For small businesses, cash indeed is king. If you run out of cash, then you cannot pay your bills, cannot get suppliers to ship you goods, and cannot continue running the business effectively. If you are in the retail business (whether e-commerce, or brick and mortar), an often overlooked, but a very important cash hog is the inventory in your warehouse.
Too much inventory in your warehouse means that you have too much of cash tied up in the warehouse shelves. If you can somehow reduce the amount of inventory in your warehouse, that reduction directly translates into free cash that you can use to run other aspects of your business. And deciding how much to stock for each item is not too hard either. In this article, I will give you 4 easy tips for good inventory management.
Here are 4 questions to ask while deciding how much to stock of each item –
- How much does the item cost? (cheaper the item, the more you can stock)
- How fast are you selling the item? (faster you are selling, the more you can stock)
- How long will it take to replenish from your vendor? (the longer the replenishment lead time, the more you need to stock)
- What is the vendor’s minimum order size?
Let us review this list in detail –
If the item is cheap (e.g., pencils that cost $0.50 a piece) then there is no harm in stocking up a large quantity. Particularly if the supplier gives you discounts for ordering large quantities (batches > 1000 units). Even if you have to stock 1000 units, you are tying up only $0.50*1000 = $500.
But what if each unit costs $100 (e.g. jewelry). The more you stock, the more cash you are tying up (e.g. 200 units will cause 200*$100 = $20,000 to be tied up). That is $20,000 out of your revolving credit line (or your credit card credit limit).
However, just because an item is expensive, does not mean you shouldn’t stock it in large quantities. What if you are selling the jewelry item mentioned above at a rate of 10 units a day? So you are carrying only 200/10 = 20 days of inventory. Which may not be a bad deal at all.
For the same item, let us say it takes 30 days for you to receive a new shipment from the vendor, counting from the day you place a purchase order. Now you are in trouble. Even if you place an order today, you will receive the shipment only 30 days from now. But you have only 20 days worth of inventory in stock. So for the last 10 days, you are out of stock, and therefore you are losing 10 days worth of sales.
And finally, you should consider the vendor’s minimum order size. If the vendor requires you to order in batches of 500 units (for the jewelry item mentioned above), now you need to pony up 500*$100 = $50,000 in cash to purchase the inventory. At a rate of 10 units a day, it will take you 500/10 = 50 days to sell the inventory.
I hope these ideas explain the intuition behind deciding inventory levels. In a future article, I will explain how to use the concept of “cost of money” to make financial sense of these intuitive ideas.