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5 steps to optimize your inventory management

Inventory costs more to carry than you might think.

5-minute read

Your inventory may be one of your company’s biggest assets. It could also be one of your main—and most overlooked—sinkholes for costs.

Inventory can add as much as 30% to 40% to an item’s purchase price once you factor in expenses for storage space, warehouse personnel and more. And that doesn’t take into the account the opportunity cost of the idle capital.

“People are often shocked at that,” says Glenn Yonemitsu, who works in BDC’s Growth Driver Program as Managing Director of Executive Advisors in Ontario. The program advises high-impact firms on how to grow.

“Inventory is money you can’t use elsewhere. It’s using a scarce resource. Too many businesses never think about how much inventory costs to hold. They just use their gut feel when reordering inventory.”

The good news is that optimizing your inventory management can be a huge opportunity for reducing costs. Yonemitsu shares these 5 steps.

1. Appoint the right manager

It’s crucial to appoint the right person to manage inventory. Too often, this vital task is relegated to a poorly trained person or someone whose primary focus isn’t costs.

For example, if a salesperson is in charge of reordering inventory items, their main interest is likely to ensure that the business doesn’t run out of stock. Costs may take a back seat, and you could wind up with excess inventory.

“Most people responsible for ordering inventory don’t realize the cost,” Yonemitsu says. “In many companies, no one is interested in managing it. For many businesses, the best option is someone who balances the need to have products for customer service, with the cost of carrying inventory.”

2. Determine service level

Next, determine the service level you want to achieve for various inventory items. Do you need to have the product available immediately, or can delivery wait? The service level may be different for each item. Also determine for each product:

  • Its margin
  • Inventory holding cost (storage space, utilities, insurance, shrinkage, financing, warehouse personnel, inventory counts, obsolescence)
  • Ordering cost (shipping, discounts, tariffs, procurement, administration, damaged goods)
  • “Stock-out” cost (the potential cost in lost sales of not having it in stock)
  • Reordering lead time

Use this information to better plan reordering and figure out whether each product’s margin justifies the cost of carrying it. Your goal is to find the right balance between your desired service level and financial objectives.

Inventory is money you can’t use elsewhere. It’s using a scarce resource.

3. Classify your inventory

Inventory managers often cite the 80/20 rule: Eighty percent of a company’s sales are typically generated by 20% of its products. In other words, most inventory space is taken up by low-volume items.

What to do? Go through your inventory, and classify every item based on how much it sells over a year or another timeframe. A simple way of doing so is an ABC analysis:

  • Category A—Items you can’t afford to be out of stock ever
  • Category B—Items with low sales but that you must still keep in stock
  • Category C—Low-volume items with high carrying costs that you don’t need to carry

Now look for ways to reduce your inventory. “Your goal should be for 80% of your inventory to be category A,” Yonemitsu says.

Category B items should generally be priced with extra margin (e.g. using velocity pricing—that is, setting the price based on a product’s turnover) to ensure you have enough profit to cover the carrying costs. Category C items shouldn’t be in your inventory. You can offer them on backorder or suggest a substitute product to customers.

4. Choose an inventory management system

One of the simplest ways of managing inventory is the min-max system. You set the maximum and minimum number of items you need, then reorder accordingly. For example, you may set a maximum of 10 items and minimum of two, then reorder when you hit three because you have a lead time of a week.

Many businesses—especially smaller ones—set a single maximum and minimum number for their entire inventory. This is called a static system because the numbers don’t change.

“Using static inventory management techniques gets you into a lot of trouble,” Yonemitsu says.

Some businesses base their reordering on volume discounts, without taking into account the cost of carrying inventory. “You might think you are ahead by buying large amounts of inventory because of discounts, but you might end up carrying products for a long time,” Yonemitsu says.

Instead, he advises clients to manage inventory with a dynamic system. Under such a system, reordering quantities and timing vary for each product based on its sales volume, lead time and safety stock level (a buffer to help ensure you don’t run out of stock).

5. Make full use of software

Using software is vital for managing inventory properly. It could be anything from a basic Excel spreadsheet to an accounting package, an enterprise resource planning system or material requirements planning software. “Ignoring the power of software may cost you a ton of money,” Yonemitsu says.

It’s also important to customize the software to your own company’s specific needs. “Businesses often don’t know how to program it,” he says. “Only the tip of the iceberg of the app is being used.”

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