Inventory optimisation and why it matters for your business

Small Business Guides

5 min read

Inventory is money. If you manage it properly, you'll improve your cashflow, increase revenues and keep your customers happy. Let's look at how inventory optimisation can help you get it right.

The engine of your business

For retailers and manufacturers, managing goods well is the key to a business that runs smoothly. Without inventory you have nothing to sell – you have no business.

So far, so obvious. Yet the management of goods is far from simple. It depends on so many factors. In fact large companies such as Amazon rely on complex algorithms to predict what goods they should hold.

Smaller businesses don't always have access to those kinds of tools. But there are other techniques that are available to everyone. In this guide we'll look at how inventory optimization can help your business run efficiently.

The price of holding inventory

Holding goods is expensive. That's true whether you manufacture goods from raw materials or sell finished products. The costs aren't always obvious, but they include:

  • purchase price
  • shipping, handling, storage and distribution costs
  • obsolescence as items lose market appeal
  • wastage of perishable products
  • theft or pilfering
  • supply chain delay costs.

All of this would be costly enough if you made or sold only one type of product. But most businesses have several product lines. And they each have their own requirements.

One simple rule you can use is to make the cost of holding inventory 25 percent of the inventory on hand. This could include things like the cost of warehouse space, insurance, any special needs (such as food refrigeration), potential damage, obsolescence or moving costs.

The basics of inventory optimization

Managing your goods well is a trade off. You must balance the real cost of holding it with the opportunity cost of sales. For example, high levels of it can help you meet customer demand. But they also mean:

  • higher handling and storage costs
  • higher rates of obsolescence and wastage
  • higher risk of theft
  • slower cashflow with more tied-up capital.

On the other hand, low goods levels can keep costs down but they also mean:

  • missed sales opportunities
  • more time to fulfill orders
  • lack of flexibility when demand varies over time
  • unhappy customers.

So getting the balance right is vital. Inventory optimization done well, will:

  • free up cash and reduce investment in working capital
  • improve cashflow
  • reduce wastage
  • reduce opportunities for theft
  • improve customer relations.

These are all important goals, but how do you achieve them? Good inventory optimization requires a deep understanding of your business – and your customers.

If you manage your inventory properly, you'll improve your cashflow, increase revenues and keep your customers happy.

Find out what you need

If you've been in business for a while, you may have some assumptions about what goods you will need. That's a good starting point, but you can also look for more detail.

Start with actual data. Your POS (point of sale) system or order book will be invaluable here. Every sale you make tells a story rich in data – time, place, item, value, payment method, salesperson and more.

Good accounting software will tie into your inventory management system and use your sales records to create reports. These will tell you which products sold well, and when. They will also highlight products that may not be worth holding.

You can use this information to make demand forecasts. Accurate forecasting is right at the heart of inventory optimization. If you have a good idea of what you're going to sell, you can start creating a system to match.

Identify your key products

Once you're happy with your forecasts, you can act on them by deciding where your resources are best applied.

Many firms use a technique called ABC analysis. Often a small number of items represents a large value in terms of revenue. For example:

  • Product A makes up 20% of sales, 70% of revenue.
  • Product B makes up 30% of sales, 25% of revenue.
  • Product C makes up 50% of sales, 5% of revenue.

This type of analysis quickly tells you where to target your efforts. In this example, it would make sense to optimize A and then move on to B. But C is far less important.

Allow for lead times

When you run out of goods, you can't just pick up the phone and order more for delivery in an hour. There will be a time delay between ordering an item and having it delivered. This lead time must be built into your business model – it's part of inventory optimization.

Let's say you expect a spike in demand on April 20th and the lead time for delivery is 14 days. You should place your order by April 6th at the latest.

This assumes that your suppliers are all 100 percent reliable. Some will get close to that level, others won't. If you know your suppliers aren't reliable then you could hold some safety goods. That means keeping extra supplies to cover times when your suppliers let you down.

But this is far from ideal, and isn't practical at all if you sell perishable goods. The only effective solution is to find more reliable suppliers.

Be intelligent about your business

More than ever, the management of goods is built on business intelligence. That means analyzing data to find patterns that help forecast demand. This gives you an even clearer idea of which items you will need, and how many of them.

For example, drilling down further into sales data will show you all the costs for each type of product you sell. This will help you decide which ones are likely to be profitable at particular times.

If you're not comfortable doing this yourself, you could hire the services of someone who can. Business intelligence is a fast-growing field. The information it generates can quickly pay for itself.

An alternative option

If this all sounds complex, that's not surprising. Inventory optimization is a moving target. It's based on detailed information that changes over time – just as your sales change over time.

If you're not sure it's something you can handle in-house, consider outsourcing the work. There are companies that will handle this for you.

There are costs associated with outsourcing, of course. But there are costs associated with doing the work in-house too. Financial analysis will tell you which option is best for your business. Get your accountant to help you, by running reports using accounting software.

Inventory optimization is a skill

As you can see, managing inventory is much more than a simple admin task. Doing it well requires:

  • in-depth knowledge of your business
  • an understanding of customer demand
  • awareness of sales fluctuations over time
  • cost-benefit analysis of different levels of goods
  • knowledge of forecasting and lead times
  • the ability to think and act quickly as the market changes.

It's hard work and requires careful thought. But the rewards are immense. An agile business that can scale up without losing control of inventory is one to be envied. Just ask Amazon.