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, higher revenue, or a combination of the two.
In general, there are a few rules to remember when talking about inventory.
- Understand the all-in price of your inventory
This first rule is simple: 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
Second, 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. 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.
- Weigh the pros and cons of holding costly inventory
Lastly, the shorter the expected usable life of your inventory, the less room for error you have. If you’re selling bananas, it’s a matter of days before they become unusable by anyone not making banana bread, so you have to know how many to keep on hand at any given time. Raw steel, on the other side, will remain usable for years assuming it’s not left outside in the rain, although by then storage costs will likely have eaten away any profits it would have made.
While this concept is obvious to most business owners, what isn’t as obvious is knowing when discounting the price of your products is less expensive than continuing to hold costly inventory. While it may be painful to sell your product at a discount, if it frees up capital to be better utilized then it may be a good idea.
Elevations Credit Union is a member-owned not-for-profit financial institution serving Colorado’s Front Range. We believe it’s good business to help good businesses grow. 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.