Retailers need to sell as much as possible. That means knowing how much inventory to carry, but without having to cut prices or offload surplus stock. But the retail business fluctuates by nature, and demand changes from day to day and week to week. So, is there a good way to figure out how much inventory to carry?
It’s a little complicated. In retail, it’s generally considered better to sell out than have leftover stock—no business owner wants to see old inventory piling up and cutting into storage space for new stock. On the other hand, you want your inventory to match consumer demand so that you make as much revenue as possible, without having to mark down prices.
Unfortunately, there’s no magic formula for figuring out how much inventory to carry. However, there are best practices and calculations to follow. These will help you figure out the best way to strategize inventory, and forecast demand specifically for your retail business.
Key Considerations for Carrying Inventory
As any retailer knows, the cost of inventory involves much more than just the price per unit—purchasing, transporting, and holding inventory all have separate (and variable) costs.
These are the critical aspects of product inventory to keep in mind when forecasting how much stock to carry.
Cost of Inventory
This seems simple, but the cost of the products you sell will be the biggest factor in determining how much inventory you’re able to purchase at a time.
Storage Space, Seasonality, and Shelf Life
Holding inventory is a major expense for many retailers, especially for inventory that requires climate control or special storage conditions.
The cost of storage space factors into how much inventory you’re able to carry, too. Depending on the availability, cost, and convenience of storage in your area, you might need to strategize against your products’ shelf life. For instance, the inventory at the farmer’s market has a different turnover rate than an appliance store.
Knowing how much it costs you to pay for storage space, and how long your products can be stored, will help you make orders as far in advance as possible.
Bulk Orders vs. Batch Orders
Next, think about how many products you can realistically sell, and decide whether to order your products in bulk or by batch.
Smaller orders might incur an upcharge from suppliers. But if you aren’t confident you’ll sell units of a product to justify a bulk order, it’s usually worth it to only buy what you know you can sell—rather than being stuck with excess. And depending on your products, you might save on orders by reducing the number of variations or sizes you offer. That’ll also make taking inventory easier, since there will be fewer SKUs to keep track of.
That said, boutique and specialty retailers might specifically focus on small-batch products, which makes bulk ordering difficult or impossible to do. If this is the case, you might be able to save on ordering by forming relationships with your suppliers, even if you can’t pre-order or bulk order a specific product.
5 Rules for Determining How Much Inventory to Carry
Taking inventory shouldn’t just be an annual, quarterly, or even monthly activity. Get in the habit of regularly checking on inventory and making adjustments to forecasts throughout the month. And if you use the same unit of measurement every time, you’ll be able to calculate estimates with greater accuracy and consistency.
With reliable cost estimates, you can reap the benefits of increasing or reducing orders on products appropriately—and optimize your entire inventory management process.
1. Count Something Every Day
Taking inventory every day might seem like an unnecessary annoyance. But there are a few good reasons for working inventory into your daily routine.
For starters, product discrepancies and shrinkage can slip through the cracks if you’re only doing inventory on an infrequent or irregular basis. Taking stock of products every day—or week, if that’s more doable for you—helps you identify recurring trends. That might make it easier to predict how you should order.
A product that consistently sells out is probably already on your radar. But paying close attention to subtle patterns can help you identify where you can adjust product orders or expand selection. Inventory management systems (IMS) can be useful for tracking and reporting on sales, and automating things like stock monitoring and order fulfillment. A software solution makes sense if you sell on multiple online platforms, because you can manage each channel through one consolidated inventory.
That said, until your business is simply too large to run without automation, good records and regular inventory checks will keep you informed about your inventory and ahead of demand.
Expert Tip: Units Matter
The units you use to count inventory and estimate cost might be different than the manufacturer’s and customer’s methods. For example, you may purchase your stock by weight, count inventory by product (or “eachs”), and sell by the crate.
