary
Series 640 194 20 A
42
Gear Driven Rotary
Series 670 180 19 A
20
TOTALS $950 100%