How to Find The Right Amount of Inventory to Carry (and Why it Matters)

October 31, 2022

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For any small business making its money by selling a product, there’s a sweet spot to be found in inventory management. You want to carry enough product to meet customer demand, but you don’t want to have too much of your cash flow tied up in excess product you’re unable to move.

“It is not an exact science,” says Kris Graham. Graham runs Crafted Solutions, a small business based out of Golden, Colorado offering bottles, closures, barware, labels, and marketing materials for distilleries, breweries, and pubs. Graham says that proper inventory control is a mix of calculation, intuition, opportunity, and luck. So read on to learn more about simple calculations you can do to help ensure you’ve got enough inventory and a few things to keep in mind as you think about keeping your supplies at the right level.

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Maximizing income as a retail small business means selling as much as possible. If that was the only factor involved in inventory management, small business owners could just keep inventory levels as high as possible at all times and never worry about running out. As Graham says, “With unlimited cash, you wouldn’t have to worry about anything. You could have all the inventory you need.”

That, unfortunately, is not the reality of the world. Excess inventory can create several serious problems for small business owners.

  • Loss of perishable product. If you run a company that sells perishable products like food, nutritional supplements, tobacco or cannabis products, alcohol, or medicine, overstocking can lead to product loss if that product goes past its expiration date without being sold.

  • Storage costs. If your product takes up much space, storing excess inventory can be very expensive. If you’re selling something tiny, like jewelry or greeting cards, you likely can keep storage space to a minimum. But overstocking large products like appliances, furniture, or sporting goods can require huge amounts of warehouse space.

  • Cash flow disruptions. Graham calls cash flow management the single biggest challenge in inventory management. “It’s a balance of consistently bringing in enough items while looking forward to make sure you’ve got enough cash,” he says. Having stock to sell is important. So too are rent, wages, debt payments, equipment repairs, and working capital in general. If too much of your funds are wrapped up in extra inventory, you’ve limited your company’s ability to do anything else. In fact, Alternatively, the problems with insufficient stock levels are obvious: you won’t have enough inventory to sell anything to your customers.

Both you and your suppliers have what’s known as lead time, which is the time between receiving a purchase order and that order getting in the hands of the customer. Insufficient inventory means making frequent orders from suppliers. And if the supplier lead time is excessive, your customers will be stuck waiting, leading to an unsatisfying experience.

Finding Your Inventory Turnover Rate

One common and helpful way to determine how much inventory you’ll need on a year-by-year basis is using inventory turnover rate. It’s a simple calculation that will show you how long it takes for your company to go through all of its average inventory.

COGS: Cost of Goods Sold

To calculate inventory turnover ratio, first find your cost of goods sold, or COGS. That’s a separate calculation and can be done over the course of a week, month, year… any time period you’d like. You’ll add up the total cost of your inventory at the beginning of the period, add the cost of any additional inventory you’ve purchased during that period, and subtract the cost of inventory that remains at the end of the period. In theory, any inventory that was present at the beginning of this period or purchased during the period but is no longer present at the end was sold. The equation looks like this:

(Beginning Inventory Value + Cost of Inventory Purchased – Remaining Inventory Value) = COGS.

Let’s say you run a business selling t-shirts. At the beginning of a given month, you’ve got $300 worth of t-shirts. During that month, you purchase an additional $600 in t-shirts, and at the end of the month, you’ve got $150 worth of shirts. Your COGS equation would look like this: ($300 + $600 – $150) = $750.

Average Inventory

Next, you can calculate the value of your company’s average amount of inventory over that same period. Add the value of inventory at the beginning of the period and the value of inventory at the end of the period and divide by two. For the above t-shirt company, that’d be ($300 + $150)/2, or $225.

Inventory Turnover

To calculate inventory turnover, you then divide COGS by your average inventory. This number is also known as inventory turns, or how many times in that given time period the company will completely sell out its inventory. For the t-shirt company, that’d be $750 divided by $225, or 3.33. When you divide the length of the period for which this was calculated by the inventory turnover rate, you find the number of days it takes to cycle through the company’s entire inventory. In this case, our t-shirt company cycles through its full inventory every 31/3.33, or 9.3 days.

What That Means

Inventory turnover rate isn’t the be-all-end-all of inventory management, but it does give a helpful indication of whether your company is holding too much or too little inventory. In our t-shirt company example, cycling through their entire inventory in a little over 9 days means that they’re cycling through their inventory about 40 times a year. They should almost certainly look into carrying additional inventory, as a supply chain disruption or large orders from a customer will likely render them unable to fill orders. According to Oracle, the ideal turnover ratio in most industries is between 5 and 10. That ideal ratio means the company replaces its full industry a little over once a month, not every nine days like our t-shirt company.

The ideal number of turnovers per year will depend on your product and your industry. If your business is involved with perishable items like flowers, food, or medicine, you’ll want to have a higher turnover rate than our t-shirt company, as t-shirts do not expire.

How To Fix Improper Inventory

If you’ve looked at your inventory turnover and decided that you’re either too light or too heavy on inventory, there are a few things you can do to fix the issue and restore balance.

  • Hustle. Kris Graham says that when he finds himself with too much inventory, the best thing he can do is put his head down. “You have to get on the phone,” he says. “You have to make cold calls. Reach out to new clients. Old clients. This is where the rubber meets the road. Hammer the emails, and try to sell quickly.” Expanding your reach when you’ve got excess means freeing up cash flow and storage space.

  • Run a discount. While markdowns aren’t ideal, as the lower price will take dollars off your bottom line, offering a limited-time discount is a great way to clear out some inventory and free up capital. A word of caution from Graham here, though. “When you do sales, you sometimes see a sales increase,” he says. “But it’s almost always followed by a dip when the price goes back to normal.” You may find that your new customers who were so enamored with a sale price are now put off by your normal rates.

  • Work with distributors. If you find your company reordering inventory too often, like our t-shirt company above, you might want to consider working with your suppliers to find a better system for making your orders. Can you buy in a slightly higher volume to secure a discount while not veering so far into overstocking that you end up with the opposite issue?

  • Use inventory management software. Graham says inventory software is one of the top ways to tackle inventory and cash flow management issues. This software can be built into your point-of-sale system or be a separate tool. The best inventory software products can track sales in real-time against your inventory, generate metrics to help forecast sales and inventory needs, and ensure that you’ve always got sufficient product.

  • Try drop shipping. Drop shipping is an e-commerce strategy that takes inventory out of the equation altogether. Drop shipping companies receive orders from customers and then immediately pass that order along to the supplier, who ships it to the customer. There are obvious upsides to this strategy, but a few drawbacks as well, including the fact that drop ship companies give up control of inventory in exchange for the simplicity of having the suppliers handle it.

  • Work with mentors and peers. During his time running Crafted Solutions, Kris Graham says he’s faced several moments of high inventory and low inventory alike. And when those situations arose, he reached out to friends and mentors who’d been there before. By keeping friendly relationships with competitors of various sizes, Graham is able to reach out when he needs some extra stock and be there when his competitors do too. “Don’t burn bridges,” he says. “Just because you know somebody’s in a bind, that’s never the right time to take advantage of someone… People remember that.”

Closing Thought

A good inventory management system helps ensure that cash isn’t being tied up in items that aren’t being sold, that your company’s got enough to sell to customers, and that you’re maximizing profits. Finding the right balance between turnover and supply is one of the hardest parts of running a small business, so take care to use all available resources to achieve that appropriate level.

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