Four Best Practices for Inventory

You’ve probably heard Apple CEO Tim Cook quoted as saying that inventory is evil.  The smart alecky response--especially in these days of supply chain issues--is that it’s a necessary evil because even service-based businesses need some materials to perform their services with, and retail businesses especially wouldn’t have anything to sell without it.

But that doesn’t change Cook’s fundamental point:  Inventory represents a capital outlay by your business, and until you use up that inventory to generate revenue and collect cash, that investment has to be financed, remains at risk, and depreciates over time.  Oh, and it gets worse.  There’s an opportunity cost to holding that inventory because you could have done something else with the capital required to purchase it, like generating more sales through advertising and sales team members.

So the bottom line is that you probably have to have some inventory, but you don’t want to have any more than you need. And over time, you’d like the amount of inventory that you have to have on hand go down.  Getting to that state of affairs requires you to manage your inventory efficiently.  Here are four best practices to help you do just that:

1. Organize Your Inventory Floor Space.

Take a tip from Toyota, the Japanese auto manufacturer known for their Toyota Production System, which prizes being as lean and efficient as possible.  The way to become lean and efficient is to eliminate as much wasted energy and activity as possible.

Take a step back and think about how your inventory moves through your business as a system.  Inventory comes into the system when it gets delivered, and it leaves the system either by moving to the front of the house or by getting shipped out.

Organize your inventory floor space around traffic patterns.  Inventory that will ultimately be used in operations in the front of the house or sold as merchandise in the front of the house should be located closer to the entrance to the front of the house.  That way, when someone needs to restock items in the front of the house, they won’t have as far a distance to travel.  They’ll waste less time going back to the inventory floor space to get the item to restock it in the front of the house.

In contrast, inventory that’s more likely to be sold online and shipped out from the back of the house should be located closer to the pickup area.  They’ll spend less time traveling back and forth to get inventory and package it for shipping, and they and employees from the front of the house will spend less time getting in each other’s way.

2. Organize Your Shelving Units.

There’s a similar policy in play here:  you want to organize your shelving units to maximize the speed with which employees can find the items they need and minimize the amount of time they spend looking for them.  That will allow them to get items out the door faster, which means you’ll get paid sooner.

Try organizing your shelving units with a few common-sense principles in mind:

First, items used more frequently should be stored between waist-level and eye-level to make it easier to grab them and go.  Storing them any lower makes it more likely that an employee will waste time looking for them and then bending down to pick them up.  Make it easy on everyone to speed up the process.

Second, heavy items should be stored at ground level to eliminate the wasted energy of lifting them up higher and the risk of injury involved in doing so.  When someone throws out his or her back lifting something heavy, you’ve just lost a worker until he or she heals, and you may have to deal with a worker’s comp claim.  So organize your shelves to minimize that risk and you’ll hopefully see less leakage from lost productivity and worker’s comp claims.

Finally, label your shelving units with an alpha-numerical system, not the item name.  To see why, consider that you may not always carry the same items of inventory in the same proportion if you find out that it’s more profitable to carry more of one item and less of another.  If that happens, then labels with product names won’t necessarily reflect what’s actually sitting on the shelves, so the time you spent labeling them in the first place was wasted, and now you either need to redo it or leave your employees with a confusing and unhelpful system.  Try the alpha-numerical system instead, and then employees who need to go grab an item can check the inventory management system and go right to where the item is being stored.  Simple.

3. Determine the Best Reorder Formula to Use.

Your inventory may look great now that you’ve got it organized, but hopefully it won’t be there for all that long.  As products start flying off the shelves, you’re going to need to reorder.  But just like how you organized your inventory on the shelf for maximum efficiency, you can also organize how you reorder, also for maximum efficiency.

Here’s what we mean:  Carrying inventory is costly.  When you purchase inventory, you tie up capital that you could have used elsewhere, so you lose whatever return you could have earned on that capital.  The more inventory you carry on hand, the higher your holding costs.  So all other things being equal, you’d rather hold less inventory than more.  But you also don’t want to run out of important items that customers really want, so you want to carry enough so that you don’t run out.  But you also have to pay shipping costs whenever you order inventory, and that adds up.  These goals are in tension:  The more inventory you carry on hand, the higher your holding costs will be but the lower your reordering costs will be because you’ll be reordering less often.  The less inventory you carry on hand, the lower your holding costs will be but the higher your recording costs will be because you’ll be reordering more often.

Someday we’ll go into the math on how to minimize the sum of your holding costs and reordering costs, but for now, let’s focus on how to set up the right reordering system.  One method is to reorder a fixed quantity of an item whenever you reach a predetermined number of items left in inventory.  We call this a fixed-quantity ordering system, or a Q-system for short, because you always know how much of an item you’re going to order; it’s just a question of how often you’re going to reorder.

Alternatively, you could simply check your inventory levels on a periodic basis and then order however many items you need in order to get your inventory levels up to full capacity.  We call this a periodic ordering system, or P-system for short, because you always know when you’re going to reorder; the only thing you have to determine each time is how much you’re going to reorder.

A you might be stuck with a P-system if your supplier can only make deliveries on a periodic basis, but if your suppliers are more flexible, then give a Q-system serious consideration.  It can be advantageous when demand for a product is fairly consistent across the year and will generally result in having to hold less inventory.  But there are always trade-offs, and a Q-system might require you to place several separate orders from the same supplier for different items, and you may need to spend more time monitoring inventory levels.  (Fortunately, a system like Haven does this for you by alerting you when you fall below your reorder point!)

4. Track Your Cash Conversion Cycle.

As you make changes to your inventory practices, you can actually monitor how you’re doing by monitoring your cash conversion cycle.  The cash conversion cycle is a metric that measures just how long it takes you to acquire inventory, sell it, and collect the cash.

Think of it as a timeline:  The clock starts ticking the day you purchase inventory, which you’re likely doing on your supplier’s credit, generating an account payable.  When your supplier sends you an invoice and you pay it, that’s when cash goes out the door.  The time in between is your days payable, or the number of days your account payable obligation to your supplier remains outstanding.  Now you sell the inventory.  The time between when you acquired the inventory and when you sold is your days inventory, or the number of days that the inventory sat on your shelves.  At some point, hopefully, your customer will get around to paying you, and the time between the sale and when your customer paid you are your days receivable, or the number of days that your accounts receivable are outstanding.  The total cash conversion cycle is equal to your days inventory plus your accounts receivable minus your days payable.

Days payable, days inventory, and days receivable are actually a little more complicated because we use accounting ratios to help us calculate them across all of your products, not just one particular item.  But the point here is that the longer your cash conversion cycle, the more outside financing you’ll need, and that doesn’t come free.  The longer your suppliers let you take to pay your invoices the better because they’re helping to finance your business.  And the faster you can get your customers to pay the better because they’re helping you reduce your need to borrow.  But the piece here that you have the most control over is your days inventory.  The more inventory you hold and the longer you hold it, the worse your cash conversion cycle will be and the more you’ll need to think about outside financing.  So even if you can't bring yourself to go quite so far as Tim Cook and think about your inventory as evil, treat it as morally ambiguous at best and manage it accordingly!