How to Manage Inventory Strategically to Improve Profit
When you review the balance sheet of a company, you may find that inventory represents one of the largest asset balances. All assets require some sort of additional spending. You may need to store, repair, and insure many types of assets. The costs related to inventory are called carrying costs.
Carrying costs represent the costs of holding inventory, which include the following:
Storage: You must pay for the cost of storing the inventory in a warehouse or other location.
Insurance: Inventory is a valuable asset that you must insure against theft or damage.
Interest: If you borrow money to finance the purchase of your inventory, you incur interest costs.
The more inventory you carry, the higher your carrying costs. So, a buildup of inventory is usually something to avoid, if possible. But carrying just enough inventory to meet demand is a difficult challenge. You need enough inventory to meet customer demand, but not so much inventory that the carrying costs eat up your profits.
Carrying excess inventory increases carrying costs, resulting in less cash to use for other purposes, such as advertising, payroll, and product development. To ensure that your company has sufficient cash flow to cover inventory and other costs, you need to plan your operating cycle — the process of acquiring materials, manufacturing the product, selling it, and collecting the payment.
When creating a budget, consider the connection between cash, inventory, and sales. Start with sales, at the end of the operating cycle. Sales drive the quantity of product you need to produce and the amount of inventory you need to meet sales.
With accurate sales projections, you can manage inventory more cost-effectively in two ways:
You produce only as much product as you sell, reducing the amount of inventory you need to carry.
You may be able to schedule production closer to the time your product is scheduled to ship, so you carry inventory for a shorter amount of time.
Knowing when carrying excess inventory makes sense
In certain cases, carrying excess inventory is a smart business decision. Consider aluminum, which is used for many products: beverage cans, cars, airplanes, and various products in home construction, not to mention aluminum foil. Sometimes, aluminum producers hold excess inventory, even when the market is flooded with it. On the surface, this strategy doesn't seem to make sense; the aluminum producer ends up paying carrying costs for a product whose price isn't likely to rise.
In the aluminum industry, however, producers can charge hefty fees to access their stocks on short notice. So, when a can manufacturer places a last-minute order for more aluminum, the warehouse can recover some of its carrying cost by charging the extra fees.
The fees charged to customers who need fast access to aluminum increases revenue. If storing excess inventory causes a cash crunch, the producer may need to borrow funds to cash flow the business. Borrowing results in an interest expense. In this instance, the producer needs to consider whether the revenue from fees is greater than the interest expense to meet cash demands. If the fee revenue is higher than the loan's interest expense, the producer can justify carrying excess inventory.
Justifying higher inventory levels for certain economic trends
Producers may hold extra inventory because they expect sales to improve. Again, it's about meeting the demands of the customer. Assume the producer expects economic growth and warmer weather to drive larger orders from the construction and automotive sector.
This means two things for a producer:
Prices may increase. Higher prices enable the producer to earn a larger profit margin and cover the higher carrying costs.
Inventory levels may decline. Demand may exceed production. Higher demand may allow the producer to sell all its current production and reach into existing inventory to meet demand. As a result, ending inventory may be lower, and less inventory results in lower carrying costs.