The Delicate Balance of Inventory Management

Any business that holds and manages inventory does so with the goal of selling that inventory to produce revenue for the company. The key is to maintain just enough to meet demand but not so much as to have money tied up in inventory for a period longer than necessary. No business holding inventory desires to have more or less inventory than is needed to meet customer demand at any given time because failure to meet customer demand will negatively influence sales and profitability. These factors make inventory management one of the most significant challenges any business, but particularly a small business can encounter.

Depending on the kind of business, there can be many different types of inventory. For example, manufacturers will likely have an inventory of raw materials, work-in-progress inventory, and finished goods inventory at a minimum. A retailer might have merchandise inventory, a service business might have an inventory of hours available to resell, and a magazine or online publication might have an inventory of space that could be filled with advertisements. How each business type manages its inventory may differ, but each has the same purpose: maximizing cash flow.

Demand forecasts are an integral part of inventory management. If the business demand forecasts are incorrect, it can significantly blow cash flow. For example, if the business assumes the demand will be high, and the assumption is erroneous, it may have too much cash tied up in inventory assets, which in turn would restrict cash flow because the product on hand is not selling as predicted. Conversely, if the business predicts the demand will be low, and the assumption is incorrect, it may not have enough inventory to meet customer expectations, resulting in lost sales and, therefore, tighter cash flow.

One of the simplest ways to manage physical inventory is to measure productivity and turnover (Traster, 2007). The idea here is to determine how often during the year the business can convert its inventory assets into cash (learn more about inventory turnover and other financial ratios here). Assessing the most appropriate turnover rates is a factor in a company’s sales volume. The goal is to either turn the inventory more times over the course of the year or reduce the amount of inventory held at any given time to maximize cash availability. If money gets tight, it is smart to evaluate the slower-moving inventory and determine how price adjustments might help improve sales and increase cash flow, even if the margin on the sale is lower than desired.

Another way to manage inventory levels to maximize cash is to improve supply chain processes using a just-in-time model. For example, gaining agreement from a supplier of raw goods to hold those items necessary to produce a finished product in the warehouse but not take them into inventory until manufacturing demand requires it means raw materials are not in stock before necessary. This is one way to hold on to cash a little longer. Another approach might be to make a process change and delay the final assembly and packaging of the product until just before a customer may need the product, thereby reducing labor costs and inventory levels until the very minute (Anderson, 2010). These are only a few ways that small supply chain process modifications might reduce inventory levels and improve cash flow.

Service businesses and publishers have a slightly different problem. In these companies, fixed inventory is available, and revenue is lost when it is not used in the defined period. A consulting firm or advertising agency might have calculated its available inventory of hours by assuming that every revenue-producing person should bill (to clients) an average of 95% of his or her hours per week for the firm to be successful. Assuming a 40-hour work week and 30 minutes for lunch each day, each should bill 35.625 hours per week. If less than 35.625 hours are billed, that inventory of hours and the revenue it would have produced is lost. The firm must somehow make up that lost revenue elsewhere. Sometimes, hourly rates increase over time to help make the difference. But often, the solution means firing those who consistently underperform.

Publishers allocate and maintain an advertising space inventory within a publication for a specific time. The revenue is lost if the advertising does not sell before the publishing deadline. To offset lost revenue, the publisher might offer deep discounts on the unsold space at the last minute to improve cash flow. The publisher might also increase the inventory availability in subsequent issues in an attempt to recoup revenue lost to unsold advertising space.

Inventory management is an art and science. It requires diligence, a reliable inventory system, and designated staff to maximize cash efficiencies. While different business types have different requirements for inventory levels, all businesses must keenly understand their customer needs and market demands to forecast needs. Moreover, companies must have detailed knowledge and control of cost and production schedules to ramp up or down, depending on the demand forecast. Striking the proper balance with inventory is vital to maximizing cash flow.

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References

Anderson, L. (2010). Accelerating Cash Flow Through Supply-Chain Innovation. MWorld, 9(1), pp. 36-38.

Traster, T. (2007, May 14). 5 steps to get a grip on inventory. Crain’s New York Business, 23(20).