The Importance of inventory control in building a profitable small business.
By Sherron Lumley.
Understanding the shelf-life of your company means taking a careful look at the amount of merchandise, parts, supplies, or finished goods your business is keeping on hand. When done right, inventory management can pay big dividends, notes Jonathan Byrnes, a profitability expert and a senior lecturer at MIT. “Product flow management,” he notes, “leads to improved earnings and happier customers.”
But according to the U.S. Small Business Administration, these important connections often go unseen by entrepreneurs. “Many small business owners fail to appreciate fully the true costs of carrying inventory,” notes the SBA in an “Inventory Management” white paper. This mistake can be a fatal one for a small company, however, as the paper’s authors note that “many small businesses cannot absorb the types of losses arising from poor inventory management.”
There isn’t one single method of inventory management that will optimize results for every business, however. So, it’s worth looking at two of the top schools of thought on the subject.
Traditional Approach: First In-First Out (FIFO)
Graphic Products in Beaverton, Oregon, a company that provides safety products to support OSHA compliance, favors the more traditional First In-First Out method of inventory control. “It’s very important when you have inventory items that may have a shorter shelf life to make sure they are received, shelved and shipped out using this system,” says Kelly Hardin, Graphic Products’ inventory manager. A slightly different variation on this approach, Last in-First Out (LIFO), is sometimes used when prices are rising because it eases the taxable income burden on the business.
So what are the advantages of FIFO? For one, it is often easier to manage since the materials flow through a company typically follows an orderly, chronological path. (Here’s a simple example of how FIFO inventory would move during a typical month.) Second, by allowing for a larger inventory base, FIFO can make a small business more nimble and able to adapt to fluctuating demand.
“Many customers need products right away and cannot afford to wait days or weeks for their orders to ship. If we don’t have what they need, they might look elsewhere and we lose that sale,” Hardin explains. “Having the inventory on hand to fill orders right away means satisfied customers, and satisfied customers will be repeat customers.”
But stockpiling large amounts of raw materials isn’t without its drawbacks. All that inventory takes up money and space, after all. And customer returns can begin to wreak havoc on a system that is generally designed to be a single-file, one-way street.
New Favorite: Just-in-Time (JIT)
In the Just-in-Time inventory strategy, a large inventory is viewed more as a burden rather than a benefit and supply-on-hand approaches zero in some cases. The idea behind JIT, or lean manufacturing, is to have the necessary inventory arrive at the manufacturer or retailer at the exact moment that it is needed. James Womack, founder of the Lean Enterprise Institute in Cambridge, Mass., believes JIT will remain popular because of the potentially significant cost savings to small companies, despite its admitted disadvantages
“The downside with Just in Time is it doesn’t allow for unplanned swings in consumption, and an upturn or swell could mean an inability to meet demand due to inventory shortages,” acknowledges Ken Leava, a retired Supply Chain Specialist for Shell Solar. In addition, the complicated logistics involved in JIT inventory control sometimes become too difficult for a small business to manage without outside help or tracking software.
“The pros are that it keeps inventory at a minimum, so it’s financially efficient and doesn’t require a lot of space,” Leava explains. “Inventory sitting on a shelf is not healthy for a company, and not a good use of capital.” For example, at his former company, Leava reduced a $5 million-per-year expense item to just $50,000 in inventory on the shelves—a one-day supply. As a result, when an unexpected power outage hit, it only caused the loss of one day’s worth of stock. Thanks to a strong vendor relationship and the existence of an inventory contingency plan—both musts when adopting a JIT system—Leava had his supplier air freight all the replacement materials. “[It] wasn’t cheap,” he acknowledges, but he points out that it was still less costly to the company overall than incurring the long-term expenses of all that extra storage and potentially lost capital.
Which inventory method works for you? Weigh flexibility versus cash flow
Still, the JIT technique is not right for every business and the cost-savings may not be worth the potentially disenchanted customers for some businesses. But at companies with more steady production flows, slimming down the shelves can free up much needed capital for other investments.
One good metric to have on hand when you start this analysis is your company’s inventory turnover ratio. Defined as the cost of goods sold divided by the cost of an average amount of inventory, this ratio is a good bellwether of a business’s inventory churn. A low ratio indicates stock is sitting on your shelves for longer amounts of time and, so, is less efficient. Comparing your individual business’s inventory turnover ratio to industry averages can then give you a good sense of where you stand relative to your competitors. (Here’s a simple case study using this process.)
Nearly every small business looks for ways to better use its assets, keep costs down, and improve profitability. And because inventory represents an often-sizeable investment of a business’s cash that can’t be used elsewhere, balancing the competing requirements of fluctuating customer demands and cash flow is a challenge small business owners must get right.