For many businesses, product inventory is their biggest asset. Effectively managing the inflow, storage, and outflow of inventory is critical to the financial success of the company. When inventory management is done right, customers can place orders with confidence, stock levels are kept at optimum levels, waste is minimized, and sales increase.
On the other hand, poor inventory strategies can result in undesirable stock levels, late deliveries, and loss of revenue. Remember that while inventory is a current asset, it is still higher risk than cash, as it may not always be possible to liquidate inventory.
What Is Inventory Management?
Inventory management involves knowing how well products sell, keeping the right number of products in stock, filling orders in an accurate and timely manner, and carefully controlling costs. Many businesses employ some form of inventory management software to help manage the process. Ideally, this should be a “perpetual” or “continual” inventory management system that tracks the movement of inventory items in real-time and continually updates the accounting system.
There are several factors involved in effective inventory management. Following are some inventory strategies CFOs use to help minimize losses and maximize profits.
How to Maintain Proper Stock Levels
Because a significant portion of the company’s assets may be tied up in inventory, it is important to have enough products in stock to fulfill orders while keeping the cost of inventory at an acceptable level.
Maintaining the right amount of product ensures the ability to fulfill orders without tying up too much working capital in inventory that may not move very soon.
When determining the amount of stock to keep on hand, look at sales projections as well as the cost of storing and maintaining inventory. Without proper tracking, inventory held on the shelf for too long can actually cause you to lose money. You can also lose money (and customers) if you don’t keep sufficient stock of high-demand products to fill your orders on time.
Many companies use one or more of the following ways to manage their stock levels:
Economic Order Quantity
There is a formula for determining ideal stock levels, known as Economic Order Quantity (EOQ). This formula has been around since its discovery by Ford W. Harris in 1913, and it is still relevant for many businesses. For a given product:
EOQ = square root of [(2 x demand x ordering costs) ÷ carrying costs]
If the math seems daunting, don’t worry – most inventory management systems will calculate it for you. The purpose is to determine the ideal amount of inventory to obtain from suppliers in order to meet peak customer demand without running out of stock or tying up too much capital.
Companies that carry a variety of products can often benefit from a technique that sorts inventoryinto three categories, based on their popularity and the cost of keeping them in inventory:
- “A” products are best-selling items that have low carrying costs.
- “B” products sell regularly but may cost more to hold in inventory.
- “C” products are those that sell more slowly and are least profitable.
An ABC analysis can help a company control its working capital costs, by showing which products should be reordered frequently and which can be restocked less often. This can optimize inventory turnover, help reduce obsolete inventory, and factor into product pricing and supplier negotiations.
This method helps companies to analyze profitability and determine which products need adjustments such as lowering costs or increasing prices. The analysis may also discover “D” or “Dead” products that don’t sell well enough to justify keeping them in inventory at all. These unprofitable products may need to be liquidated and discontinued.
Inventory that is over valued needs to be adjusted accordingly. Businesses need to carry their inventory at the lower of purchase cost or market.
Many product sales are subject to peaks and troughs, depending on such factors as the season of the year, holiday buying, or special events. Some products may take longer to obtain from suppliers at particular times. Companies need to pay attention to these trends, take note of the patterns, and adjust their inventories accordingly.
Safety stock is a quantity of surplus inventory kept on hand to prepare for peaks in demand and supply-chain lags. Without safety stock, a company may find itself unable to fulfill orders in a timely manner. This could result in loss of revenue and possibly loss of customers and market share.
However, safety stock needs to be kept to a minimum and monitored carefully, as it can lead to overstocking and tied-up capital. Observation of long-term sales patterns can help you determine when and whether to keep safety stock in inventory.
The reorder point is the optimal time to order additional stock from a supplier. This is the point where your inventory of a particular product has reached its lowest sustainable quantity. Some supply chain managers rely on their “instincts” to determine reorder points, but this can lead to unexpected stockouts when circumstances change. Other companies may find the following formula to be useful:
Reorder Point = (Average Daily Unit Sales X Average Lead Time in Days) + Safety Stock
When reorder points are correctly determined, the amount of inventory on hand can be optimized with minimal risk to fulfillment functions and profits.
