May 20, 2016
Proper inventory management and its impact on cash flow are vital to the success of your business. If you invest too much, you may be vulnerable to cash shortfalls. Invest too little and you’ll suffer the consequences of lost orders.
Understandably, for many business owners, their inventory is the single largest investment the business will have. At its most basic, the task of the business owner is to sell the inventory at a profit, within a reasonable period of time. Although this sounds simple in theory, in practice there are many pitfalls, and it can be fraught with complications.
Business owners, by design, want to minimize their inventory. But they often set up a structure that is less than advantageous. It takes cash to buy or build inventory. This is cash that has to be spent before getting paid by customers. Typically, borrowings are incurred to
acquire inventory. When the inventory is sold, it is converted into accounts receivable, which eventually is converted into cash. Interest costs are incurred during this cycle, along with selling, general and administrative costs.
Consider, for example, if inventory turns four times per year (every 90 days), the average accounts receivable collection period is 45 days, and typical vendor terms are 30 days. In this example, interest and other carrying costs are being incurred for 105 days, or about 3 ½ months! There is a more efficient and profitable way to handle this.
First off, the business must take positive steps to address issues of inventory control. Some of the areas that often need to be addressed are purchase orders, inventory receipts, sales orders, and shipments. Good inventory management software can provide detailed data that can be analyzed to help make better decisions about what to purchase, when and in what quantities. Previously considered best practices, such as periodic complete physical counts, may not be necessary. A better and less expensive practice may be the adoption of a cycle count program. Cycle counts eliminate the shutdown periods, provide early detection of inventory inaccuracy and allow for better planning and scheduling decisions due to accurate inventory balances.
The next thing the business owner should do with regard to inventory management is develop a forecast of inventory requirements. Existing inventory mix and sales projections are the key factors in developing this critical information. Customer and market demand, seasonality, competition, supplier pricing, and credit or equity availability are also significant factors that need to be considered. Once the forecast is properly planned and developed, actual results should be compared with forecasts and differences evaluated and corrective action taken when necessary. When a forecasting process is effectively implemented, business owners can make decisions knowing that the existing inventory balance is accurate and the forecasted usage of inventory has been subjected to a thorough and rigorous thought process.
A few other considerations regarding inventory management are purchasing options and safety stock levels. Does buying in bulk make sense or does it raise the risk of obsolescence beyond acceptable limits? Are drop shipments an option? A drop shipment is when the
supplier ships directly to the customer. Are suppliers willing to provide their inventory on consignment? In a consignment arrangement, inventory is not required to be purchased until the business sells or uses the inventory.
Drop shipment and consignment arrangements both eliminate, or at least significantly reduce, carrying costs. Developing and implementing an effective inventory management system will lead to improved cash flows, higher business valuations, and ultimately a more profitable business.