The “Four-Letter Words” of Inventory | SBDC UNF

The “Four-Letter Words” of Inventory

There are a number of “four letter words” related to the ins and outs of inventory; that necessary evil of business: both loved and cursed because it represents hope for profit, enables making a sale, generates cash, but also represents a cost, and if not controlled can be lost, or at least result in a loss. To examine inventory in greater detail, read on… includes definitions of ‘inventory’ both as a noun and as a verb. Three of the noun definitions that apply to small business are:

  1. A complete listing of merchandise or stock on hand, work in progress, raw materials, finished goods on hand, etc., made each year by a business concern.
  2. The objects or items represented on such a list, as a merchant’s stock of goods.
  3. The aggregate value of a stock of goods.

The most appropriate verb definition for small business purposes is “to keep an available supply of (merchandise); stock.”

Profitable management of inventory requires both use of internal controls and effective planning. Your business needs inventory to make sales and inventory represents hope for profit (you will sell at a price above cost that leaves a margin for profit), but inventory also has a cost of acquisition and carrying, as well as represents a value that can be lost by obsolescence or theft. Inventory considerations include the following thoughts.

How much is enough? Obviously, you must have enough inventory on hand to meet customer demands. However, you should also balance lead time between reorder and delivery with your rate of sales. As your inventory is either financed or represents a cost of capital if you paid for it outright, every day it is “on the shelf” represents a cost that is reducing your potential profit. During periods of slower sales due to economic conditions or seasonal factors, you should adjust your inventory downwards to reduce costs. Similarly, in anticipation of increased sales activity you should increase inventory in order to be able to meet demand. Inventory levels should be dynamic and relate to sales activity… you should never “always have six on the shelf.” A large stock of hula-hoops and Slinky’s may have been acceptable in the 1960’s. Today they are just curiosity items. Technological obsolescence should also dictate inventory levels. Having too many older version iPhones in stock when new ones are issued can be a liability.

When is a bargain a bargain? Periodically, there are opportunities from suppliers to purchase additional stock at a discount. Paradoxically, these opportunities increase during periods of slower sales as manufacturers try to keep their production volume up.  Should you increase inventory levels during slow sales periods if you can save 12%?  What about 18%? Or 25%? You need to consider the cost of carrying the inventory.  How long will it take you to sell, what the finance or carrying cost amounts to, and how that affects your profit margin must be considered to decide if the offer is worthwhile or not.

Just how old are you? You can not manage your inventory effectively unless you can answer that question about every item it contains. Most small businesses have an accounts receivable aging, but fewer have an inventory ageing. Your inventory in total may “turn three times yearly,” but that calculation is an average. There might be items turning over 12 times and some that have been in inventory three years. At some point the carrying cost will exceed the profit margin and each additional month the item is in inventory your loss will be greater. Which leads us to…

Out with the old, in with the new! If you have inventory that is not selling, and in fact is eroding your profit margin each day it “sits on the shelf,” you need to convert it to cash as soon as possible. Cash will allow you to purchase different inventory that is turning over and generate profits. Sometimes you will have to sell inventory at a loss to do this, but the overall result will be positive. Let’s look at an example and, for simplicity, ignore inventory financing, although if considered, it will make the point greater. If your markup is 100% and you have an item that cost you ten dollars which has a price of twenty dollars, you potentially have a profit margin of ten dollars. If that item has been in inventory a year and might be there another year, you would be better off selling at “25% off” for $15. Now you will have $15 cash (I’ll ignore profit, as you may even have a loss due to inventory financing cost) which can be used to purchase three $5 items you can sell for $10 each. If those items are popular and turnover four times a year, you will make a $5 profit margin times three items times 4, or $60 in profit margin from the $10 that was tied up in non-moving inventory.

One person’s trash…  Is another person’s treasure. You will have to discount non-moving inventory to sell it, but there will always be a buyer. If you don’t want the image of your store to include discounted merchandise, you can sell unwanted inventory at flea markets, on the Internet (even as single items on eBay), or via an inventory liquidation company or off-site auction. Remember the goal is to turn non-moving inventory into cash that can be used to purchase new inventory that has a high turnover. Some other ideas are to package one-of-a-kind items into a gift basket, or to swap (barter) with another retailer in the area as what moves slowly in one type of establishment may sell in another.

Show me the money…  Inventory can be financed in a number of ways:

  • By cash purchase, in which case the cost is equal to your cost of capital (the return you could earn on the money if used in an alternative investment).
  • Floor planning, also called trust receipts, is another form of inventory financing where the loan is secured by using the firm’s inventory as collateral. Floor planning generally tracks individual inventory items and is used for higher value merchandise usually having serial numbers.
  • Blanket inventory loans are also secured by using the firm’s inventory as collateral, but only tracks inventory value.
  • Open lines of credit, which may be unsecured or secured by something other than inventory, are another financing method.
  • The lowest cost of inventory is on a consignment basis, where the vendor is paid when the item is sold. This is generally used on higher priced inventory like high value electronics, appliances, and equipment.
  • Various forms of vendor financing may include one or more of the above. Vendor terms can be considered a form of financing if they are for a period (45-60 days for example) during which the inventory is expected to turnover.
  • Now you see it, now you don’t…

Now you see it, now you don’t…  Inventory that is stolen, either by shoplifters, employees, or vendors with access to your showroom has a large negative effect on your profit. If your pre-tax profit margin is 30%, and an inventory item that cost you $50 is stolen, then you must sell another $167 of merchandise just to recover your $50 (50/.3)! If you don’t have management controls in place to deter, prevent, and monitor those losses, your business may be deemed an “easy mark” and the thefts will reoccur. Some thefts are insidious but can be deterred with management controls. Do your service personnel keep a supply of parts in their trucks? Unless you account for it against jobs and treat the truck inventory as petty cash, they may have a “side business” on weekends using parts you paid for. While not strictly an inventory issue, if you have a fleet of vehicles, do you track gas mileage of each one? While it will vary from vehicle to vehicle due to vehicle age and routes, they should all be in the same range. If all vehicles in your fleet range from 10 to 15 miles per gallon, but one gets 5 mpg, then there has to be a reason. Among them are the vehicle idles all day and the others don’t, the vehicle needs a tune-up or repair, or somebody is siphoning fuel out of it. All of those possibilities reduce your profit, and all can be corrected. You need to know!

Get an Attitude!  Think about inventory as a wasting asset. Unless you are dealing with wine or single malt scotch whiskey, inventory does not improve with time. Although it seems like one of the less dynamic or demanding aspects of your business, inventory management can actually be the lynchpin between you and profitability, so make sure you’re proactive about it.

By Dr. Phil Geist, Associate Director (West), Small Business Consultant, Florida SBDC at UNF

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