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Updated: Feb 15, 2019
The key to running a profitable business is optimizing sales. And the trick to optimizing sales is answering the question: How much inventory should I carry?
You want to stock enough inventory to meet customer demand without sending your business into financial crisis. Finding a balance, however, can be tricky. Excess inventory can ramp up storage costs and restrict your business’ cash flow. But if you don’t purchase enough inventory, you risk losing sales and alienating eager customers.
The ideal amount of inventory to carry varies from industry to industry, and each business has to consider its own products and financial situation. Not only do you need to think about how much money it takes to make or procure your inventory, but you also need to consider storage costs, seasonality, and the shelf life of your products.
To get started, add up your business’ inventory-related expenses — from storage costs to paying suppliers — and compare this figure to your sales from last year. Once you have a better idea of what it costs to keep inventory, you can implement a few smart practices to ensure you purchase the correct amount of stock.
Here are four critical steps to take.
Reviewing your company’s past and current inventory data is a great way to uncover sales patterns and better predict how much stock to buy. Using inventory management software, like QuickBooks or SYSPRO, you can see which products are most popular, which items sell slowly, and whether certain times of the year are more profitable than others.
It’s also a good idea to regularly audit your inventory. Consider implementing a daily or weekly spot-checking practice, wherein you count one high-selling product to check that your online records match the physical number in your warehouse. Doing this can help you discover trends, identify quantity patterns for bulk ordering, and ultimately make more accurate sales forecasts.
Just make sure you use a standard measurement — whether it’s per product, per batch, or per pound — to track and count your inventory so the numbers are always accurate.
Determining how much inventory to carry isn’t an exact science, but there is a formula you can use to figure out how fast you sell out of stock.
To calculate your inventory turnover ratio, divide the costs of goods sold (COGS) — which is the amount of money it takes to produce, process, and carry your products — by the average cost of inventory you have on hand.
Say your COGS was $75,000 and the value of the inventory you held was $10,000. In this case, your inventory turnover rate would be 7.5. This figure doesn’t necessarily mean much on its own, but when you compare it to the national inventory turnover averages for your industry, it can reveal a lot. According to CSI Market, for example, the average inventory turnover ratio for the retail apparel industry is 8.58, meaning the average apparel company sells out of its stock more than eight times a year.
If your business’ ratio is low compared to national industry averages, you may have extra inventory eating up cash flow and storage space. A higher number, however, could indicate that you’re not carrying enough stock.
The amount of time it takes to order and process inventory affects how much you’re able to sell.
First, you need to have a firm grasp on supplier lead time, which is how long it takes your suppliers to deliver inventory after you place an order. Does it take two weeks or 30 days? Does the estimated lead time always align with the actual lead time? Get into the habit of tracking your orders to see how quickly they’re fulfilled.
You should also factor in internal lead time, which is the amount of time it takes your team to process items, conduct quality control inspections, complete production, package, and ship everything to customers.
If, for example, it takes you a week to process 50 boxes of candles, but you typically receive orders for twice that amount every week, then you need to carry at least two weeks worth of ready-to-go stock — or 100 boxes — to cover yourself.
Safety stock refers to the extra inventory you keep on hand in case of emergencies, seasonal changes, or event-based spikes in shopping.
A company that sells yard maintenance equipment, for example, should keep safety stock in case of snowstorms that drive up the demand for shovels and ice picks. A sports apparel company, on the other hand, may want to hold safety stock for games like the Super Bowl, when more people want to rep specific team paraphernalia.
Review your sales records and inventory data from previous years to determine which items, if any, go up in demand during specific times of the year. Next, look at your cash flow forecasts to ensure you have enough funds to purchase extra stock; an online tool like Float can help you see exactly what you have to work with. The cost of carrying extra stock may seem high, but if you’re prepared to give customers what they want when they want it, you can grow your profits.
If you need more inventory than you can afford to carry, consider your financing options. A business loan can give you the freedom to purchase more inventory and maximize your sales without limiting cash flow.
Maybe you need to fulfill a large order, as was the case for Besame Cosmetics, or buy a ton of inventory at once to avoid steep price increases à la Koshland Pharm.
Whatever your situation, Funding Circle can help. Our business loans are designed to help you grow your operations on your own terms. And we know the importance of getting funding fast, so we made the process as simple as possible. Applying takes just 10 minutes, and you can get a decision in as little as 24 hours after document submission.
Paige Smith is a Content Marketing Writer and Senior Contributing Writer at Funding Circle. She has a bachelor's degree in English Literature from Cal Poly San Luis Obispo, and specializes in writing about the intersection of business, finance, and tech. Paige has written for a number of B2B industry leaders, including fintech companies, small business lenders, and business credit resource sites.