Inventory Management: How Much is Too Much?
When the U.S. economy slowed in 2008, many small retailers began to experience the impact on a time delay. The cheaper, fast-selling items kept selling, but the higher-priced items with less momentum sat on the shelves. Budgets tightened and the high-priced, but slow-moving items locked up cash that could have been better used to replenish the fast sellers.
With the prospect of the whole ship sinking, the option left was to jettison the high-value inventory at a lower price and free up cash for better-selling items. It was a tough lesson in inventory management, but an example of how sacrificing inventory can save a business.
Excess inventory is a simple concept since it’s defined as any inventory a retailer carries beyond what they should carry. Figuring out the should is the tricky part.
You can miss out on sales when you don’t have enough inventory on hand, but can tie up precious cash with too much.
No matter how well the economy is doing — or how well your business is performing — a critical question to ask is: Am I carrying the optimal amount of inventory?
Diligent inventory tracking and a little bit of math sheds a lot of light on how much stock you should keep on hand, helping you answer this question.
While accounting concepts such as COGS and inventory turnover rate run quite deep, a cursory understanding of inventory management will help you make more informed decisions about how much inventory you should carry to make the most of your resources.
Inventory Management Tips
Calculate Inventory Turnover Rate
First, calculate your inventory turnover rate. To do this, divide Costs of Goods Sold (COGS) by the average cost of your inventory on hand. If you finished year-end inventory last month, you should have your COGS on hand. This article explains how to calculate COGS.
For example: Consider an Amazon third party merchant whose Costs of Goods Sold was $50,000 the first year and kept $5,000 worth of inventory on hand on average. By dividing $50,000 (COGS) by $5,000 (Average Inventory), an Inventory Turnover Rate of 10 is calculated.
Use Inventory Turnover Rate as an Indicator for Inventory Management
It may help to think of this inventory turnover rate as the inventory on hand selling 10 times over during the year, even though the reality is a mix of items sell quickly and others sit on the shelf.
A low inventory turnover rate could show that a retailer is overstocking, while a high rate might suggest keeping more inventory on hand.
Calculate Inventory Turnover Days
Now that we have our merchant’s inventory turnover rate, let’s determine his inventory turnover days.
Use one year as the time period and simplify by using 360 as our number of days. If we divide 360 (time period) by the inventory turnover rate of 10, we get 36 as inventory turnover days.
This means it takes 36 days for our merchant to sell the value of her average inventory. Here, a high number can reveal slow sales and possibly too much inventory.
Use Industry Averages to Estimate Ideal inventory levels
With these numbers our merchant can use industry averages to ballpark the ideal amount of inventory to keep on hand for the upcoming year.
For the sake of example, let’s say that the industry average turnover rate for his industry was 15. Dividing our merchant’s COGS ($50,00) by 15 (industry average inventory turnover rate) gives an ideal inventory rate of $3,333.
As he’s been keeping $5,000 worth of inventory on hand instead, he may try to optimize by moving closer to $3,333 in the next year. He will want to keep less inventory on hand.
While industry averages offer direction, they shouldn’t be rigidly implemented. Each retailer can be unique and will need to track their own numbers to best inform decisions about how much inventory to keep on hand.
How to Achieve Ideal Inventory Management
Research suggests erring on the side of less inventory and higher turnover. Examining 20 years of data from large retailers, researchers found that the companies with low inventory and high turnover outperformed those with high inventory and low turnover.
While these results were gleaned from large retailers, small businesses should use this information to reflect on those items that offer a high margin when they sell, but may sit on the shelf too long.
If you’re a merchant looking toward investment, excess inventory can be a problem for investors. Professor Ananth Raman writes in the Harvard Business Review: “Retailers beware! Investors whom we’ve studied…are watching inventory closely and will increasingly penalize retailers for carrying too much inventory on their balance sheets.”
Showing an understanding of inventory management and improvement over time will be a key part of growing your business. Tracking inventory over time will provide the data you need to make decisions about how much inventory to keep on hand. While retailers learn a lot about the rhythm of sales by experience, keeping a record of your all your numbers will best inform your inventory decisions.
Guest post contributed by Stitch Labs, provider of an online application for simple inventory management, order fulfillment, invoicing, expense reporting and business analytics. With Stitch, keep track of your inventory and sales from popular sales channels such as Amazon and Shopify as well as wholesale all in one place.