Why You Shouldn’t Keep Too Much Inventory On Hand
Many small business owners struggle with inventory control.
Running low on inventory is obviously bad. If you can’t meet customer demand, you’ll quickly lose customers.
But many entrepreneurs don’t realize that keeping too much inventory can be just as detrimental to a business.
Some might make the mistake of holding onto excess inventory, thinking that more is always better. But, this can cause all kinds of problems.
This article will reveal ways that overstocking can put undue stress on your business.
5 Negative Effects of Keeping Too Much Inventory
If you have too much inventory, you put excess pressure on your bottom line in a variety of ways.
Here are the five ways your excess stock is damaging your business:
- Limits cash flow
- Reduces profits
- Increases storage costs
- Heightens risk of product obsolescence
- Limits flexibility
We’ll discuss each of these points below:
1. Limits Cash Flow
The more inventory you purchase, the more money you have tied up in unsold products. This can take a significant toll on your cash flow.
To see any improvement in your cash flow, you will have to sell your inventory.
In the meantime, you may be put in a position of having to borrow money to pay bills, payroll, or other expenses to keep your business afloat. These loans will likely come with interest payments.
Not only do you lose money this way, but you could also lose out on an opportunity to advance your business due to limited cash on hand.
2. Reduced Profits
The longer your inventory sits on the shelf, the more they lose value, and the more they cost you to hold. To move these products out of your inventory faster, you will have to sell them at a reduced price.
You will earn a lower profit from these goods, and this will affect your balance sheet. When things get really desperate, you may even lose money on these products, selling them for a fraction of the cost you paid for them.
3. Increase Storage Costs
Things take up space — the more inventory you have, the more storage you need.
This begins to get expensive. Every square foot costs money in rent, electricity, and staffing (storage space must be managed in some form by an employee).
Don’t forget the cost of insurance paid on inventory to protect your investment from natural disasters or theft.
4. Heightens Risk of Product Obsolescence
As a small business owner, you see products come and go in your supply chain.
You expect your suppliers to offer you the newest and the best products to use in your business, and your customers will expect the same from you.
Since you know that your customers will always want the newest products and that it will only be a matter of time before your old products become obsolete, you will want to keep your stock levels low.
The easiest example for understanding this problem is food. If you make too many cupcakes and can’t sell them all, some of them will go bad.
But, it happens with all kinds of products — electronics, clothing, etc. They don’t rot like food, but they fall out of fashion and become outdated.
If you buy too much of one product, you may fall victim to product obsolescence. The newest model will replace the old one, and you’ll be stuck trying to get rid of it.
Once again, you’ll be forced to lower the prices of your unsold merchandise and take a cut in your profit margin.
5. Limits Flexibility
When your cash is tied up in unsold products, you may not have the funds to invest in new products.
As we already discussed, your customers will always be looking for something fresh and new, but if you have limited cash flow when a new product emerges, you won’t be able to offer these to your customers.
How Much Inventory Do You Actually Need?
Since you’ve read through the five devastating reasons not to overstock your inventory, but you know you need to have stock on hand, you may feel like you’re dealing with quite a conundrum.
Don’t worry; we want to help you learn how to manage your inventory.
To know how much inventory you should have on hand, you need to consider these three factors:
The inventory turnover rate is a huge factor in determining the amount of a particular product to keep on your shelves.
The turnover ratio is high when your products sell quickly and consistently. The higher the turnover ratio, the better.
This is, of course, what every business owner hopes for. But how do you know if your inventory turnover is high enough?
If a particular product has low turnover, the ideal average inventory would be low, as well.
Corporate Finance Institute has a great explanation of turnover rate and even gives you a free template to calculate yours.
Costs of Goods Sold
The cost of goods sold is the amount it costs to produce the goods you sell. Each item will have a unique cost of goods sold. The costs include not just the material to produce the goods but also the labor and overhead.
Products with higher costs of goods sold would require a higher turnover ratio since more of the company’s money was used to produce that item.
When accounting for costs of goods sold, there are four different ways to value this number.
The four ways are:
- Specific identification
- Weighted average
Learn more about these four ways to calculate COGS in this article.