It is important to periodically review vendor relationships and contracts. How well are they working? Is the vendor providing good services at good prices or is it time to consider alternatives? Is your current supply chain in line with market trends? Could more favorable vendor contract terms be negotiated? The goal should be to reduce the amount of time between when you must pay for the inventory and when you get paid for it.
What if a vendor holds a special sale? It might be beneficial to take advantage of the tempting offer and stock up. But this could also be risky if it increases carrying costs or ties up capital that is needed elsewhere. The decision of whether to accept or pass on the offer should include the following considerations:
- How soon will you be able to move the goods?
- How much it will cost to hold the inventory in stock?
- How much capital will be tied up?
- Is this a good time to stock up?
- Is this the best place to tie up capital right now?
- Are items costs anticipated to rise significantly in the short term?
- Is it known how much stock your competitors have on hand?
FIFO, LIFO and Average Cost Methods of Valuing Inventory
All three methods are U.S. GAAP (General Accepted Accounting Principles) compliant. However, only FIFO and Average Cost are accepted by IFRS (International Financial Reporting Standards).
FIFO is the most common accounting method. In most cases, you will want to use FIFO to sell the oldest inventory first and keep it rotated. For instance, if your business handles food, medicines, or other perishable goods, it is important to prevent waste and loss of income by selling the older items before they reach their expiration dates. This is less important if you sell items such as bricks or hand tools that don’t expire or go out of fashion.
For accounting purposes, FIFO values the items currently in inventory at the most recent cost. This generally gives you a relatively high inventory valuation and low cost of goods sold.
LIFO usually results in a lower inventory valuation and higher cost of goods sold (COGS). Higher COGS will reduce net income and could result in lower taxes. Although, LIFO accounting may be more complicated and again, is not acceptable internationally by the IFRS.
Average Cost looks at the weighted average of all items and continuously revalues all inventory.
Periodic cycle and/or annual physical counts should be performed to verify system inventory levels and adjust as needed.
Continual Product Line Analysis
The familiar 80/20 principle states that 20% of effort produces 80% of results. Similarly, a very small percentage of your goods provides the largest amount of revenue. Therefore, it is important to regularly evaluate your product line and watch for trends. The goal should be to revise or eliminate those products that have lower profitability (or no profitability) while maximizing the most profitable products. Of course, it is necessary to keep in mind any market and production limits.
Drop-shipping is a low-cost sales model often used by online retailers that allows them to sell products without stocking them. Typically, the wholesaler owns, stocks, and ships the products, while the retailer sets the selling price and makes the sales. The retailer forwards the orders to the supplier along with the wholesale payment and keeps the remainder as profit. The supplier fulfills the order and ships it to the customer as though it came from the retailer.
This model can be beneficial in minimizing the cost of inventory and shipping, but it also has its drawbacks. If the wholesaler doesn’t provide good service, all the blame goes to your company. Many retailers choose to regularly purchase small quantities of items and keep them in stock as a way to monitor the wholesaler’s performance and as a hedge against any issues such as the wholesaler running out of stock or shipping damaged goods.
This alternative allows the wholesaler to store product it owns with the retailer. The retailer only pays for items it sells. The retailer benefits by taking advantage of just-in-time inventory. However, this inventory takes up space in the retailors warehouse. In the addition, the retailer is typically responsible for product protection and insurance.
Successful businesses cannot afford to mismanage their inventory costs. Efficient inventory management is key to profitability and customer retention. Continual evaluation is critical to ensure proper inventory levels and maximum sales revenue. If you would like help in setting up or improving your inventory strategies, give us a call. Preferred CFO will be glad to assist.
This article was originally published in March 2021 and has was reviewed, edited, and updated in November, 2023 for content and relevance.
About the Author
David Guyaux brings over 25 years of experience as CFO, VP of Finance, and Controller roles within both public and private enterprises. He has organized finances for companies to turn around operations and meet compliance and governmental requirements, as well as to prepare for mergers and acquisitions.
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