In a competitive retail environment, there’s little margin for error. If your business exhausts its inventory of a key product when it’s most in demand, you’ll lose out on sales to competitors. And if you err in the other direction, you could be saddled with extra inventory and storage costs, potentially crushing your bottom line.
It doesn’t have to be that way. How do you know whether your inventory management is in trouble?
Common Signs of Mismanagement
The problem might not be obvious — except in extreme cases. Here are a few red flags that may indicate you’ve got a problem:
- In a brick-and-mortar store, you have products that sit on the shelf too long and begin to appear worn, leaving little choice other than to put them in the clearance bin.
- It’s not always readily apparent whether you have an item in stock, so you sometimes order products you already have.
- You’ve been restocking inventory much faster than you’re selling it.
- Your revenue is growing, yet your profits are in the cellar.
A Good Place to Start
Managing inventory is a multifaceted process, but a one-step-at-a-time approach makes it doable. Start by reviewing your product offerings and grouping them into three categories:
- High-value items that aren’t high-volume sellers,
- Medium-value items that sell in moderate numbers, and
- Low-value items that sell in large numbers.
Unless you’re catering to a narrow customer niche, you need products in all three categories to stay in business. Grouping products this way allows you to customize your inventory management process.
Assess sales patterns in each category, then fine-tune your sales forecasts. You may reveal opportunities to price some products more aggressively at times, allow you to target your marketing strategies more effectively and adjust your ordering to match demand.
Match Your Supply Chain with Customer Expectations
Another key facet of inventory management is understanding your supply chain for various products, and how reliably and quickly you can replenish inventory. Just-in-time inventory management, for example, is a great way to avoid carrying excess inventory costs. But it relies on knowing your suppliers well enough to trust that they can deliver on short notice. Supply chain delays during the COVID-19 pandemic have made us all into skeptics to some degree.
Not all products need to be made available to customers immediately upon sale. Some buyers may not expect or want immediate delivery if they also have space limitations. If you can determine who those buyers are, you can open the door to reducing your inventory costs dramatically, or eliminating them altogether, by backordering. That is, just place an order with your wholesale distributor when you make a sale. Of course, you need to be sure your suppliers can hold up their side of that bargain.
Other Inventory Options
Consignment is a cousin of the backorder approach to inventory cost control: You take delivery of goods from suppliers, but without buying them. When items sell, you pay the supplier. This strategy isn’t always an option, however, because it shifts all the inventory financial risk to the other party. For many wholesalers and product manufacturers, it just isn’t worth the risk and/or finance cost.
You might find a willing consignment partner when there’s a sharing of risk. For example, suppose you’re dealing with a new product that hasn’t been consumer tested yet. If you’re not willing to take that risk, the supplier might need to offer a consignment arrangement. And remember, you’re offering something in return — a “free” display shelf and storage space. That’s an opportunity cost for you.
At the other extreme end of the inventory management spectrum is bulk purchases. Buying in bulk allows you to pay a lower unit cost and save on shipping. A lower cost for you gives you more flexibility in pricing the product. So, if you need to generate sales fast for cash flow reasons or to make space in your storage area, you can have a clearance sale without losing your shirt.
Factoring Math into the Inventory Equation
The “science” part of inventory management takes the form of calculations you can make. (See “DIO: A Critical Metric for Inventory” at right.) Abundant software options exist to help you crunch the numbers and keep tabs on what’s in your inventory.
Most software can also integrate with mobile scanners and point-of-sale systems.
Before you purchase a software solution, take your time in reviewing the options. There are many that range widely in sophistication and price. Assess your needs first, then begin shopping.
When fortifying your inventory management processes, it’s important to evaluate the results of your efforts using key benchmarks. Record those indicators at a baseline for measuring your progress over time.
Partner with a Pro
Optimal inventory management doesn’t happen overnight, rather it’s a continuous improvement process. Contact your CPA for help evaluating your current practices and suggesting ideas for improvement and ways to benchmark results. He or she has seen retailers at their best — and worst — and can help you identify weaknesses and implement cost-effective solutions.
DIO: A Critical Metric for Inventory
The days in inventory (DIO) metric is critical to gauging the effectiveness of your inventory management system. DIO is the average number of days products are held in inventory before they’re sold. You can calculate it for individual products or product categories.
How do you calculate DIO? First, you need to compute two other numbers:
1. Cost of average inventory (COAI). Add the value of your inventory at the beginning of a month to the value at the end of the month, then divide the sum by two. The result is your COAI.
2. Cost of goods sold (COGS). This equals your beginning-of-year inventory, plus the costs of inventory purchases during the year, minus the value of your end-of-the-year inventory.
To calculate your DIO, divide COAI by COGS and multiply the result by 365 days.
Suppose your COAI is $100,000, and your COGS is $1 million. In this case, the average number of days products are held in inventory before they are sold is 36.5 days [($100,000/$1 million) × 365].
In a vacuum, DIO is a meaningless number. But once you have the average for your business, you can look for averages for your retail sector to see where you stand compared to competitors in your local market and of similar size. You can also use it to benchmark your company’s improvement over time.
Today, cost segregation studies continue to be a hot button with the IRS, and auditors remain vigilant in finding taxpayers that claim deductions based on overly aggressive studies. Under a 2017 Chief Counsel Advice, the IRS argued that it may also assess penalties against tax professionals who prepare aggressive cost segregation studies for aiding and abetting taxpayers in the improper preparation of their tax returns.
The Tax Cuts and Jobs Act expands the benefits of cost segregation studies. (See main article.) So, expect ongoing IRS scrutiny in the coming years.