If you’re a small business owner who sells products, you’ve probably wondered, “How much inventory should I carry?” Good question. Keeping too much inventory on hand ties up resources and space, but too little could disappoint customers, sending them elsewhere if you don’t have the item they want in stock.
Since retail sales can fluctuate based on the season and customer demand, it’s important to create an inventory plan that will help you sell as many products as possible without needing to offer steep discounts later. While there isn’t a clear-cut way to determine exactly how much inventory to carry, there are some best practices you can follow to find the sweet spot.
Set Up an Inventory Management System
Every business needs a strategy in place for managing inventory; this plan will enable you to track sales and notice patterns, helping you to answer the question, “How much inventory should I carry?”
Inventory management shouldn’t just be a task done on a quarterly or annual basis to help you complete your tax filings. You should be tracking inventory on a weekly or even daily basis, depending on your business type. When you track inventory frequently and efficiently, you can adjust your levels more quickly.
Years ago, companies would need to take a physical count of inventory with pen and paper, but today hardware and software solutions like inventory management systems streamline the process. In fact, several point-of-sale systems have this function built in, automatically adjusting inventory when an item is sold in your store or online. While you should still conduct a physical count to ensure the numbers match and to identify shrinkage, data reports can reveal subtle patterns that aren’t easily detected when you’re only counting by hand.
An inventory management system will identify best-selling products as well as items that could be considered stale. You may be aware of the products that are in high demand, but a system will also give you reliable trends to watch, such as how seasons or holidays impact your inventory.
Once you recognize patterns, you can establish a reorder point for each product, ensuring that you don’t run out of in-demand items. This is especially helpful if some vendors take a few days to deliver. If you know the pen and paper days are behind you, equipment financing can help you afford the software needed to manage your inventory effectively.
Consider Your Industry
Your industry will often dictate how much inventory you need. If you sell clothing, for example, you’ll have to stock a variety of sizes and consider how fashion trends may impact sales. If you own a restaurant, your inventory consists of the ingredients you use, and you’ll need to factor in expiration dates of perishable foods. If you own a hair salon, your inventory is the beauty products you sell as well as the products you use on clients.
Take into consideration any outside forces that impact the question, “How much inventory should I carry?” For example, the season may affect your industry. If your business goes through slow cycles, you can reduce your rate of inventory replenishment, but you’ll want to place higher orders during your peak season, such as holidays.
Innovations can also impact inventory needs depending on your industry. Some products can become nearly obsolete, such as 35mm film or VHS tapes. If your business sells items that are constantly being updated or changed, you may want to limit your investment so you’re not left with too much inventory on hand.
Determine Inventory Costs
The cost of your inventory will determine the answer to our main question, “How much inventory should I carry?” But cost goes beyond price per unit. You’ll also need to consider if the product is seasonal or has an expiration date, and you’ll need to calculate inventory storage costs.
How you place your order will also impact the cost. Retailers are often given a discount when they order large quantities, but if you own a small boutique or want to try out a product, it would be smart to pay more for a smaller order. You don’t want to be stuck with too much inventory on hand if the item doesn’t sell, no matter how good the discount is on a higher quantity.
Also, consider the opportunity cost. If you order too much of an item, you won’t have the resources available to order something else. Investing in more inventory might mean bigger profits, but only if you can actually sell those products. To make an informed decision about additional quantities or new products, it’s important to determine how much you can afford to spend without hurting your bottom line.
Know Your Inventory Turnover Ratio
With an inventory management system in place, it’s time to calculate your inventory turnover ratio. This number will help answer, “How much inventory should I carry?” Calculate your ratio with this equation:
cost of goods sold (COGS) ÷ inventory = inventory turnover ratio
“COGS” is the cost of your inventory, and “inventory” is the value of your products. By calculating your inventory turnover ratio, you’ll learn how many times you sold and replaced inventory within a set period of time.
If your business has seasonal peaks, using your average inventory can account for the fluctuation at certain times in the year, according to Investopedia. For example, retailers might have higher inventory numbers leading up to the fourth quarter and lower levels after the holidays. Calculate average inventory by adding inventory numbers from the beginning of the year and the end of the year, dividing the sum by two.
If your cost of goods sold was $200,000 with an average inventory of $40,000, then you turn over your inventory five times a year.
Most companies consider a desirable turnover ratio to fall between 6 and 12, according to Investopedia, but this can vary greatly. Fashion retailers average between 4 and 6, grocery stores are often around 14 and a business that sells high-priced items, such as a car dealership, is often as low as 2 to 3, reported TradeGecko.
