How much inventory should my business hold?
Given the current situation, businesses are reevaluating how much inventory they need to hold. Before the pandemic hit, they thought that they had a good handle on their needs. They could forecast demand quite well. But thanks to the recent disruption, they’re now wondering whether they can rely on old models at all. Sure – they worked okay during business-as-usual – but they were clearly not equipped to deal with what happened in 2020.
Inventory building up or depleting is an unnerving experience. There are costs associated with both scenarios. When it gets too high, it suggests that your firm isn’t operating efficiently, balancing supply and demand. When it gets too low, it leads to lost profits and brand damage.
Unfortunately, we’ve seen both these scenarios unfold at businesses during the pandemic. For some companies, demand dried up completely as new laws and changing spending habits redirected consumers. For others, demand spiked without warning, leading to rapidly emptying inventories.
Naturally, therefore, the questions of how much inventory firms should hold, and how long to hold it for, are on everyone’s minds. So what’s the answer?
How much inventory your business holds depends on your industry
When it comes to establishing how much inventory your business holds, there isn’t a one-size-fits-all policy that works in every situation. It all depends on your industry.
If you stock food or other fast-moving consumer goods (FMCGs), then you’ll want to keep inventory levels tracking demand as closely as possible. Any surplus is likely to go to waste. For companies in these sectors, it is better to risk understocking than overstocking and offering customers sharp discounts.
For durable goods with more predictable (and less trendy) demand patterns, the cost calculus changes. Some goods you can potentially keep indefinitely. (Books, for instance, can sit unopened in a box for decades). The question in this circumstance is, how much capital are you willing to dedicate to inventory costs?
Buying more inventory comes with certain perks for non-perishable goods. For instance, you have way more leeway if consumer demand suddenly spikes, as it did in the pandemic. But you also have to factor in the opportunity cost of capital. Whenever you purchase inventory, you could have put the money you spent on storing goods into other activities that also generate profits. So it’s a balancing act.
Interestingly, there are some industries that sell non-perishable goods but require inventory strategies similar to businesses operating in the FMCG sector. Fashion is a good example. Firms in this sector often need to sell goods before consumer tastes change. If they don’t, they may need to offer substantial discounts. Some stock might not sell at all.
Inventory turns by industry
Many companies like to keep track of inventory turns and see how they compare to other firms in their industry. Inventory turns are a measure of the number of times inventory sells on average in a pre-defined time period. The calculation is the cost of goods sold divided by the average value of your inventory. Because dollars are in both the numerator and denominator, the units cancel. Financial reporting companies keep track of this data by sector, allowing companies to see if they are broadly in line with their sector or not.
For instance, research shows that in the agricultural crop industry, inventory turnover was 163 in 2020. In the apparel industry, it was 148. Other sectors, such as petroleum refining and printing/publishing have much lower figures: 36 and 25 respectively.
The higher the figure, the faster the rate of inventory turnover. So, as predicted agriculture and fashion tend to have the highest turnovers since their inventories do not hold their value in the long-term. They need to get rid of stock as rapidly as they can. Other industries selling durable goods that are unlikely to go out of fashion, such as the petrochemicals industry, have much more inventory to hand, should they need to suddenly meet new demand.
What inventory turnover tells you
Inventory turnover can be a helpful metric for finding how fast your company sells your inventory. In some cases, a low number indicates weak sales and overstocking. If you fail to sell as many goods then, relative to the average value of your inventory, your total cost of goods sold will be lower. By contrast, if you have a high turnover, then it could indicate that you’re not stocking enough inventory. Consumers are getting through it too often, forcing you to continually replace it, potentially leading to shortages.
Of course, whether your inventory is problematic all depends on what is actually happening on the ground. Many firms actually do quite well with low or high figures. So it is often a matter of finding which approach works best for you. In a fast fashion business, it’s a good idea to run low on inventory quickly, since older items may not sell easily or at all. Dead stock that won’t sell can cost a fortune.
Whenever you look at the inventory turnover of your industry, make sure that you’re comparing apples to apples. If your firm sells generic t-shirts and jeans with no branding, then your situation is very different from a highly fashion-conscious company that sells designer products. They need to shift their stock fast seasonally up with the latest trends, but you don’t.
Determine the right items to stock
Once you know how much stock to determine based on your business model and industry, the next step is to pick the right items to keep. Both the quantity and composition of your inventory matter. After all, very few businesses stock a single line.
Most companies choose to use planning software to determine their stock needs in real-time. These tools take data from multiple sources to predict likely demand patterns much faster than traditional spreadsheet setups. By integrating data streams, firms can get advance warning of demand changes and adjust their inventories accordingly. Arguably, it’s the best way to figure out how much inventory your business should hold currently available.
