Danger lurks in your inventory

20070103
Inventory has a way of growing like Topsy. The justification is usually that "if we don't have it we can't sell it", so a connection is made that translates as "the bigger the inventory we have, the more sales we'll make". If only it were so.

Carrying an unnecessary amount of stock can be a dangerous thing. If it's not properly managed it becomes the equivalent of money that's depreciating at an increasing rate and can actually drop below zero value. Be aware of the danger and don't let this situation develop.

Some businesses manage to trade quite profitably without much inventory at all. "Just in time" manufacturing processes created a whole new outlook on parts inventories that made maintaining huge stockpiles of components obsolete and saved manufacturers a lot of money. This line of thinking can be successfully applied to just about every inventory situation.

Using JIT effectively is predicated on having accurate sales forecasts and that's the basis of any inventory management strategy - knowing what the demand for a product is most likely to be period by period (say, monthly) into the time ahead, usually the next twelve months or so. Orders for components or retail items can then be placed just far enough in advance to get them there when you estimate they will be needed. The need to retain huge inventories is eliminated.

The first step in inventory management is to have your expected demand figures in place item by item since, of course, some items turn over more quickly than others and some will need to be replenished more frequently.

This sort of analysis can be very revealing. For instance, look at the age of what's in stock as well as how quickly each item turns over and the search will soon find some real opportunities to cut down on the number of items there. It's also possible to discover some items in the inventory that haven't moved for so long they're virtually obsolete. So it's not just the total value of an inventory that's important, it's what it consists of bit-by-bit.

Now look at the profit margins the business earns on each item in the inventory. Relate this to the turnover rate for each item and some surprising facts will emerge. Finding items that turn over slowly and generate low profit margins should ring a huge alarm bell that perhaps these products can be either dropped from the range or sourced from suppliers "on demand".

Inventory on its own doesn't sell itself. Certainly a business wants to be able to provide its customers with fast moving, high margin items with the least possible delay, and that's where the focus should be. In most SMEs the "80/20" law applies to the products they sell - 80% of the turnover comes from 20% of the products. It makes sense to have those 20% of products dominate your inventory and find alternative ways to handle the less important 80%.

If an organisation's inventory is made up mostly of those "80%" products it's time to do some housecleaning. All they're doing is depreciating from year to year and that capital could be better employed in selling more of the 20% products. Liquidate them and free up the capital for more productive uses. They can always be repurchased when and if required.

The desire to hold a lot of stock so as to maximise sales opportunities is a real trap. It even has a name - the "chasing the last sale" fallacy. If you usually sell 100 pieces of item x per month and you are stocking 120 "just to capture the last sale" then you have added 20% to the amount invested in inventory. Factor in the annual carrying cost of the extra inventory (often as high as 20% to 30%, depending primarily on the obsolescence risk), and that last sale is not nearly as profitable as you might think.

Always keep in mind that an inventory represents cash you can't use. It's not cash in the bank; it's cash that's been invested and which needs to generate a return as quickly as possible.

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