SOUTHERN TORO DISTRIBUTOR, INC.
Teaching Notes
1
Synopsis and Purpose
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.
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 the Southern Toro
distributorship for both 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 2013, 2014, and 2015.
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 2015. 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. How can they continue to operate a business
that only returns less than 5% on new worth (owner’s equity) and the return on assets is less
than 3%?
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
SOUTHERN TORO DISTRIBUTOR, INC.
Teaching Notes
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 2013 to 2014, sales declined 10.3% while ending inventory was reduced only 3.2%.
Between FY 2014 and 2015, 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 2014. In FY 2015, an abnormally dry year, the company “stocked out of
most goods” yet had ending inventories of $1,000,000 in June of 2015.
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
inappropriate.
Development of an appropriate inventory system for Southern Toro must begin by examining
SOUTHERN TORO DISTRIBUTOR, INC.
Teaching Notes
3
Order Placement
Coverage Until
Order Period + Lead Time
October 15-30
May and June
7-8 months
February 15-30
August and September
6-7 months
June 15-30
December and January
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 2015 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,
4
SOUTHERN TORO DISTRIBUTOR, INC.
Teaching Notes
5
EXHIBIT TN-1
Financial Ratios
Ratio
2013
2014
2015
Liquidity
Current:
4.87
3.54
2.26
Quick:
2.14
1.82
.88
Leverage
Debt to Equity
.49
.59
.98
Activity
Inventory Turnover:
4.5
4.5
3.2
Day’s Receivables:
44 days
62 days
54 days
Total Asset Turnover:
3.33
2.83
2.80
Profitability
Return on Assets: (ROA)
.033
.025
.023
Return on Net Worth:
.049
.040
.046
SOUTHERN TORO DISTRIBUTOR, INC.
Teaching Notes
EXHIBIT TN-2
An ABC Analysis
FY 2015
Item
Class
% Sales
in Inventory
Product Description
$ Sales
% Sales
Free Controllers Series 150–4+8
15
2
C
80
Customer 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/angle 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
Total
$ 950
100