Stocking for Success

The surprising key to a thriving bottom line? Inventory management.
by : 

William J Lynott

November 1, 2011

Inventory management may seem like a dry subject, but for retailers, it can have a dramatic effect on profitability. A system that ensures you are carrying the right merchandise in the right quantity is an essential ingredient in a healthy bottom line. Too much inventory will tie up badly needed money while taking up valuable space on your shelves; too little inventory will eat away at your cash flow and disappoint customers you can’t afford to lose.

You may or may not be using one of the commercial packages of computer software to help manage your inventory. However, whether you’re using a manual or a computerized system, there are inventory basics you need to understand. Here are some of the most important:

Either system can be made to work

Many small retailers still rely on manual record-keeping for inventory, and if done properly, a pencil and paper system can be quite adequate. Still, computer-based systems undoubtedly are more efficient and less likely to suffer from costly lapses than manual systems.

While retail-specific commercial programs probably offer the optimum choice, there is no need for the small retailer to invest in costly software. “We are a small company and we use Quickbooks and Microsoft Excel to manage various aspects of our inventory,” says Marcy Roth of Accessory Artists, an online retailer. “They both have a role in inventory management, and so far they have worked quite well for us.”

Accurate records are essential

Eugene Fram, emeritus professor of marketing at Rochester Institute of Technology’s College of Business, emphasizes the importance of inventory record-keeping for retailers. “Make certain you have adequate records of critical inventory information, even if they are in paper and pencil format,” he says. “This includes best-selling items, staple stock items, and items you do not carry but have been requested by customers. There is no substitute for having data on which to make merchandising decisions.”

Whether you maintain a manual system of records or a sophisticated software package, you must use great care in the information you enter. “Remember, inventory accuracy matters,” says Lisa Anderson of LMA Consulting Group in Claremont, Calif. “Even if you happen to place your order for precisely the amount you intended, if you were incorrect about how many you had on hand when you ordered, you’d end up with too many or too few. Either mistake will eat away at your profits.”

Strive for accountability

“To minimize inaccuracies it’s essential that one person be accountable for overall tracking, maintenance, and updates to all software or manual platforms that track inventory,” says Roth. “Wherever possible, the same person should be accountable for tracking order placements as well as shipping and receiving.” And that’s true even if that one person is you.

Don’t be afraid of markdowns

No retailer likes to think about markdowns, but merchandise sitting on your shelves unsold is tying up needed cash, and the longer it sits there, the more damage to your profits. If you’ve made a bad buy, or simply bought too many of an item, it’s important to move that merchandise even if you have to lower the sale price.

“When markdowns are required, make them substantial enough to move the inventory quickly,” says Fram. “Haste does not mean waste when it comes to markdowns.”

Unfortunately, there are times when even a lowered sale price won’t move an item. When that happens, a total markdown—removing the item from both your inventory records and your shelves to make room for saleable goods—is a difficult but wise decision. Many retail executives believe merchandise unsold for one year is a good candidate for complete markdowns.

Policy in larger retail companies usually requires that items completely marked down be immediately destroyed or discarded. That may seem like a harsh policy for your store; however, many inventory professionals frown on the practice of retaining any merchandise once it has been marked out of the inventory. Stock keeping units (SKUs) held on the premises once they have been officially removed from inventory records can be a temptation for employee pilferage. Also, the fact that some items on the shelves are in inventory and some are not can lead to costly errors and confusion in record-keeping and inventory control.

“Reconcile your physical inventory with your records at least monthly,” says Roth, “Use that time to also analyze inventory levels. This is a good time to assess what inventory has been hanging around long enough that you want to move it along or unload it.”

Record-keeping for complete markdowns can be tricky, so you should consult with your accountant on the proper way to handle it for your store.

The importance of turnover

In the minds of many experienced retail executives, the best single yardstick for measuring the health of your inventory is called turnover. Because of the math involved, it’s a term that scares some people, but it’s really quite simple.

To illustrate how it works, imagine you carried only one item in your inventory, and during the year you sold and restocked it four times. In that example, your inventory turnover was 4.0—called four turns.

Here’s a more realistic example: Let’s say your average inventory in 2010 was $50,000; total merchandise sales for the year were $200,000. Again, your annual turnover was exactly 4.0.

In short, your turnover rate tells you how well the items you’ve decided to stock are selling. Obviously, that’s vitally important information to a retailer. To figure your own turnover for last year, just divide the cost of all merchandise sold by your average inventory level during the year. Here’s how that looks in the simple formula for turnover:

Cost of goods sold ÷ Average inventory at cost = Turnover

Selling values could be used in place of cost, but cost is the preferred method. To get average inventory, just add the cost value at the beginning of the period you want to measure to the cost value at the end of the period and divide by two.

Once you’re comfortable with computing your past inventory turnover, you’re ready to set your goals for improving it. What should your goal be? That will vary from one store and one owner to another. On average, though, you probably won’t go wrong if you set four turns as your goal. Whatever your goal, the idea is to get your turnover as high as possible without reducing inventory to a level that will cost you sales by not having demand items in stock.

Yes, it’s possible to get turnover too high. Like most inventory statistics, turnover must be fine-tuned so it works in harmony with other inventory requirements.

Keep a watchful eye on trends

“Carefully monitor merchandise trends for new and unique items,” says Fram. “Experiment with the few that might fit your inventory requirements.”

Anderson agrees. “It’s important to give some attention to thinking about future sales trends; maintaining optimal inventory levels depends heavily on the accuracy of your sales forecasts,” she says. “Be careful, though. It’s easy to waste tons of time on this topic, especially if you dig into a lot of detail. Instead, look at prior sales history, then ask yourself and your employees which SKUs are selling the quickest or slowest, and focus on what appear to be significant sales trends. Overall, what do you expect to happen? Are there any promotions to consider? Is there seasonality in your operation? Make a few adjustments and track results. Over time, you’ll have a good idea of which adjustments make a difference in your ability to keep inventory at the right level without taking too much time.”

How much inventory should you carry?

How you choose the items to carry in your shelf inventory is crucial to an optimum bottom line. No warm feelings on this, please. No stocking of items because they happen to be personal favorites; no stocking items just because they seem to be selling or just because a vendor has offered you a special deal on merchandise that isn’t moving well for the vendor.

One way to estimate the optimum size of your inventory is to use your turnover goal as one of the factors. Using four turns as your objective, the formula for optimum inventory size at cost is:

Cost of Merchandise Sold ÷ 4 = Optimum Average Inventory at Cost

Even if you do a careful job of keeping inventory records, you may find human nature working against your efforts to carry the right items in the right quantity. Despite the precision you can achieve by doing what your records tell you to do, it’s always tempting to second-guess the figures just to prove you know more than the “dumb” system. Watch out for this. Skillful inventory management is largely a matter of simple mathematics. Two plus two is four; don’t try to make it five.

William J. Lynott is a veteran freelance writer who specializes in business management as well as personal and business finance. Visit him at www.blynott.com.