Controlling Small Business Expenses with Inventory Management
Small and large businesses alike are facing unprecedented inventory crunches. Manufacturers are producing less and domestic businesses are forced to run on less than a 30-day inventory on-hand. Finding the right balance between inventory and consumer demand is an ongoing daily numbers game.
Rule number one in inventory management is know precisely how much capital your business has tied up in inventory. Then frequently ask, is this dollar amount a good investment or, is it hurting my cash flow and risking future business opportunities?
What does inventory cost?
Inc.com recently reported that small business inventories are “‘critically low nationwide with most companies having an average of less than 29 days of inventory on-hand, an 11.5 percent drop from the previous year.” The trick is that in small business accounting circles, inventory is considered an asset to your small business. But not all assets are easily convertible to cash and, unfortunately as many businesses with dust-covered product can attest to, inventory can sometimes be very difficult to move and even more challenging to liquidate.
The cost to carry inventory can include:
· Rick of obsolescence
· Inventory taxes
· Opportunity costs
The greatest intangible is opportunity costs. If you don’t spend your business’ cash on inventory, where else in your business could the money be better utilized? That means that your inventory should be working for you and not costing your business more than the profits it generates.
To determine the cost to maintain an inventory, accountants use what is known as, the carrying cost percentage. It is calculated by dividing the sum of the above expenses by the average inventory value. The longer the inventory sits in your warehouse or on your retail floor, the more it will cost your business in upkeep. The resulting figure is usually expressed as a percentage of the cents per dollar that will be spent on inventory overhead per year.
While expert opinions vary on the rule-of-thumb amount small businesses should use, from as low as 15 percent to as high as 35 percent, taking the time to perform these calculations will provide you with the most accurate data.
If inventory costs so much, why carry a large inventory?
For many businesses, having inventory on hand is a customer convenience benefit. Shoppers like not having to visit multiple stores in order to find the exact item they need. Once a business has determined exactly which items to carry, it’s time to begin reducing stock while still maintaining a positive impact on service.
A cost-effective alternative to carrying inventory yourself is to work with vendors and create a shared inventory plan that will allow your business to maintain higher inventory levels while lowering financial risk. Vendor managed inventory and consignment inventory are the two most popular forms of vendor inventory management.
Vendor managed inventory is defined by Scott Frahm at North Carolina State University as "a mutually beneficial relationship where both sides will be able to more smoothly and accurately control the available flow of goods."
The distributor or manufacturer assumes responsibility for inventory planning of their products on behalf of the customer. This model is popular in grocery and retail food chains. For example, an ice cream distributor delivers, inventories, and stocks ice cream in the grocery store’s freezer. The distributor performs its duties separate from the store’s management and manages all aspects of the product with the exception of sales at the register. This alleviates the store of the inventory management as well as the liability of carrying too much of one type of product that won’t sell. The store must still provide display space and marketing assistance.
Consignment inventory is inventory that is in possession of the customer, but is still owned by the supplier. The supplier does not receive payment until the goods are sold. The benefit of consignment inventory is that it doesn’t tie up the retailer's capital while still providing its customers with a wealth of choices. The downside is that the distributor bears the risk of reduced cash flow and must also pay any taxes on unsold product still in the customer’s possession. The retail store must manage the inventory, provide space for its marketing, and encourage sales. This model works well for new and relatively unknown product or models, introduction of existing products into new sales channels, and high end products into markets where lower end models already have a position.
Ensuring good vendor relations begins with a well defined contract. Carefully review your vendor contracts to include specifics in the following areas:
· Level of consigned inventory. This will determine the specific quantity of items to place into inventory. That way both you and your vendors will determine the number of goods they can provide profitably.
· Responsibility for slow-moving inventory. Discuss how you will keep inventory moving and what will happen if there is a reduction in sales. Will items be returned to the supplier or purchased by your business?
· Damaged or lost inventory. Outline specific responsibilities for inventory that is damaged or lost on your business’ premises. It is wise to conduct at a minimum, an annual physical inventory of warehouse and retail space.
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Copyright Information 2011 Professional Association of Small Business Accountants