Even if using multiple measures makes sense for your business model, try to find a standard you can use for financial calculations and recording inventory. It’ll make your calculations (which we’ll show you later) much more accurate.
2. Know Your Industry
Different types of products have different rules of supply and demand. Fashion, for example, is a tough business for getting rid of old inventory—and even with the same product, different sizes and colors might sell out completely or not at all.
Changing trends in your industry or fluctuating commodities prices might prevent you from planning inventory orders more than a few months in advance. In that case, pay attention to the sales volume of different types of products, even if you aren’t re-ordering the exact same items.
3. Risk vs. Reward
If you’re considering ordering new or additional inventory, consider whether the potential rewards (aka profit) outweigh the risk (of investing in items you won’t end up selling).
That’s the attitude Jean Grant, the purchasing manager for online retailer Find Me a Gift, takes when she’s restocking her business’s inventory. (And she knows her business’s inventory: Find Me a Gift has been in business for nearly two decades and offers over 9,000 products.)
Decide first: risk or reward? Which is most important to your business: limiting your risk in terms of stock investment, or capitalizing on the potential rewards of purchasing stock in larger quantities? Is secured, lower-priced stock-holding most important to your business, or is it minimizing the investment and maximizing your flexibility to adapt to changing demands?
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.
4. Innovate Your Inventory
Finding a new way to finance your inventory might mean finding a new inventory source altogether.
Believe it or not, 3-D printing was the solution to inventory sourcing for Adler Riley and his business, Ideas to Stuff. By eliminating the supply chain, 3-D printers enable Riley to create products without sourcing different materials.
“If you look at a store with a high number of plastic goods, like a toy store, the majority of those items are made of only a handful of materials. Each one of those goods has its own packaging, supply chain, and logistics depending on where it was originally manufactured. What I’m doing is removing all that mess by manufacturing my goods on-site at the retail store. The PLA plastic that one day is used to create a child’s toy dinosaur can be made into a toy space ship the next day, without the need for dedicated inventory of either being kept on hand before the customer makes a purchase.”
Innovating inventory with 3-D printing is just one way entrepreneurs avoid traditional supply chains. Handmade, recycled, and vintage products are all alternative sources to a wholesale merchandiser, and might even make your products more interesting to consumers.
5. Crunch the Numbers
Yes, you can calculate how much inventory to carry—you just need to use the right formula.
By using a formula to calculate inventory turnover, you’ll get consistent estimates for how much you need to purchase, and how often. Feel free to use different calculations to get an idea how different variables could influence your costs—just keep in mind that calculations only reflect the factors that you input, not a complete picture of your inventory costs.
Start by experimenting with the three following inventory calculations:
Inventory turnover ratio: One of the most common ways to calculate inventory turnover ratio is to look at sales (or you can use the cost of goods sold) divided by average inventory.
Simply put, this shows how quickly you sell out of your stock. But this calculation can also indicate sales strength, alert you to excess inventory if the ratio is low, or if you’re under-ordering if you have a high turnover ratio.
You can compare this number to national averages to get a general idea of inventory turnover for your industry. Consistent turnover of full-price inventory indicates that it might be time to expand your offerings.
Inventory value (retail method): You can use the retail method of calculating inventory to know how much your inventory is worth. This calculation converts the retail value of your inventory to a cost value. This approach doesn’t require you to take physical inventory, and can be useful for financial projections and accounting.
Days sales of inventory (DSI): The number of days it takes your inventory to sell—measured as DSI—shows how long it takes a business to turn its inventory (like inventory turnover ratio). This calculation is particularly relevant in the context of your industry, because turnover varies for different products—for example, ice cream has a lower days inventory than freezers.
To get this value, simply divide Inventory by Cost of Sales, multiplied by 365 (days). For more help calculating your DSI and cash conversion cycle, you can check out an online calculator.
