Inventory Management Techniques From a Financial View (2024)

Inventory is the largest balance sheet asset in your business: If your margin is 50%, that means your cost of goods is 50%. In other words, 50% of your net sales are spent on inventory and inbound freight.

So why aren't merchants more aggressive in dealing with inventory? In particular, marketers need to do more to liquidate aging inventory, and look closer at how to achieve the optimal balance point between high order fill rate and increased inventory.

Most multichannel companies have plenty of room for improvement in how they manage inventory. These 10 inventory management techniques will allow you to deal with inventory more aggressively and make more profit:

1. Get a handle on inventory status and condition

Most direct companies use their order management system for inventory control. But top management does not use these systems: What they use to monitor inventory status may be a summarized or Excel-based report. Companies need to have a “single version of the truth” for all data: sales, inventory, purchases, stock on hand, etc., including plans and actuals.

What's more, there can be dozens of system codes describing inventory status and condition. The inventory application needs to have status codes used in reporting that can accurately and helpfully describe inventory status to management — such as active product, inactive product, assigned to liquidation, discontinued, return to vendor, and so on.

Sound basic? Sadly, it's not one of the inventory management techniques in practice at many companies. In fact, it's the root of a lot of inventory management issues and attempts to gain useful reports.

2. Get senior management, the chief financial officer and inventory manager on the same page

Inventory managementis not a clerical activity, but a strategic function. Come to an agreement about which key inventory metrics you can do something about, and how to measure them. Then review this on a frequent, scheduled basis.

There are lots of things you can measure, but many are meaningless. Just by focusing on these inventory metrics, you will see improvement if you can put in place the inventory management techniquesto improve performance.

3. Analyze the age of inventory

Many companies either cannot report age of inventory, or they are less than proactive in dealing with it. What is old inventory to you? For some companies, the answer may be 12 to 15 weeks on average; for others, 25 weeks. There are two key points here:

• Are you as active as you need to be to liquidate slow sellers? One of our clients said its goal was to turn the inventory at least four times a year, up from the current 3.15 inventory turnover ratio. But when we talked about how long the company carried inventory before it deemed the stock as old, the response was 20 weeks. This is a classic example of where most small- to mid-size companies are from an inventory management perspective, and in using key performance indicators. By choosing to focus on inventory as it hits 20 weeks and older, they may end up doing only 2.6 inventory turnover ratio annually. For this client to get four turns annually, the company needs to be concerned with inventory as it hits 11 to 13 weeks on average.
• Develop a strategy to liquidate inventory when it's obvious it's a slow seller rather than waiting. You need to develop long-term strategies and follow up with the actions or tactics needed to achieve them. You must also understand the goals, agree to how they will be measured, and report on them regularly.

Are you assigning inventory carrying costs? As with the managers who didn't think there were such costs because they “owned” the inventory, you must realize that there are costs you incur, including occupancy cost (space and utilities), cost of money or lost opportunity, taxes and insurance, and labor to maintain the inventory.

4. Free up cash from inventory

Inventory turnover ratio is an age-old retail inventory metric. It's surprising how many owners and business managers don't have it reported or use it, especially ecommerce companies that have started up in the past 10 years.

Think about the inventory turnover ratio this way: How many days does it take to get your cash out of inventory? If your turnover on average is three times annually, then it takes 122 days on the average. If you are a b-to-b company selling wholesale and the customer negotiates terms that are 60 days, your average for a 3.0 turnover becomes 182 days — nearly half a year.

Big-box retailers are the masters at this; they don't pay for anything until it's sold. Start measuring turns by product and meaningful product categories, and put in place liquidation and purchasing strategies. This will increase turns and improve profits.

5. Dynamically project end of period inventory

Many companies can't project, to the end of the month or sales period, where the stock on hand will come out. To do this, you have to update the planned sales, stocks, purchases, etc. with the actuals for the month.

If you can't do this dynamically, management loses a timely view of how sales trends affect inventory value. Retail companies are more apt to use a dollars open to buy (OTB) process (think of it as a purchase checkbook for inventory).

