Inventory. What's the first thing that comes to mind when reading that word? For a banker or insurance agent, it probably doesn't have much consequence. To goods producers manufacturing, mining, agriculture, and construction inventory represents a significant investment. For wholesale, retail and distribution, it represents the lion's share of current assets on the balance sheet. The importance of effective product management is directly proportional to its relative value in your business.
Inventory management, or control, is the attempt to balance the requirement to have merchandise available for sale with the need to minimize the costs of purchasing and holding it. A key management principle is to know exactly how much capital your business has invested in inventory. Then, constantly reassess whether the amount continues to be a beneficial investment or if it is unnecessarily risking future business and negatively impacting cash flow. Finding the right balance between the stock of goods and consumer demand is speculative, but arming yourself with as much information as possible can help you strategize. Inventory ratios can provide you with key information and help reduce the guesswork.
Inventory turnover ratios
The inventory turnover ratio is one of the most important financial measures. It both evaluates the efficiency in managing and selling merchandise and gauges its liquidity. It also helps determine how to increase sales through more effective control. The calculation shown below uses the beginning inventory and ending inventory divided by two to arrive at the average inventory amount:
Cost of Goods Sold/Average Inventory
Generally, a high ratio means that the company is efficiently managing and selling its products. The faster the supply of goods sells the fewer funds the company has tied up in it. However, companies have to be careful if they have a high inventory turnover ratio in order to prevent stock shortages that can result in dissatisfied customers and lost sales.
Conversely, if a company has a low turnover ratio, there is the risk of holding obsolete, difficult-to-sell items, which will eat into profits. However, a company may be holding a substantial supply of stock for legitimate reasons. Therefore, it is important for a business owner to not only understand whether the inventory turnover ratio is high or low, but also why it is at that level. In order to do that, it is essential to use data such as time series (trend) or industry data for comparison and to determine what portion of the stock on hand is most productive.
Inventory carrying costs
In addition to the purchase of the product itself, there are other tangible costs, known as carrying costs, which include:
* Set-up costs
* Storage
* Insurance
* Damage
* Inventory taxes
The carrying cost percentage, shown below, is used to determine the cost to maintain a stock of goods:
Carrying costs/Average inventory value
The longer the merchandise sits in your warehouse or store, the greater the drain on your cash flow. The result of this calculation is usually expressed as a percentage of each dollar that will be spent on inventory overhead each period. Expert opinions vary on what this rule-of-thumb should be and range from as little as 15 percent to 35 percent. Obviously, the lower the ratio, the less you are expending to stock products.
Many small business owners fail to properly account for and plan for other intangible costs that are less obvious and thus, more difficult to quantify, including:
* Administrative purchasing and order approval
* Obsolete goods
* Inventory shortages
* Production inefficiencies
* Opportunity costs
It is critical to determine when items can no longer be sold and need to be written off as obsolete. Product shortage costs can include lost revenue and customer goodwill. But of all of these, opportunity costs may be the most overlooked, while at the same time being the most significant to management strategy. If the business' cash isn't spent on inventory, where else in your operations might the cash be better utilized to create profit? Simply put, your merchandise should be making money, not costing more than it generates.
Why then, would a business choose to carry what would appear to be excess products if it costs so much? Some legitimate reasons include the desire to:
* Meet customer demand
* Protect against operational interruptions
* Allow for lead time
* Provide a hedge against price increases and inflation
* Take advantage of quantity discounts
Manage to optimize inventory, maximize the bottom line
To take as much guesswork as possible out of your inventory strategy, consider budgeting based upon different scenarios. Create three budgets: one with an aggressive forecast for sales increases; another using more conservative assumptions; and a third with worst-case scenarios. Most businesses currently exist in an environment where potential demand is difficult to forecast. Your top consideration should be the effect of increased costs on cash flow, a critical issue when demand increases, since your needs for working capital will also rise.
Budgeting season is also the perfect time to scrutinize vendor relationships. Your suppliers are mapping out their expectations for the next year; you can help them by providing your outlook. Share your financial plan and the variety of situations you might face to see whether they can handle each level of demand, or if you need to find additional, or different, suppliers. Relying on one provider for key products is chancy at best. Many businesses fail because they couldn't meet consumer demand. There's no good reason to join those ranks if you plan ahead properly and ensure you maximize your inventory efficiency.
Summary
By regularly analyzing a few key metrics to understand if you have the right merchandise at the optimum levels, employing budget planning techniques, and partnering with your major vendors, you can protect and maximize the profit potential of your inventory, one of your most significant and valuable business investments.
Teresa Martin is the principal of The Profitability Solution, a business consulting firm that specializes in improving finances, operations, HR and systems. Contact her at Teresa@tp-s.com or 775-825-1568.
