By Ken Bauer, VP of Business Banking at Elevations Credit Union
How a business manages its inventory can have a tremendous impact on the financial health of the company. Managed properly, inventory can be a great source of increased margins. To start with, it’s important to understand the all-in price of your inventory and optimize your inventory for an efficient return.
Understand the all-in price of your inventory
Always know what your inventory costs. Cost is not merely what you paid a supplier for it. You need to understand the all-in price, which includes things like storage, obsolescence, spoilage, borrowing (if you are carrying balances on lines of credit), supplier discounts and the opportunity cost of capital that could be used elsewhere. Remember, every dollar tied up in procuring and keeping inventory is a dollar that cannot be spent elsewhere, so knowing how many dollars are really invested into your inventory, especially as it ages, is an absolute must.
Optimize your inventory for an efficient return
Next, a business should carry enough inventory to support its sales objectives and growth, but not so much that it becomes an inefficient use of capital. Thus, optimizing your inventory for an efficient return. The trick lies in calculating what the “efficient” (or desired) return on capital should be for your business, and then either optimizing inventory to help reach it or increasing your gross margins to compensate for the all-in cost of carrying more inventory.
For example, take a company that specializes in hard-to-find appliance parts, shipped within 24 hours. To be able to do that, this company would have to stock a very diverse, large inventory so it can fill the order and ship it right away. The cost of maintaining such an inventory would be tremendous, as it could be years before some of the more obscure parts are sold and converted to cash, if ever at all. To counter these costs, the company should charge a premium price for its products, which presumably its customers would happily pay due to the hard-to-find nature of the parts and the fast shipping.
In contrast, a gas station sells a high-volume, more commoditized product that could be easily bought from any number of other sellers. For this reason, gasoline sells at a much lower margin because its customers could go down the street for a better price. Most of the time, the owner does not have the option of increasing prices to compensate for excess inventory because doing so would negatively impact sales. Instead, the opportunity to achieve higher returns on capital comes from things like reducing the all-in cost of every gallon of gasoline and carrying a wide variety of high-margin convenience items (as a side note, this concept is why gas stations are so often connected to a convenience store). If a gas station owner can use effective balance sheet management to lower his all-in cost of every gallon of gasoline even by a few cents that can translate to a meaningful increase in net income when selling thousands of gallons a week.
Understanding the all-in price of your inventory and optimizing your inventory for an efficient return are both key ways to help your business achieve better margins.
Elevations Credit Union is a member-owned not-for-profit financial institution serving Colorado’s Front Range. With a consultative approach to solving your business banking needs, Elevations local business bankers can help you improve your cash flow, reduce your borrowing needs or decide whether a term loan or line-of-credit is best, including quick-turn credit decisions. Click here to learn more about Elevations business banking or schedule an appointment.