Manage the fine line between too little and too much inventory!
It may seem obvious that too little inventory can have a very direct and negative influence on reaching potential customers. But what is less obvious is that overstock can be just as damaging to satisfying customer needs and accomplishing operational excellence. Product waste, eroding margins and cash flow commitments are three ways that excess inventory can cripple the profitability of your business:
When excess inventory or “supply” accumulates, there will be a surplus unless sales or “demand” increases proportionately. So what happens when a surplus of inventory occurs? If demand does not increase, the product will remain in a location for a longer period of time without being purchased and ultimately used by the customer.
Think about ordering 10 cases of bananas if you sell 2 cases of bananas per day. Those bananas will be sold to customers in 5 days (10/2= 5 days) and this scenario has little risk because bananas can stay fresh for longer than 5 days. However, what if you received 100 instead of just 10? There is risk here because it will take 50 days (100/2 = 50 days) to sell through the inventory and the product will be spoiled before the customers can consume the bananas.
Unfortunately, we cannot think of fresh fruit alone when thinking about product waste. Technology becoming obsolete, fashion changes and end of season are other areas where businesses must be mindful of the risks that excess inventory can hold.
Once the product is “spoiled”, it is either reduced in price, donated, returned to the original supplier or thrown away. This is not only bad for the environment but also for your business’s bottom line because further costs are being incurred rather than the revenue and ultimately profit that these goods should have been contributing to.
As mentioned above, excess inventory is when supply increases and demand does not increase proportionately. Another way to reduce excess inventory is to encourage demand to grow through the use of price reductions.
Recall the example above, the risk of having 100 cases of bananas or 50 days worth of sales is a large risk because the product will most likely spoil in 15 days, and will need to be thrown away. In this example, the worst case scenario is to throw away the goods since $0.00 revenue will be made for the purchase of the inventory. It may be worth while to reduce the price of the goods from $2.00 per case to $0.50 per case in an effort to increase the demand from 2 cases per day to at least 10 cases per day (100/10 = 10 day). This way, the business can sell through the inventory and generate revenue greater than the cost of throwing the product away.
In this example, the business owner is making much less money on these goods since at regular price they would have added $200 of revenue to the business (100 cases * $2.00 each). However, with the price reduction they will bring in $50 of revenue (100 * $0.50 each).
Margin or “profit margin” is the difference between the cost the business owner paid the farmer for the Bananas and what the business owner eventually sold the bananas. So if the farmer paid $0.30 per case for the bananas, at full price the business owner is making $1.70 per case of bananas ($2.00 per case sold - $0.30 per case bought). However, after the necessary price reduction the business owner is only making $0.20 per case ($0.50 per case sold - $0.30 per case bought).
Effective inventory management is necessary because it allows business owners to earn margins on the full price of items rather than needing to reduce the price of goods to sell through surplus inventory. This increases profitability because business owners earn larger margins on items sold.
Improve Cash Flow
This area is a bit more abstract because it is less tangible than imagining rotten bananas, or sending a rack of clothing back to the manufacturer. Cash Flow is an accounting term that seeks to monitor how much cash is available at any given point in time for the business. Managing cash flow is all about being able to “pay your bills on time” and measuring the cost of having or not having available cash.
Using an extreme example, your business could be making $1000 per month with costs as little as $100 but if your business pays bills today, and the $1000 comes in next week, you have $0.00 cash and cannot “pay your bills on time”. This is a very basic example and cash flow management is arguably the most important part of running a business.
Consider our banana example above, the business owner purchased 100 cases of bananas from a farmer at $0.30 each upfront. Let’s say that since the farmer sells 2 cases per day, the business owner only needed 14 cases because the farmer visits the retail store every 7 days (2 cases per day, 7 day intervals = 14 cases sold during the delivery interval). However, in our example below the business owner received 100 cases, or 86 cases of surplus. Not only does this excess stock have a risk of waste and an associated risk of margin reduction but it also has cash flow implications.
The farmer bought 86 extra cases of bananas today for a total cost of $25.80 (86 cases x $0.30 each) which is a poor use of cash because the bananas are not needed immediately. A rule of thumb is that delaying expenses as long as possible (without penalty) is always best for cash flow because cash can earn interest while it is in your possession. So what is the cost of incurring an expense of $25.80 much earlier than required? It is the cost of not being able to invest that money elsewhere, most companies use a minimum rate of return that they could earn in a bank, let’s say 6% per year.
- Interest is 6% per year, or 0.12% per week (0.06 / 52 weeks)
- 86 cases was bought 43 days too early (86 cases / 2 cases per day)
- 43 days is equal to 6.14 weeks (43 days / 7 days per week)
- Using this formula: cost * (1+rate of return) number of periods
- The formula becomes $25.80 (1.0015) 6.14
- The total becomes $25.98, meaning that the interest on these goods would have earned $0.18 over the 6 week period if it were invested elsewhere
- NOTE: To simplify, I have assumed that the entire shipment will last 50 days
The example above may seem like a small implication to profitability, but consider the cash flow implications of 200 excess TVs at $500 each and the cash flow opportunity is much greater.
By managing excess inventory, a company can limit the amount of goods wasted, earn the highest possible margins on inventory and ensure that they are making the most of their available cash.