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What Is Channel Inventory?

Manufacturers have long used retailers to sell their goods to end customers. A manufacturer makes money by selling its products to retailers, and retailers make money when products are sold to the end customer. Here's a simplified supply chain diagram that will help explain what channel inventory is.

Graphic by the author.

The manufacturer sells its product wholesale (in large quantities) to the retailer. An example of this would be Apple selling large quantities of iPads to Target. Once the product is shipped to the retailer, the manufacturer "counts" or "recognizes" revenue for that sale (as represented by the star in the above picture). At this point, the manufacturer considers that product to be "channel inventory" because it hasn't been sold to the end customer yet. Once the product is received by the retailer, it is counted on the retailer's balance sheet as inventory.

The word "retailer" means:

a person or business that sells in small quantities for use or consumption, not for resale.

Once Target sells the iPad to the end customer, it recognizes revenue. At that point, the product is no longer counted as inventory on Target's balance sheet, and the manufacturer considers it no longer in channel inventory.

Image Source: Getty Images

Reporting channel inventory

Once the manufacturer recognizes revenue, there's not any requirement for it to report the status of that inventory, nor is it shown on the manufacturer's balance sheet. Often, manufacturers don't even have visibility to the amount of channel inventory unless retail partners communicate back to the manufacturer.

In the case where the manufacturer is also the retailer, the concept of channel inventory doesn't apply. If an iPad is sold through an Apple store, the iPad remains in Apple's inventory until it is sold to the end customer. This scenario has the advantage of real-time feedback of inventory levels throughout the entire supply chain.

Sometimes a manufacturer's management will talk about channel inventory on an earnings call. Management may refer to the weeks of inventory in the channel, which is the number of weeks it would take to sell that amount of inventory based on the rate the product has been selling in the past. This gives the investor a general idea of the inventory levels sitting on retail shelves. Other terms that might be used when talking about channel inventory are "sell-in" and "sell-through."

Sell-in versus sell-through

Sell-in is the transaction when a manufacturer sells its product to the retailer.

Sell-through is the transaction when the retailer sells the product to the end customer.

When sell-in is higher than sell-through for a specific period of time, channel inventory levels go up. This might be in the case where a retailer is getting ready for the holiday season, or when a manufacturer is launching a new product. When sell-through is higher than sell-in, channel inventory levels go down. This might be when a manufacturer is transitioning to a new product and wants to sell out of the existing product in the channel.

Because the manufacturer recognizes revenue before a product is ultimately sold to an end customer, channel inventory can be an important gauge as to how many end customers are actually buying the product (or not).

Significance of channel inventory

This section could also be titled, "what happens when things go wrong?" Generally, channel inventory levels ebb and flow with seasonality and product transitions and are usually not something that manufacturers have to focus on. But there are two cases when channel inventory really matters to a manufacturer: when a product is "supply constrained" or when a product is not selling well.

A product is supply constrained is when there is not enough supply to meet customer demand for a product. In this case, channel inventory will be low or even zero. Manufacturers and retailers don't like this situation because it frustrates customers, leaves revenue on the table, and the manufacturer will likely pay extra fees to expedite new supply of product.

In the case when a product is not selling well, channel inventory will be higher than normal. Depending on the contract terms between the manufacturer and retailer, this can lead any number outcomes, none of which are good. The retailer can mark-down the product for quicker sale or return product back to the manufacturer if permitted in the contract. The retailer may also take a further step to cancel or delay future orders until it can clear product off its shelves, which impacts the manufacturer's revenue in the future. The manufacturer can provide rebates or promotional incentives to retailers to enable them to sell the inventory. Additionally, the manufacturer could end up scrapping unsold inventory or selling it for below cost.

Having channel inventory is a normal part of a retail supply chain, but if a manufacturer brings it up on an earnings call, it is certainly something for investors to pay attention to.

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Brian Withers owns shares of Apple and Target. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.