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Home>Business Resource Center >Financial Articles >Taxes and Accounting

Managing Inventory

If you sell or make products, inventory is critical – after all, without inventory, what do you have to sell? While some businesses serve as affiliate for companies by taking orders and passing those orders on to a distribution facility for fulfillment – thus allowing the affiliate to stock no inventory – most companies need at least some amount of inventory to ensure products are readily available.

The problem is determining the correct inventory levels. If too little inventory is on hand, delays and even lost sales could result, creating customer frustration. If too much inventory is on hand, costs are high, including:

• Interest on purchased finished products or materials
• Storage
• Handling
• Damage or loss
• Obsolescence or spoilage

The goal is to manage inventory effectively to ensure quick turnaround, minimize cost, and maximize customer satisfaction. Determining the right inventory levels is based on the following considerations:

Lead Times

Lead times are a major factor. Some products sell quickly. Some materials are used more frequently in production processes. Not all products and materials are used at the same rate, and not all can be replenished at the same rate.

The first steps in managing inventory is to determine the frequency of sale or use and then the amount of time typically required to replenish the item in question. In simple terms: How many of these do I sell a month, and how long does it take me to get more? Creating an effective balance is critical to maintaining sales and operations while minimizing inventory costs.

Useful Buffers

Buffers can be the difference between smooth operations and grinding to a halt when products or materials are not on hand. Even though past history and future sales and production forecasts can help indicate optimum inventory levels, most businesses create an additional buffer to handle short-term spikes in activity. The amount of buffer that makes sense depends on the business; 5% additional inventory could be enough for all but the most unexpected of circumstances. The key is to balance the cost of the buffer with the cost (and potential frequency) of needing the buffer. If an item costs $5,000, and a supplier can deliver that item in two days, maintaining a buffer may be more costly than it is worth. If a business is based on volume sales of a commodity item, then a larger buffer may make sense so that no sales will be lost due to lack of inventory.

Minimum Requirements

An effective inventory management system includes, at a minimum:

• Identifying and sourcing reputable suppliers who can deliver on time and in quantities needed
• Pre-established stock levels
• Period reviews to adapt to changes in production capacity, sales trends, and market forces
• Triggers to signal purchases or purchase delays when item or material price levels rise or fall dramatically

Ways to Reduce Inventory Costs

Then take inventory management efforts to the next level:

• Ask suppliers for help. Many suppliers will manage inventory, create just-in-time systems, and even provide items and materials on consignment, only charging when inventory is sold or used.
• Create best practices and apply those techniques across the supply chain. Multi-location companies often use localized inventory management practices; adopting the best methods for inventory control not only streamlines and standardizes processes but also reduces costs.
• Adapt operating practices to inventory goals. Producing large quantities of work in progress (WIP) goods increases raw material and work in progress inventory levels. Adjusting production schedules so that WIP is reduced saves on total inventory costs and may also increase productivity if items are "handled" less frequently.
• Dispose of obsolete stock. Often unused products or materials sit for years simply because it "feels" wrong to throw it away. Sell at a discount or even discard obsolete stock; doing so reduces cost over the long term and frees up space for productive inventory.
• Reduce review time. Some companies take a physical inventory once a month and then place orders based on that inventory. As a result, they may be forced to maintain higher stock levels because the long review time lengthens the lead time for acquiring new product. A shorter inventory review cycle creates faster order cycle times and typically reduces the level of inventory needed on hand.
• Optimize ordering processes. Purchase orders that take days to wind through a company's bureaucracy increase order lead times. To maintain control and also speed the process, consider setting order "limits" that do not require multiple management approvals; that way cycle times can be shorter while still maintaining tight financial and management control over the purchasing process.
• Analyze customer needs. Some customers, for example those in the construction business, do not need the materials for an entire order to be available when the order is placed. If customers use the product over time, delivering a portion of the order immediately and the remainder at a time in the future could allow for less total inventory to be kept on hand. The key, of course, is to ensure the lead time for ordering and receiving additional material is short enough to meet customer requirements.
• Make inventory management a key performance indicator. Most people work hard to achieve their goals. When inventory management is a key performance indicator for an entire department or company, employees will be less likely to sacrifice smart inventory control strategies in favor of more "personal" goals, like achieving productivity targets at the expense of creating excess finished goods inventory.

What is the bottom line where inventory management is concerned? The fewer materials or finished goods in inventory, the lower the cash demands. To improve cash flow, optimize inventory levels and dramatically reduce the cost of excess.

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