Calculate Your Days Sales of Inventory
Another formula that will help you understand how often you cycle through products is the Days Sales of Inventory (DSI). Simply take the number of days in the year and divide it by your inventory turnover rate.
In our $200,000 example above, it would take 73 days to sell out your current inventory, or about two and a half months (365 ÷ 5 = 73).
While a lower DSI is ideal, your industry can impact this number just like it does your inventory turnover ratio.
A Real World Example
To put numbers into context, consider this example from Target. In 2018, Target reported annual sales of $74,433,000, with a year-end inventory value of $9,497,000 and an annual cost of goods sold of $53,299,000.
Target’s inventory turnover for the year equals:
$53,299,000 ÷ $9,497,000 = 5.6
Its DSI equals:
365 ÷ 5.6 = 65 days
This means Target replenishes its inventory 5.6 times a year and it would take 65 days to liquidate it completely.
Understand the Numbers
Knowing your inventory turnover ratio can help you see how well you turn inventory into sales. This can help determine if you’re at risk of having too much inventory on hand or if you need to add more products. Maybe you need to invest in sales training for employees for good measure. Having to discount your prices will result in a lower inventory turnover ratio. And a higher inventory ratio could indicate that you frequently sell your full-priced items and need to add more products.
Keep in mind that your inventory turnover ratio and DSI are averages and not every product on your shelf will sell. The reality is that some items sell quickly while others take a while. Consider industry averages as a way to compare your inventory sales to your competitors. You can usually find these averages on market research sites like CSI Market. You want to be close to the average, but every business is unique. Tracking your own sales is the best way to make informed inventory decisions when asking yourself, “How much inventory should I carry?”
Correct Inventory Management Mistakes
So what should you do if you discover you have too much inventory on hand? Too much inventory on your balance sheet can reduce the financial health of your business. The more money you have tied up in products, the less money available for other business expenses, such as rent, payroll or supplies. You’ll also need more space to display or store the inventory.
If any of your inventory items are perishable, you’ll need to keep track of dates, rotating items in and out. Expired items result in a loss.
Consider offering discounts or special sales on merchandise. Also determine if you can freshen up the products by creating more attractive displays or by putting them in a more prominent location, such as at the end of an aisle or on a table in the center of your location.
Another way to liquidate inventory is to bundle items, giving a discount when a customer purchases multiple items or when they purchase a kit or set. For example, a gift shop could group three candles as a set or combine a notebook and pen.
You could also offer low-cost items as freebies or incentives with larger purchases. You could even donate items to a charity, which will net you a tax write-off as well as some marketing for your business.
Finally, consider liquidating inventory through an online marketplace, such as eBay or Amazon. You can also sell your inventory to liquidation companies. While this might result in a loss, it will also free up cash flow and provide valuable lessons when answering, “How much inventory should I carry?”
Of course, having too much inventory on hand is only one side of the coin. What if you don’t have enough? If you sell out of an item too quickly, customers will have to go somewhere else. You could gain a reputation of not having sufficient stock, leading to missed sales.
Finance Your Inventory
Once you’ve answered the question, “How much inventory should I carry?” you need to determine how to pay for it. Some suppliers offer businesses a line of credit or payment terms on their inventory orders. This will depend on the length of your relationship, and the financing rates can vary.
It may be a better idea to set up a small business loan. Having money available will give you an easy way to pay for inventory when you order it. Some suppliers offer a discount when orders are paid before shipment. And a business loan will allow you to stock up for your peak seasons without worrying about monopolizing cash flow.
It’s best to put financing into place before you need it. That way, you can act quickly if you get a great deal on products that you know will sell well in your store. A loan will also allow you to increase your product offerings, expand to a second location or launch an e-commerce division without worrying about not having enough products on hand.
Find Your Sweet Spot
Knowing the answer to our question of the hour,” How much inventory should I carry?” will become easier over time. Tracking your inventory regularly will provide you with a wealth of data that can help you make decisions about your products.
Keeping great inventory will help you establish your business’s reputation. When customers love what you sell, they’ll be eager to come back to your location to see what’s new. Keeping your inventory fresh will also help you grow your business. Put the steps in place to create a plan for inventory management for small business operations.
Once you find your inventory sweet spot, you can focus on delivering stellar customer service — in addition to amazing products.