Inventory Investment and Maximizing Profit

The amount of your small business's inventory investment directly affects your profit and cash flow. The management of your inventory, for a company that sells products, is crucial to the success of your company. If you hold too much inventory on your shelves or in your warehouse, you run the risk of obsolescence and getting stuck with inventory that you can't sell. If you hold too little inventory, then you are risking stock outs and loss of customer goodwill. Either problem will cost your business money.

How do you best manage your investment in inventory to maximize your profits and cash flow and minimize your expenses? You have to categorize your inventory into dead inventory, slow-moving inventory, and product inventory and deal with it appropriately.

There is an unspoken 80/20 rule in business for different situations. In the case of inventory, you usually get about 80% of your sales from 20% of your inventory. Be proactive and work on your supply chain management. You can increase your sales by properly managing your inventory. From a productivity standpoint, your inventory can be divided up into categories: dead inventory, slow inventory, and product inventory.

Invest in Assets with a Positive Rate of Return

This sounds like a no-brainer, but it isn't. Money that you have invested in inventory has been invested at a negative rate of return! You actually don't know if you are going to make any money on that investment or not. The longer it sits in your warehouse or on your store shelves, the more money you lose. You make no money on inventory until it is sold. In fact, you lose money. Invest in inventory conservatively and wisely as your money is more wisely invested elsewhere unless you are sure you can sell your inventory and sell it quickly.

Don't Accumulate Excess Inventory

Perhaps the most dangerous thing you can do as a small business owner is accumulated too much inventory. Too much inventory will turn a healthy business into a sick business in a short amount of time. In an economy on the verge of emerging from recession, don't be tempted to stock up too much on the inventory you sell. You don't yet know how fast the economy is going to recover or what the demand will be for your product. Stock up slowly and track your sales to sell what is selling and what is not.

Get Rid of Dead Inventory

Dead inventory is inventory that has been sitting on your shelves not selling for some period of time. Some define dead inventory as the stock that hasn't sold in 12 months. That's too long! Dead inventory should be defined as that stock that hasn't sold in six months.

This deadstock is probably dragging down your inventory turnover ratio. Some businesses feel like they have to keep some level of dead inventory on the shelves because it may consist of some parts, for example, that are necessary replacement parts for products they sell in their business or have sold in the past. Those businesses might consider ordering those parts by special order when their customers need them instead of holding them on their shelves.

Instead of holding dead inventory on your shelves, mark it down for quick sale. For the dead inventory that doesn't sell, deem it "unsellable" and check with the distributor to see if they will take it back. If that doesn't work, donate it to charity. At least, you'll get a tax write-off.

Look at Slow-Moving Inventory

Slow-moving inventory is not dead inventory because it is moving, but it may be moving toward obsolescence. In the current economic environment, slow-moving inventory may be hard to identify. Companies that sell products have experienced an unprecedented slowdown in their business due to the Great Recession. Those environmental factors have to be taken into account when analyzing inventory movement.

That said, slow-moving inventory ties up your cash in idle inventory. It creates a negative impact on profitability and cash flow. If you have investors in your company, it lowers their return on equity. In order to determine if some of your inventory is really slow-moving, you need to look at companies like your own, particularly in the same industry.

If you use an SKU system, you can isolate each individual product and calculate that product's inventory turnover. If you set a target inventory turnover for products that your company sells and the item you have isolated falls under that target, then you can mark it as slow-moving and take action to get it off your shelf or out of your warehouse. You can then use some of the techniques you use for getting rid of dead inventory.

Invest in Productive Inventory

This is what you want—your cash cow, your product inventory. This is the inventory that sells, adds to your profit and your cash flow. During the recession, even this productive inventory may have been selling slowly, but it's still selling and as the economy picks up, you should see a nice increase in the sale of your product inventory. You can't take it for granted. Track what you think is productive inventory and make sure it is productive. If it isn't, move it to the slow-moving or dead inventory categories.

Use the inventory turnover ratio to calculate how your product inventory is doing. You may even want to do this by product line. Be aware that the inventory turnover ratio is dependent on the industry you are in. Some industries turn inventory fairly slowly, maybe 5 times per year. Others turn inventory rapidly, up to 20 times per year. Usually, the higher the number, the better you are doing.

Unless you manage your inventory investment actively and wisely, your active, healthy business can turn sour quickly.