The word “Inventory”, according to Merriam-Webster, is simply defined as a list of goods that are in a place, such as a business location or warehouse. But many business owners know that inventory or stock can be a vastly more complex resource to manage and control successfully. Companies often over-invest in stock for the sole purpose of ensuring that they are not “out of stock” when a customer wants to buy.

Cash – The Finite Resource

Over time, in addition to tying up valuable cash resources, poor stock management often results in having too much stock they do not need, and not enough of that which they do need. This often results in purchasing more stock in response to immediate requirements, without considering the wisdom or necessity of purchasing on an emergency basis.

For instance, it is not uncommon for purchases of materials to be made, when the company already has the materials in stock. In environments with challenging stock management problems, the company often does not know exactly what stock is in the building, or the staff can’t find it. This is a common problem with many variations, all of which are usually a waste of time and resources.

Persistent overbuying is often followed by under-utilization, devaluation and eventual obsolescence of stock the premises probably should not have purchased in the first place. Eventually, many businesses find they have so much cash tied up in useless stock, providing no “return on investment”, that other parts of the business begin to suffer cash resource shortages.

While this pattern does not apply to every business with inventory, it is certainly a familiar story to many small and medium businesses, especially those that are struggling, or go out of business due to cash flow issues.

The Quick Fix

Many business owners, faced with greater awareness of stock management problems, immediately begin searching for, and acquiring, quick-fix solutions. They might hire more people; purchase limited-function inventory control or bar coding software; fire suppliers and hire new ones; and issue edicts about maximum inventory spending levels, all with the laudable goal of quickly fixing inventory management issues.

But acquiring a solution before understanding the problem is a bit like buying shoes before knowing the required shoe size. Likewise, the probability of actually solving stock control problems successfully with this approach are about the same as getting the right shoe size in such a scenario… about 1 in 10.

Cause & Effect

Before diving into stock management solutions, it is important to have a thorough understanding of the causes and effects of stock control issues within the business. Here is a step-by-step approach toward framing stock problems in relatively simple, manageable increments.

The results of these information gathering steps (which should be formally documented) can later be used as input when evaluating and prioritizing potential remedies to stock management and control issues.

Discovery Mission

There will be a temptation to try and solve problems as they are encountered and discussed in these steps. But the key objective in this phase is to gather and quantify information, not to deliver solutions. That will come later, once a full understanding of stock-related issues and requirements have been thoroughly discovered and vetted.

The 4 Steps

Here are 4 steps that can be undertaken immediately by companies ready to improve their stock management and control practices:

1. Defining the Problems

The first step involves creating a list of stock problems by department or area. This is a bold step, because it involves asking employees and managers the question: “what’s wrong with this picture?”. But even though they might not talk about it openly (without a little coaxing), employees are often the best source of information regarding what works and what doesn’t within small businesses.

There may be a temptation for managers to “fill in the blanks” on behalf of their employees, or marginalize their input altogether. While it is certainly the owner’s prerogative to decide how to proceed in this area, the best information comes from the people who actually execute the work on a daily basis in each area of your business.

So, the best approach is to call a meeting (or meetings), bring a notepad and pen, ask employees how stock control problems affect day-to-day operations, and write down everything they say. Depending on the industry served by the company, feedback such as the following will not be uncommon:

Sales – “We’re losing deals because we can’t deliver what the customer is buying”.

Marketing – “Our promotions are ineffective because customers get excited about, and take action on specials, only to find the products we’re promoting aren’t available.”

Purchasing – “We’re spending a fortune on logistics because we buy so much inventory on an emergency basis. We also routinely have suppliers drop-ship items we actually have in stock, because the service techs can’t find the parts they need before they leave for the customer site.”

Warehouse – “We never know what we have and what we don’t have, so we often think we can fill an order completely, only to find out at the last minute that we can’t, because of unanticipated inventory shortages. That requires us to start the pick/pack/ship process over again so the shipping paperwork is correct.”

Manufacturing – “Our production plans are always a mess, because we’ll plan and begin a production run, only to have to take the run offline because we’re missing a critical raw material. This stopping and starting of production jobs is killing us in unproductive labor cost and diminished productivity”.

Accounting – “Our invoices a getting paid more slowly because we partial-ship most of our orders, and our customers have to take extra steps to reconcile multiple shipments against their purchase orders. Too often, our invoices wind up in the customer’s research pile, instead of being processed smoothly and quickly”.

