A business owners understandably want to leverage every possible advantage over their competitors. Often, this means leveraging cash to make investments in a sales team, product innovation, or a new marketing plan. For businesses that carry inventory, they know that a significant amount of investment must be made to keep products on hand. That is why inventory management is so important. Without inventory management, a small business will find it hard to keep capital on hand for such investments.
Successful companies need to perform a balancing act when managing inventory. Too much inventory can result in cash shortages. If you don’t have enough inventory, it could mean that you’re missing out on sales. Choosing how much inventory to have on hand at a certain time can be difficult. Without understanding basic inventory management concepts.
Inventory is one of the most important aspects in business management. Demand for inventory management software has nearly doubled in the past 5 years. Without it, you can’t operate your business effectively. Learn how to take control of it in this article.
Why care about inventory management?
How important is inventory management? By reducing supply chain costs from 9% to 4% a small business can double profits.
How should you optimize the amount of inventory you have on hand? Your inventory is a huge investment of your businesses’ resources. Inventory is a culprit of “tying up cash,” meaning that it represents money you can’t use elsewhere in your business.
Best practices say that you shouldn’t have too much inventory on hand, or else you won’t be able to make other kinds of investments. Alternatively, inventory spoilage is another pitfall to avoid. Excess inventory going to waste costs small businesses significant money every year.
Your inventory directly relates to sales, too. For example, businesses that carry too little inventory can have products being out of stock and missed sales. Similarly, too-little inventory can also result in frequent re-ordering, which may have significant costs.
The data behind determining your inventory sweet spot
Small businesses’ need to determine the “sweet spot” for the amount of inventory they keep on hand. This is where an owner is both not tying up money and not missing out on potential sales. How is this done? Inventory management is a surprisingly complex subject. Let’s discuss a few brief terms and concepts.
Inventory turnover
How many times each year are you selling through your inventory? Inventory turnover is the number of times a business goes through their entire inventory in a certain time period. To calculate inventory turnover, you divide total costs of goods sold (COGS), by the total cost of its inventory. The result is the amount of times inventory turns over in the given period.
Too much inventory turnover is a sign that a business isn’t keeping enough inventory on hand. Alternatively, too little turnover is a sign they are keeping too much. Industry benchmarks are extremely helpful here to use as a starting point to determine the optimal turnover.
Lead time
There are several different lead times a business owner should be aware of. Lead time is the amount of time it takes for inventory to be ordered, processed, and ready for use by a business.
There are two types of lead time: supplier lead time and internal lead time. Supplier lead time refers to the number of days it takes for inventory to be delivered and usable after an order is placed. Internal lead time refers to the number of days spent on inventory after it has arrived, in processes like quality control or inspection.
Lead time is important because it will affect the ordering schedule of a business. For instance, you will want to know, that a large inventory order may not arrive for a few weeks, as that will determine how you schedule ordering and manage inventory already on hand.
Safety stock
Safety stock is the minimum amount of inventory a business keeps on hand at all times. For instance, a food manufacturer might want to keep an amount of extra honey on hand in case a certain supplier has an unexpected problem.
By analyzing trends in data, owners can determine what is an appropriate amount of safety stock. Safety stock can also be a moving target. For instance, a manufacturer might see that, for the past few years, demand for one of its products has gone up significantly in the summer. Therefore, they could then plan to have more safety stock on-hand during that time.
Days Sales of Inventory (DSI)
A businesses’ DSI is the time it takes to cycle through its inventory expressed in a number of days. To calculate it, divide the number of days in a year (365) by the inventory turnover rate for the business.
DSI helps business owners by providing a concrete timeframe for inventory turnover. For example, if an owner knows inventory will be depleted in 54 days, it would help an owner know when to schedule their next inventory order. This will ensure that there aren’t gaps in product availability.
Putting the numbers in practice
How do these terms and formulas apply to the real world of business ownership, and are they really relevant to small business owners?
Imagine, as an example, a business owner named John, who owns a food manufacturing business. John wants to determine the optimal amount of inventory to have on hand at any given time. In order to do this, he calculates his inventory turnover rate.
John’s cost of goods and services is $50,000 for the period and the cost of his inventory is $30,000. Therefore, his inventory turnover rate is 1.5. But, John finds, the average turnover rate in the food manufacturing industry is much higher than this, at about a 7 or an 8. So, John’s inventory is turning over far too slowly, and this means he is keeping too much inventory on hand. The cash flow of John’s business is likely tied up in inventory, which may be causing issues elsewhere in the business.
This is, of course, a simplified example, and only takes into account one kind of inventory management ratio. Nevertheless, it can show us how important understanding terms like turnover rate can be, since they help us find the most profitable amount of inventory to keep on hand.
Your next steps
If the math behind inventory management seems difficult to grasp, you aren’t alone. Business owners aren’t usually accounting professionals, and analyzing data in these ways requires financial expertise.
Consider outsourcing the services of a CFO or virtual CFO to help you with inventory management. A virtual CFO is experienced in finding trends in data, understands confusing acronyms like DSI and COGS. An accounting services professional will help you find the right amount of inventory to have available. Even a short consultation with a virtual CFO, bookkeeper, or other accounting services professional can help you develop some ideas around better inventory management.
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How Krieger Analytics can help with Inventory Management
Krieger Analytics specializes in outsourcing accounting services for small businesses, from bookkeeping to virtual CFO consultations. Our background in entrapuernship and finance means we know what running a business entails. We want to meet your accounting needs without burdening you with the costs of a full-time accounting staff. We understand your position as a small business owner, because we have experience running businesses ourselves.
Have questions about anything discussed in this article, or interested in what valuable insights a CFO have for your business? Conversations are free, so don’t hesitate to reach out at [email protected]. Let us explain how our services could be the right fit for you.