Business owners and financial managers need to control inventory levels. Establishing the right inventory level by item for your small business is a crucial success factor. This article will explore:
- How much inventory is sufficient?
- How much is too much?
- Is too much inventory good or bad?
Just How Much Inventory to Carry
Small businesses often find inventory management challenging. Finding the right amount of inventory keeps these business objectives in balance:
- Having sufficient inventory on hand, or when customers need it
- Minimizing lost sales
- Calculating sufficient safety stock to reduce out-of-stock inventory, and determining if just-in-time inventory methods work to some extent in your business
A just-in-time inventory system is a pull system based on near-term demand. Just-in-time is accomplished by issuing a purchase order with a delivery due date that closely matches customer or manufacturing schedule needs.
- Managing customer demand to supply chain capabilities and reliability, including lead time
- Increasing inventory turnover by calculating the inventory turnover rate and analyzing the underlying factors, looking for ways to improve it
The result of faster inventory turnover is increasing ROI and improving cash flow by not having too much cash tied up in inventory, and better matching the timing of customer demand. You can calculate inventory turnover, as follows:
Divide cost of goods sold from the income statement by average inventory from the balance sheet (which is beginning inventory balance plus ending inventory balance divided by 2)
- Managing cash flow better
- Minimizing excess inventory and obsolete inventory.
How Much is Too Much Inventory?
That’s a key question. Tracking inventory turnover and usage by product, item, and location can help you establish how much is too much inventory. Your accounting software system can help you control inventory levels in relation to the demand for those items.
Is Too Much Inventory Good or Bad?
It depends on how much excess inventory that you have. Generally, having too much inventory is considered bad. But it depends somewhat on your situation.
If inventory doesn’t sell, it may be subject to classification as excess inventory or obsolete inventory, requiring a write-down to actual worth of the inventory and write-off versus the amount recorded on the books for these inventory items. GAAP accounting standards require setting up a reserve, also known as an allowance, for excess inventory and obsolete inventory (if the amounts are material).
By lowering the price of inventory sold to customers, you may be able to reduce the amount of excess inventory in stock. That’s better than writing it off completely.
If you have too much inventory, you may need to spend more for insurance and storage space. The goods can be damaged, lost, or stolen. Cash flow may become difficult if you can’t turn over the inventory quickly to complete the cash conversion cycle. If you’re able to obtain additional financing to cover the cash shortfall, your business would incur extra interest expenses. There’s more business risk.
On the other hand, if you have an unexpected rise in demand and you have the right items in inventory, then having too much inventory would be favorable. You wouldn’t need to buy products to sell the extra items, you could deliver the order quickly to the customer, and the customer would be pleased.
One of the essential jobs for small business owners and financial managers is inventory management. Usually, having too much inventory creates business problems. Having the right accounting software to help you manage that inventory is essential. ZarMoney software offers advanced inventory management capabilities to help you determine and maintain the ideal amount of inventory by item, product, and location for your company.