Days of Inventory on Hand
Another term that is similar to turnover ratio is days of inventory on hand (DOH). This formula determines the rate of inventory liquidation based on the number of days your product remains in stock.
Since inventory takes up the most operational capital available to a business, efficient management is crucial to keeping cash flow at a healthy level.
This article will give you a few formulas to use to keep track of your DOH.
The Type of Products
With perishable products, it all boils down to the expiration date. In other words, many foods and medicine products don’t give you any choice on how long to keep them or when to throw them away.
If you don’t sell these products within a certain time limit, you can’t sell them — you have to get rid of them.
If you use perishable raw materials to make your products, you know how crucial timing can be.
While you always want to have enough on hand to satisfy your customers, you don’t want to overbuy any of these products and risk wasting your money because you had to throw them away.
The last factor to consider regarding inventory management is lead time. No matter how hard you try to control your inventory, sometimes the timing of replenishment is out of your hands.
You might need to order a product earlier if you know that it will take longer to receive it.
For example, you could order two products from two different suppliers and receive one way before the other. This is because Supplier A has a different lead time than Supplier B.
Knowing the lead times of your suppliers can help you make more accurate inventory orders. However, even your suppliers may be waiting on the lead time of their own suppliers, so it can be hard to gauge an exact lead time.
There are ways to get a close calculation, however. Check out how to do these calculations here.
Strategies to Keep Your Inventory Just Right
Once you’ve determined a ballpark number and timing for your inventory orders, you can use one of the strategies below to keep your average inventory at safe levels.
Efficient Inventory Management
The most obvious way to keep your business free of the negative effects of too much inventory, as well as keeping you free from stockouts, is to practice efficient inventory management.
To do this, you need to keep good records of how much you sell each quarter of each product. Feel free to use all the formulas we shared with you concerning turnover ratios, COGS, and DOH.
Keep your ear to the ground and stay updated on when specific products will be replaced by a newer model. Keeping up-to-date with the industry news stops you from buying more of the out of date products just in time.
It may be wise to consider inventory management software.
Not only does this save you time and effort, but many of these software programs provide real-time reports of inventory stock and alerts when stock is low.
Using computer software to do your calculations also cuts down on the potential for human error in your calculations.
One popular inventory management method for non-retail businesses is just-in-time (JIT) inventory.
This strategy involves refilling your stock of raw materials just in time for you to complete your orders on schedule.
To do this effectively, you need to be able to employ demand forecasting to have enough inventory on hand at every level of production.
Just-in-time management cuts down on the amount of cash flow that is used up by inventory. It also reduces the cost of storing those goods since they will be used almost immediately after receipt.
Of course, in order for this strategy to work, every step of production must go smoothly.
Any breakdown of machinery, stall in supplier lead times, or lack of workers can interrupt the efficiency of this inventory management strategy.
Anticipatory inventory management is another way to reduce the negative effects of having too much inventory.
This strategy involves using your past experience and knowledge to anticipate future demand for materials or products.
To use this type of inventory management system, you need to account for the fluctuation of demand throughout the year or season.
For example, products such as beach umbrellas, sunscreen, and water hoses will jump in demand during the summer months but will likely drop during winter.
Anticipatory inventory takes into account all the factors that are out of the normal range of turnover rates. This can help to derail any need for emergency stock by anticipating that need before it happens.
Anticipatory inventory management is good to use when you know your customer demands will not be consistent.
By adjusting your inventory with the rise and fall of customer demand, you can still keep your cost of inventory low but continue to provide your customers with the products they desire.
Here’s another article that might be helpful for you: How to Recover Lost Revenue Through Freight Audits
As you learned in this article, there are clear reasons not to keep too much inventory on hand. Granted, you wouldn’t want to be having stockouts all the time, either.
Just as a reminder, here are some ways to find your Goldilocks of inventory levels:
- Keep a close eye on your product turnover throughout the seasons
- Knowing your suppliers’ lead time well
- Use an effective inventory management strategy
Also, if you’re looking for a way to increase your cash flow, call Now!