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.
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