Your business's basic stock should provide a reasonable
assortment of products and should be big enough to cover the normal
sales demands of your business. If you're a start-up, you
won't have actual sales and stocking figures from previous
years to guide you, you must project your first year's sales
based on your business plan.
When calculating basic stock, you must also factor in lead
time-the length of time between reordering and receiving a product.
For instance, if your lead time is four weeks and a particular
product line sells 10 units a week, then you must reorder before
the basic inventory level falls below 40 units. If you do not
reorder until you actually need the stock, you'll have to wait
four weeks without the product.
Insufficient inventory means lost sales and costly,
time-consuming back orders. Running out of raw materials or parts
that are crucial to your production process means increased
operating costs, too. Your employees will be getting paid to sit
around because there's no work for them to do; when the
inventory does come in, they'll be paid for working overtime to
make up for lost production time. In some situations, you could
even end up buying emergency inventory at high prices.
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One way to protect yourself from such shortfalls is by building
a safety margin into basic inventory figures. To figure out the
right safety margin for your business, try to think of all the
outside factors that could contribute to delays, such as suppliers
who tend to be late or goods being shipped in from overseas. Once
you have been in business a while, you'll have a better
"feel" for delivery times and will find it fairly easy to
calculate your safety margin.
Avoiding Excess Inventory
Avoiding excess inventory is especially important for owners of
companies with seasonal product lines, such as clothing, home
accessories or holiday and gift items. These products have a short
shelf life and are hard to sell once they are no longer in fashion.
Entrepreneurs who sell more timeless products, such as plumbing
equipment, office supplies or auto products, have more leeway
because it takes longer for these items to become obsolete.
No matter what your business, however, excess inventory is
something to be avoided. It costs you money in extra overhead, debt
service on loans to purchase the excess inventory, additional
personal property tax on unsold inventory and increased insurance
costs. In fact, one merchandise consultant estimates that it costs
the average retailer anywhere from 20 percent to 30 percent of the
original inventory investment just to maintain it. Buying excess
inventory also reduces your liquidity-something to be avoided.
Consider the example of an auto supply retailer who finds himself
with the opportunity to buy 1,000 gallons of antifreeze at a huge
discount. If he buys the antifreeze and it turns out to be a mild
winter, he'll be sitting on 1,000 gallons of antifreeze. Even
though he knows he can sell the antifreeze during the next cold
winter, it's still taking up space in his warehouse for an
entire year-space that could be devoted to more profitable
products.
When you find yourself with excess inventory, your natural
reaction will probably be to reduce the price and sell it quickly.
Although this solves the overstocking problem, it also reduces your
return on investment. All your financial projections assume that
you will receive the full price for your goods. If you slash your
prices by 15 percent to 25 percent just to get rid of the excess
inventory, you're losing money you had counted on in your
business plan.
Other novice entrepreneurs will react to excess inventory by
being overly cautious the next time they order stock. However, this
puts you at risk of having an inventory shortage and continuing a
costly cycle of errors. To avoid accumulating excess inventory,
establish a realistic safety margin and order only what you're
sure you can sell.
Excerpted from Start Your Own Business: The Only Start-Up
Book You'll Ever Need, by Rieva Lesonsky and the Staff of
Entrepreneur Magazine, © 1998 Entrepreneur Press