But the key is that management of an OTB is dedicated to staying within the plans. How many companies have plans by month and can project month end?

6. Use fill rates to determine how well you are serving the customer

Don't forget the customer in all this. What are your customers' expectations for items being in stock?

Our experience is that with the advent of ecommerce, customers have developed a point-click-deliver mentality. Initial customer order fill rates (the percentage of orders that are shipped complete within your distribution center's standard for in-stock product) provide an inventory view of your customer service, and should be reported weekly.

Have you found the optimal balance point between improving fill rates and increasing inventory levels?

We recently added a vendor initial order fill rate to a client's system. We discovered that while 70% of the vendors shipped in an acceptable period of time, the bottom 30% had dismal initial order fill rates. In dealing with the lackluster performers, focus on vendors with key products.

Do you think about inventory in a segmented manner, such as an A, B, C approach in which the segments are defined by core products or by fill rates you want to achieve?

An example: Do you have core products you never want to be out of? Are core products coded on the inventory file? What is the fill rate for each of those products?

7. Take a fresh look at vendor management

There's no doubt that you need to strengthen vendor relationships; without good relationships, there is no business. Being upfront with your suppliers and understanding the pressures they are dealing with will build trust.

But remember, they need you as much as you need them. Consider these points:

• Do you have too many vendors? Can you get better pricing, service, etc. from fewer vendors?
• How financially strong are the vendors? There should be no sacred cows. Renegotiate everything: terms, delivery, discounts, prices, etc.
• Are there alternatives to owning inventory? Examples include consignment inventory, vendor managed inventory or vendor drop-shipped inventory. I can hear some say, “That won't work for us.”I used to say the same thing, except I have seen many startup ecommerce companies operating in unique ways. It all depends on your type of product.
• Where can vendor compliance policies help the financial management of inventory? Have you implemented one that reduces back orders?

Develop a vendor scorecard. Include demand dollars, cancellations, return rates, gross margin, cost of backorders and fill rate by vendor, and purchase orders delivered late. Issue it quarterly and use it in negotiation.

8. Use gross margin retun on investment (GMROI)

Put inventory turnover and gross margin metrics together — gross margin (decimal equivalent) times annual inventory turnover — and report it quarterly. For example, if I give a merchant $1 to buy inventory, 3.0 turns annually in a 50% margin business yields $1.50. But step it up to 3.25 turns and a 50% margin yields $1.625, or an 8.33% improvement.

In terms of days in stock, 3.0 turns means 122 days while 3.25 turns is 112 days. Do your merchants and inventory managers see the significance of these measures?

9. Consider cost of back orders vs. retail and lost gross margin

We have tracked the cost of backorders in hundreds of studies of catalog and ecommerce companies over the years, and found the typical cost per backordered unit of merchandise is $7 to $12. Note that I'm not saying “per backorder,” but “per backordered unit of merchandise.”

These costs include “Where is my backorder?” calls to the call center, and second shipping costs, extra dunnage and packing materials, picking, and pack labor for fulfillment. They don't count lost shipping and processing revenue, lost customer lifetime value, buyer time chasing down backorders, and so on.

We have added functionality to some of our clients' inventory management techniquesthat shows, for the first time, the backorder product history rather than just the quantity of units backordered in the last processing cycle. It gives a clear picture of how high the number of backordered units is annually.

10. Improve the effectiveness of your inventory management staff

Given the financial importance of successfully managing inventory, do you have in position the right people to achieve good performance?

Historically, purchasing and rebuying inventory have been looked at as assistant buyer or highly paid clerical tasks. But given the size of merchandise assortments, the complexity of the supply chain and systems involved, and the number of vendors and purchase orders, doesn't the effort require more strategic thinking? And finally, do you pay the staff commensurate with what you want them to achieve financially?

Today, retailers operate on many more channels, and business is more complex. But the inventory management techniquesneeded to take a financial view of inventory and manage it profitably remain the same.