The challenge of inventory management
Inventory management is a challenge for any small business. Inventory equals cash and that cash is only accessible when the inventory is sold. The longer the cash is tied up as inventory the less work it is doing for your business. Furthermore, as inventory ages the likelihood of loss, damage and obsolescence increases, along with holding costs and working capital costs.
Put simply, if you made a single purchase of £100,000 of inventory to service £200,000 of sales over a 12-month period then those sales required a 50% investment. However, if you purchased the inventory in two lots of £50,000 each time, then the investment required would be halved to 25%.
The objective of inventory management
The objective of effective inventory management is to balance supply and demand; to synchronise, as closely as possible, what inventory you purchase and when you purchase it, with what your customer wants and when they want it.
Of course, the ideal would be a perfect alignment. As your customer purchases one item, your supplier replenishes that one item immediately. Just to be clear though, this is never going to happen. There are a host of factors in every small business which work to prevent this ‘perfect’ synchronisation of supply and demand.
Factors that need to be managed
For a start, your suppliers are likely to insist on minimum order quantities. It is extremely unlikely that those minimum order quantities will reflect your customer demand patterns. If your customer wants to buy one item, and your supplier insists on a minimum order quantity of ten items, then you will end up with nine items in stock. Furthermore, there will be lead times from your suppliers which are unlikely to be consistent with the lead times your customer requires. If your customer wants something in one day, that takes you ten days to procure, then you will need to have ten days of stock. No ifs, no buts.
The science of inventory management is about balancing these external factors – supplier requirements and customer requirements – to reduce their impact on the level of cash tied up in inventory.
Here are 5 tips that all small businesses should consider when managing their inventory.
(1) Don’t measure inventory in ‘days’ supply’
Days’ supply is not a good metric for effective inventory management. Days’ supply is quite simply the number of days in the year divided by the inventory turnover ratio. This is an accounting measure and brings little value to understanding if you have an effective inventory policy.
Days’ supply does not take account of whether you have the right inventory in stock. It does not consider if the inventory held is the inventory your customer wants to buy, or if it is aged and obsolete stock that nobody wants.
It is much more useful, as a quick guide to the effectiveness of your inventory management policy, to assess the average demand for a product during the products purchase lead time. So, if it takes a 1 week lead time to purchase a product, but you have 3 months’ average demand in stock, then there’s probably an issue that you need to address.
If you want to consider how effective your inventory management policy is, you may find our article 10 Questions: How Effective is Your Inventory Management? useful.
(2) Be cautious of bulk purchase discounts
Buying more inventory than you need, to leverage a bulk purchase discount, can be risky. There are Economic Order Quantity (EOQ) calculations that you can use to assess the cost benefit of bulk purchases, however, these calculations aren’t perfect and furthermore they don’t consider the risk of obsolescence.
To test whether a bulk purchase discount is worthwhile, you should consider the cost of working capital used to make the purchase, along with the holding costs of the inventory over the length of time it will take you to sell it. Make this calculation for both the bulk purchase offer and the normal offer and compare. Finally, factor in the risk that sales for the product may decline, leaving you with obsolete stock that you can’t sell.
(3) Tightly control new product introduction
There is a tendency in many small businesses, especially start-ups, to offer huge portfolios of products and to constantly add new products on the assumption ‘they might sell’. What this often translates to is a high level of slow moving and obsolete stock and constrained cash flow.
All new product introduction should be undertaken in a controlled way, with the business case for each new product fully assessed. All small businesses should have a ‘Stage Gate’ process for new product introduction, which progressively tests the validity of introducing the product through a cross-functional review of strategic fit, costs and potential sales volumes.
Assessing potential sales volumes for a new product is obviously a challenge and you may find our article How Do You Predict Demand for a New Product? helpful.
(4) Classify the product portfolio
All products are not equal. Some of your products will generate a lot more profit than others, and consequently it is not logical to apply the same inventory policy across all products. In any small business, there will be limited working capital availability and that working capital should be aligned to get the most ‘bang for the buck’.
To ensure this happens, every product should be classed based on its performance. Performance can be measured in terms of revenue, profit, throughput and strategic value. Inventory levels should be higher, with reduced risk of ‘stock-outs’, on products that have a higher performance score. Inventory for products with a lower performance score should have lower inventory levels. Doing this ensures that working capital is focused on what is often the ‘important few’ products.
We discuss portfolio classification further in So Many Products, So Little Margin: Managing Your Product Portfolio.
(5) Continuously monitor and adjust
Customer demand patterns change and your inventory levels and product classification should also change to reflect this. For every product, there should be a comprehensive calculation of the optimal reorder points which drives the level of inventory to be held. Unless these calculations are dynamic and systems driven, you should look to revise these calculations at least quarterly, if not monthly.
As a minimum, the calculation should consider forecast demand (or historical demand), demand variance and the service levels required (or on-shelf availability). If you need support to undertake this, please read how our inventory management consultants can help and contact us today.
