How Much Is Too Much Inventory?

One thing I know is that business owners love their inventory.  Every consulting engagement I enter into always begins with a tour of the operation.  I see how the work flows through the office administration, into the production areas, and out to the customer.  The ins and outs of the business are exposed with the hope that inefficiencies can be identified.

Each owner self identifies areas of their operation they envision as the “killers of cash flow.”  They point to their invoicing and collection process, or the low billable hour employee utilization rate.  Rarely do they identify their warehouse as a problem.  In fact, it’s just the opposite.  They stand in the door with pride beaming from their eyes and point to the vast amount of options they have for their customers.  Then they say things like: “We have the best selection. Or you can’t sell it if you don’t have it.”

The owner knows that he has to have a certain amount of inventory to stay in business.  The question that’s often hard to answer is, how much inventory should they carry?  The answer - just enough to satisfy demand.  Any amount over that could be an inefficient use of your company’s valuable cash.  The small business owner’s challenge is to determine what their stock level should be. In general, it’s different for every business.

For most problems like this one, I advise the business owner to start with the amount of inventory that his competitors are carrying and adjust from that number.  The industry average is a great place to start if you don’t know how to get the process going.  A company’s Inventory Turnover rate will tell you how much inventory they have on the shelf in both the amount of times they have to replace an item or the number of days’ worth of inventory they have on hand.

Here is how it’s calculated.

To convert it to the number of days you have on the shelf use this equation.

Both of these results can be compared to the industry average.  If your company’s Inventory Turnover Rate is lower than the industry average, then you are moving inventory slower than your competitors.  Industry averages are found in many places.  RMA (Risk Management Association) data is used by banks and may be available if you ask your banker.   Industry associations are good for specific data like inventory levels, or it is built into some financial analysis products like the Free Finagraph Dashboard.

The Inventory Days conversion will tell you how many more days an item sits on your shelf in comparison.  Most analysis will stop there and advise you to reduce the amount of inventory you have on hand.  This advice is vague in my opinion.  I believe to make it more valuable you need to complete one more step. 

It’s not good enough to tell a small business owner they have too much inventory.  It’s more helpful to tell them by how much inventory they should reduce their stock level to align with the industry.  The result of the next calculation will identify the dollar amount to reduce the inventory level by.

Target Inventory $ identifies how much inventory a small business should have on hand if it was operating like the average company in their industry.  Now let’s find out the difference in the two comparative companies.

The Financial Impact of Inventory is the number we need to know to make a change in the businesses inventory operation.  The result will inform the owner how much to reduce his inventory by eliminating guesswork and giving him a methodology of identifying problems with his stock levels.

As I said before, every company is different and you may need a little more or a little less than the industry average.  But starting by comparing yourself to others will help you see how fast inventory is moving in the industry and hopefully prevent you from buying too much.  After all, there are plenty of other things to do with cash besides admire it on a shelf.  It might be nice to put the extra amount in your pocket as profit.