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The ABCs of Inventory Control Read on to learn what to buy, when to buy it, how much to buy and how to track it.

By Teresa Ciulla

Opinions expressed by Entrepreneur contributors are their own.

In their book Start Your Own Business, the staff of Entrepreneur Media Inc. guides you through the critical steps to starting your business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors explain the key elements of inventory control so you can more easily understand this key business function.

When it comes to inventory, 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. Since you won't have actual sales and stocking figures from previous years to guide you during startup, 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, you must reorder before the basic inventory level falls below 40 units or you'll have to wait for 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 to do; when the inventory does come in, they'll be paid for working overtime to make up for lost production time.

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 from overseas. Once you've 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, and holiday and gift items. These products have a short "shelf life" and are hard to sell once they're 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 should be avoided. It costs money in extra overhead, debt service on loans to purchase the excess inventory, additional personal property tax on unsold inventory, and increased insurance costs. 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.

Some novice entrepreneurs 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. To avoid accumulating excess inventory, set a realistic safety margin and order only what you're sure you can sell.

Inventory and cash flow

Cash-flow problems are some of the most common difficulties small businesses encounter, and they're usually the first signs of serious financial trouble ahead. According to management education expert Ashok Rao, tying up money in inventory can severely damage a small company's cash flow.

To control inventory effectively, prioritize your inventory needs. It might seem at first glance that the most expensive items in your inventory should receive the most attention. But in reality, less expensive items with higher turnover ratios have a greater effect on your business than more costly items. If you focus only on the high-dollar-value items, you run the risk of running out of the lower-priced products that contribute more to your bottom line.

Divide materials into groups A, B, and C, depending on the dollar impact they have on the company (not their actual price). You can then stock more of the vital A items while keeping the B and C items at more manageable levels. This is known as the "ABC" approach.

Often, as much as 80 percent of a company's revenues come from only 20 percent of its products. Companies that respect this "80-20 rule" concentrate their efforts on that key 20 percent . Most experts agree it's a mistake to manage all products in the same manner.

Once you understand which items are most important, you'll be able to balance needs with costs, carrying only as much as you need of a given item. It's also a good idea to lower your inventory holding levels, keeping smaller quantities of an item in inventory for a short time rather than keeping large amounts for a long time. Consider ordering fewer items but doing so more often.

A good inventory tracking system will tell you what merchandise is in stock, what's on order, when it will arrive, and what you've sold. With such a system, you can plan purchases intelligently and quickly recognize the fast-moving items you need to reorder and the slow-moving items you should mark down or specially promote.

Some retailers track inventory using a manual tag system, which can be updated daily, weekly, or even monthly. In a manual tag system, you remove price tags from the product at the point of purchase. You then cross-check the tags against physical inventory to figure out what you have sold.

Dollar-control systems show the cost and gross profit margin on individual inventory items. A basic method of dollar control begins at the cash register, with sales receipts listing the product, quantity sold, and price. You can compare sales receipts with delivery receipts to determine your gross profit margin on a given item. You can also use software programs to track inventory by type, cost, volume, and profit. A few programs to investigate include inFlow, AdvancePro, and Inventory Traker for Manufacturing/ Distribution.

Unit-control systems use methods ranging from eyeballing shelves to using sophisticated bin tickets—tiny cards kept with each type of product that list a stock number, a description, maximum and minimum quantities stocked, cost (in code), selling price, and any other information you want to include. Bin tickets correspond to office file cards that list a stock number, selling price, cost, number of items to a case, supply source and alternative source, order dates, quantities, and delivery time.

Retailers make physical inventory checks daily, weekly, or as often as is practical—once a year at the minimum. Sometimes an owner will assign each employee responsibility for keeping track of a group of items or, if the store is large enough, hire stock personnel to organize and count stock.

Inventory turnover

When you've replaced 100 percent of your original inventory, you've "turned over" your inventory. If you have, on the average, a 12-week supply of inventory and turn it over four times a year, the count cycle plus the order cycle plus the delivery cycle add up to your needs period.

For instance, suppose you decided to count inventory once every four weeks (the count cycle). Processing paperwork and placing orders with your vendors take two weeks (the order cycle). The order takes six weeks to get to you (delivery cycle). Therefore, you need 12 weeks' worth of inventory from the first day of the count cycle to stay in operation until your merchandise arrives.

You can improve your inventory turnover if you count inventory more often—every two weeks instead of every four—and work with suppliers to improve delivery efficiency. Alternate ways of distributing goods to the store could cut the delivery cycle down to three weeks, which would cut inventory needs to six weeks. As a result, inventory turnover could increase from four times a year to eight times.

Another way to look at turnover is by measuring sales per square foot. Taking the average retail value of inventory and dividing it by the number of square feet devoted to a particular product will give you your average sales per square foot. You should know how many sales per square foot per year you need to survive. Calculate your sales per square foot once a month to make sure they are in line with your expectations.

Teresa Ciulla

Freelance Editor

Teresa is a freelance editor and project manager from southern California.

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