2. Quantifying Stock Management Problems

This step involves quantifying and applying a euro value to the inventory management problems outlined in Step 1. It’s a more challenging step, but it has to be done, and the results will help prioritize issues and (down the road) measure the value of potential solutions against the cost of the problems.

It will also provide a reality-check against management’s perception of how stock issues are really affecting the company. Relevant questions to employees might include the following:

Sales – “How many deals have we lost in the last 90 days due to stock-outs, and what is the euro value of those losses?”.

Marketing – “How many promotions have missed their targets because of delivery problems, and what is the value of those promotions?”.

Purchasing – “How much have we spent on emergency delivery cost due to raw material or finished goods shortages?”.

Warehouse – “How many orders are we unable to ship on time, and complete because of finished goods or packaging material shortages?”

Manufacturing – “How many production runs have been pulled offline because of unexpected raw material shortages? What is the value of labor and equipment downtime due to production interruptions relating to inventory shortages? How is our production capacity being impacted by inventory-related issues, and what is the value of that impact?”.

Accounting – “How are payment delays relating to stock shortages affecting aged receivables, and what is the value of those payment delays?”.

3. Calculating Inventory Turnover Ratio

Although there are variations for different industries, the stock turnover (or “turn”) ratio provides a key indicator as to how quickly stock is being utilized or sold over time. Stock turnover is the number of times stock is sold or otherwise consumed (i.e. used in manufacturing) relative to cost of goods sold for a particular accounting period.

Optimal Stock Turn Ratios are usually unique to specific industries and the nature of products being sold. For instance, high value stock such as estate agents properties or expensive medical equipment may not move (or turn) as quickly as products characterized by lower euro values and higher demand per capita. Still, Stock Turn Ratio is an important metric for any company investing in stock.

The most common calculation for Stock Turn Ratio involves two variables: Cost of Goods Sold, and Average Stock Carrying Cost, both measured during a common reporting period. For instance, in order to calculate the Stock Turn Ratio for an annual period, the total Cost of Goods Sold (from the Profit and Loss Statement) for that annual period should be determined first. Then, a calculation of the Average Stock Carrying Cost per month should be made. This can be accomplished by averaging the Stock Asset value on the balance sheet for each month in the same reporting period as the Cost of Goods Sold value from above.

The actual Stock Turn Ratio calculation is then: Cost of Goods Sold ÷ Average (monthly) Stock Carrying Cost for the same reporting period. For example, if a company wants to calculate the Stock Turn Ratio for the year 2012, the numbers might look like this:

2018 Cost of Goods Sold 2,156,000
÷
2018 Avg Monthly Stock Carrying Cost 310,000
=
2018 Stock Turnover Ratio 6.96

Preliminary Indicators

We will address how to analyze the results of this calculation more thoroughly in another article, but here are some general guidelines to consider:

Low Ratio – A low inventory turn ratio (say, under 5) may indicate stock over-investment, reduced demand for certain raw materials in manufacturing (perhaps due to redesigned products), or not enough sales relative to the average inventory carrying cost.

High Ratio – An excessively high ratio (over 17) may indicate that the company is not keeping enough stock on hand to meet demand, possibly spending excessively on emergency shipping costs or drop-ship fees, or simply failing to meet its delivery obligations due to inadequate raw material, finished goods or packaging inventory levels.

4. Valuating Devalued Inventory

As a final step in the initial investigation and quantification of stock management problems, it’s time to take a realistic look at the lost value associated with obsolete, slow moving and scrap stock. This involves calculating (or estimating, if necessary) the difference between the amounts originally paid for the devalued inventory still on-hand, versus the present value of the same stock.

For a business owner, this can be a painful assessment to make, because it essentially measures euros “flushed down the drain” as a result of poor stock management and control practices. But it should also serve as a catalyst for making changes that will be positive for the company, now and in the future. As with most other aspects of managing a small business, owners must be willing to face reality in order to solve the company’s management and control problems.

Understanding and quantifying stock management issues thoroughly is an important first step toward positive change and improved use of the company’s capital resources (specifically, cash and inventory), and most importantly, people. It helps owners, managers and employees become more knowledgeable about stock control challenges, and prioritize which stock management issues need to be addressed first. It also sets the stage for better stock management and control practices that will benefit the entire company in many ways, both tangible and intangible.

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