What impact does inventory have on your company’s profitability?
5 minutes read
When you started your business, you probably learned to manage your inventory with an in-house system. But as your company grows, this system may no longer be suitable. As inventory management greatly impacts a company’s profitability, it’s better to act now to prevent losing control of the issue.
“It’s important to understand how to strategically manage inventory according to the specifics of your business and its current challenges, because having excess or insufficient inventory directly impacts your company’s profitability,” says Karina Amram, Director, Business Restructuring, BDC.
This is little-known, but every dollar of inventory that a company holds over its ideal level generates 20% to 30% of additional costs.
Normally, the size of a company’s inventory fluctuates with its sales. “It is expected that inventories will increase proportionately to increases in sales, but when sales decrease, inventories should also adjust downward,” adds Dany Couillard, Director, Business Restructuring, BDC.
What is inventory?
Inventory refers to any item or unit of resource that is:
- deployed in processing (raw materials)
- created in an intermediate stage (work in progress)
- the result of processing (finished units of product)
- goods you may purchase and distribute (finished goods)
What are the costs of excess inventory?
Excess inventory results in costs, often hidden, from sources such as:
- additional space taken up by the inventory
- electricity, heating and taxes associated with the space
- personnel required to manage it
- insurance required for this inventory and the additional space
- interest on the portion of the line of credit that finances this inventory
The company is also exposed to the risk of its inventory becoming outdated or expired.
“This is little-known, but every dollar of inventory that a company holds over its ideal level generates 20% to 30% of additional costs.,” says Couillard. “For example, a company that holds a million dollars in excess inventory would spend between $200,000 and $300,000 annually to support that excess.”
Why does excess inventory impact your business?
Banks often set a maximum limit on inventory financing in their lines of credit. “The excess inventory in proportion to the financed portion must be supported by the company’s working capital and directly reduces your operating cash flow,” says Amram.
There is also an opportunity cost for holding excess inventory. “If your million dollars is still tied up in excess inventory, that money isn’t available for any business opportunities that come your way,” Couillard added.
“You have to find a balance between holding insufficient inventory and too much of it, depending on your field of business and the current issues,” says Amram. “To put the right inventory and purchasing management processes in place, it is important to seek out the necessary expertise, such as at BDC Advisory Services.”
How do you ensure that inventory is properly measured?
These are some pitfalls to avoid to properly measure your inventory.
First, ensure that the cost of the inventory is recorded at the right value. Slow moving, outdated, defective or damaged inventory must be written off. “For example, collections quickly become outdated in the fashion industry,” says Couillard.
Also, pay attention to how you measure works in progress. “For example, there are products that can take months to complete, and the company often estimates the value of that work in progress,” says Amram. “However, this value is sometimes overstated and a portion of it must then be expensed in the income statement, thereby reducing profitability.”
“Because inventory is an asset, profitability can be artificially inflated in the case of its overstatement,” Couillard says. “It is important to analyze what is included in the inventory and to ensure that the correct values are communicated to the chartered bank. The latter relies on this information to finance the company.”
Most businesses now use a system of stock keeping units. Also known as SKUs (pronounced “skews”), they are unique ID codes that you assign to every item on sale. They allows a seller to know what's in and what's not in stock—but, most importantly, what sells.
Opt for an inventory management system
If you are used to working on an Excel spreadsheet for periodic physical inventories, there are several advantages to migrating to a perpetual inventory management system. “An inventory management system allows us to inventory updated, adjusting it whenever sales are made or orders come in. We can then avoid costly shortages or excess inventory,” Amram explains.
This not only saves time, but also helps you know what’s in stock at all times, so you can plan and adjust your purchases according to your sales and your physical inventory.
Avoid dependency on a supplier
The risks associated with depending on a supplier have always existed, but they became highly visible with the COVID-19 pandemic.
“Many companies that source from China, for example, have seen their inventory get held up at the port for long periods, causing major delays in deliveries,” says Couillard. “This may have led to lost orders and even breach of contract penalties. Having more than one supplier in different regions reduces this risk.”
“Depending on one supplier is never ideal, COVID-19 or not, because they themselves may have delivery issues and back-orders, or they may suddenly raise their prices or change their delivery terms unilaterally, leaving the company that is dependent on them in bad shape. It’s important to diversify your sources of supply as much as possible,” Amram adds.