Inventory: The Crucible of Success

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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I visited Hoover Dam for the first time in my youth. I was impressed by its sheer size and amazed by its strength. During a more recent visit, I could not help but draw a few parallels from the operation of the dam to a business. Yes, it may sound a little bit weird, but I cannot look at Hoover Dam now without thinking of inventory and cash flow.

The dam itself exists to capture water and then use it to efficiently generate power to the surrounding states of California, Arizona, and Nevada. A business exists to capture cash flow (cash flow and water are life-sustaining elements to business and people, respectively) and maximize its use for the generation of even more cash flow — some of which eventually ends up in the business owner’s pocket.

Inventory is often the biggest challenge many businesses have with cash flow. Imagine a dam that is letting more water flow through it than is being replaced on the side. Eventually Lake Mead (the lake formed by Hoover Dam) will dry up, just like the cash flow in a business will dry up if inventory is not managed effectively.

Inventory is really a test, or crucible, for business owners because improper inventory management will either drain your cash flow faster than it can be replenished or cause you to lose opportunities to sell more products and make more profit. If you can pass this crucible of inventory successfully, inventory will drive cash flow through your business and create opportunities rather than waste them. To help you through this crucible, here are three important elements you should consider.

1. Inventory Levels

Just as the lake behind Hoover Dam has an optimal level, so does the inventory in a business. While an inventory level that is too low initially helps cash flow, it will eventually hurt it. Low inventory leads to not having enough product on-hand to fulfill manufacturing and/or customer requests. Slowing down a manufacturing process or losing a sale to a customer is devastating. Too much inventory makes it easier to fulfill customer requests but absorbs more cash than is needful and causes a strain on the business.

So, how does a business successfully determine its appropriate inventory levels? The answer comes from lots of details and data. For each item in inventory, you need to know how many you need or sell each day, week, and month. You also need to understand your lead time to replenish your inventory for each item. Then, when inventory balances for each item hit the critical point just before you will run out, you order more. How many more? Based on your experience with that item and your best projections, just enough to cover through the next lead time. This takes a lot of time and effort, which is perhaps why we call this the crucible of inventory. But those who understand this part of their inventory usually pass the inventory test.

2. Inventory Turns

I cannot stress enough the need for every business to understand why its inventory turnover is so critical to its cash flow and profit. Let’s assume you turn your inventory over 12 times per year. Looking at one spot on your shelf, you purchase an item to sit in that spot for $70 and you sell it for $100. This means you make a gross profit of $30 each month from that spot on your shelf, or $360 for the entire year.

Now imagine increasing your turns to 13 times per year. That’s $30 more of gross profit per shelf spot with almost no additional fixed costs to support it — meaning that $30 should flow straight to the bottom-line if overhead was covered by the first 12 or fewer turns. That may not seem like much, but imagine when you consider the 1,000 shelf-spots you have and the additional $30,000 of gross profit you will make by speeding up your inventory turns.

How do you accelerate your inventory turns? The bottom-line to this is to use and sell products that fly off your shelf. Some companies use drop-ship partners for the slower turning products and only inventory its biggest and most predictable sellers. Others have found an optimum mix between high profile but slow-moving products and common, steady, and predictable sellers. There is some art and some science to this formula, but it exists and needs to be utilized to make your inventory work for and not against you.

3. Inventory Controls

Yes, you have to physically count your inventory regularly. There is no way around this fact of running a business. No matter how good your inventory tracking system is, you have to count. This keeps product from disappearing and provides a check and balance to your system (which is only going to be as good as you set it up to be and the data you put into it). Nobody that I know enjoys doing a physical inventory count, but it is a necessary step to overcoming the crucible of inventory.

If the water level of the lake is too high, the water is not being used efficiently — a lot of water is generating a relatively low amount of power. If the water is too low, then the generators may not work at all. Managing inventory is no different. Finding the optimum level, moving as much through the system as possible, and measuring and controlling it will help you win the battle of inventory, and your cash flow will thank you for it.

This is a guest post by Ken Kaufman, Founder & CEO of CFOwise®, serves as the Chief Financial Officer for a dozen start-up, emerging, and medium-sized businesses.