Crucial Calculations from an Industry Expert
Any of those three calculations will give you an idea of how much inventory you can stand to carry, and at what cost. But you can also take a look at these approaches suggested by Matt Warren, the CEO of Veeqo, an Inventory Management System. Warren offers these two calculations as the best ways to make sure you never have too much—or too little—inventory.
1. Safety Stock
Seasonal changes in sales volume are typical of the retail industry, and you might stand to make a sizable profit if you’re prepared with safety stock (or, simply, additional inventory for popular products).
Safety stock is worth considering if you sell products that have event-based increases in demand, like team merchandise and emergency weather necessities. If you’re looking for a place to start, try searching sales records for unexpected increases during certain times of year or specific products.
Here’s Warren’s suggested calculation:
“A couple of variations exist to the equation for working this out, but I suggest…
- Taking an average of your top three days’ sales volume over the previous month/quarter/year…
- …and subtracting the average daily sales volume for the same period.”
Safety stock = (Sales volume of top 3 days/3) – Average daily sales volume
2. Reorder Point
If you know which products you reorder each month or quarter, establish a “reorder point” when inventory is running low. That way, you’ll avoid long periods with low or no stock for top-selling items. It’s also a good idea to track how long it takes your suppliers to fulfill purchase orders so that you know how far in advance to place new orders.
“The following equation works well:
Take the average number of days (lead time) between ordering items and having these items ready for sale…
- …multiply this by your average daily sales volume over the past month/quarter/year…
- …and then add your safety stock number.”
This calculation shows you the exact point to place a new order to continue fulfilling orders, without going into safety stock.
3 Ways to Finance Inventory
You’ve figured out exactly how much stock you need. Great! Now you need to pay for it.
Many entrepreneurs take out a small business loan or establish a line of credit when starting a business, but did you know there are also financing options available specifically for purchasing inventory for your retail business? Depending on how established your business is, and how much financial assistance you need, there are a few ways to go about funding your inventory.
Inventory Financing
Many retail business owners aren’t aware of the financing options available specifically for investing in goods for sale—like inventory financing.
Similar to equipment financing, the stock you purchase with the loan acts as collateral for the investment. This means that if you don’t make payments on time, eventually the lender can repossess your inventory to make up for the missing debt. If you think you can’t afford the stock you need, but haven’t been in business long enough to apply for a business line of credit, it’s worth exploring your inventory financing options.
Purchase Order Financing
Lack of cash flow can make fulfilling orders impossible—even if you have the demand, you might not be able to purchase all the inventory you need. If you can’t pay a supplier for the goods ordered by a customer, a lender offering purchase order financing might be able to help. Purchase order financing is obtained in advance of fulfilling a customer’s order—the supplier fulfills the order directly, and in turn is paid directly by the customer.
Business Line of Credit
Established retailers who have at least a year of solid sales performance and strong credit might find that the best way to finance their inventory is with a business line of credit, which is one of the most flexible financing options available. Rather than a lump-sum loan, like a term loan or inventory financing plan, you can choose when and how much of your line of credit you tap into, and you’ll only pay interest on the amount you use. These are best used for smaller, recurring inventory expenses.
Bottom Line: Implement a Process to Track Your Inventory
Unfortunately, there’s no simple way to know how much inventory to carry. But if you start taking stock today— and keep taking stock regularly—you’ll better understand how to make the most of your inventory.
Being vigilant about monitoring stock, and consistent in your measurements and units, will make it easier to track inventory turnover over time—and that’s the best indicator of how much inventory to purchase. Once you know what you need, and how much you should sell, you can start exploring the options available for financing your inventory.
Finally, a crucial factor in ordering inventory is the actual business transaction. Unless you manufacture your own products, you rely on a network of suppliers to source your inventory. The relationships you form with wholesale retailers and distributors—and the deals they give you on orders—can make or break your profit margins on the products you sell.
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from Fundera Ledger https://www.fundera.com/blog/how-much-inventory-should-i-carry/
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