A crucial concern when optimizing your inventory is determining how much stock to hold. Generally speaking, we know that overstock means cash is sitting on the shelves when we could be using it elsewhere, and understock means we’re missing out on sales. But what is the right amount of stock to have on hand? What is ‘enough’? Here are key considerations for determining how much stock to have on hand for your business.
Consider your risk tolerance as it relates to stockouts (running out of inventory). Is it most important for you to be in stock at all times? Is reliability and availability part of your value proposition to customers? If so, you are more likely to be overstocked as part of building in a buffer for supply chain issues that can come up.
Or, is it more important to tightly manage cash flow so that you don’t have too much capital tied up in inventory? If cash flow is your paramount concern, then figure into your consideration the cost of lost sales due to stockouts. You may find the opportunity cost of using cash elsewhere in your business outweighs occasional lost sales.
Using inventory forecasting and demand planning, you can forecast the cost of lost sales per item per day. Look at the margin of each product to determine your forecasted lost profit. That will help to determine if spending money on inventory is your highest priority – or if that capital is better spent elsewhere in your business.
How long would you like your stock to last? Another way to think of this is, how often do you want to reorder inventory? Stock cover (also known as days of stock) is the length of time that your current inventory will last based on the sales velocity for that item. Sales velocity is calculated as units sold divided by days in stock.
Note that sales velocity is different than average sales because it takes into consideration days when the item is in stock. If an item is out of stock and therefore as no sales, then figuring sales velocity is more accurate. Using average sales can lead to under-forecasting…which leads to more stockouts. Break the cycle – use sales velocity instead of average sales for forecasting calculations!
Like risk tolerance, determining your ideal days of stock depends in part on your priorities. If cash flow is your primary priority, then you want to know how quickly you can turn new inventory into sales which can then be reinvested into more inventory. Knowing your sales velocity, how quickly can take $10,000 worth of inventory and sell it for $20,000? Does it take 7 days? 30 days? 90 days? The longer it takes to produce a return on your initial investment, consider the opportunity cost of using your capital to buy inventory. What could you do with $10,000 worth of inventory that will take 90 days to sell? Is there a different product that you could make $20,000 on quicker?
Supplier conditions may also play a role in determining your ideal level of stock on hand. Is there a minimum order quantity (MOQ) or minimum budget you need to meet when placing an order? If there is an MOQ, then you may be forced to purchase 90 days of stock when you would ideally like to store only enough inventory to cover 30 days.
Another vendor-related factor that may influence your decision is how quickly can your vendor produce new items? Are you ordering custom items with a long lead time? Your forecasting should consider your lead time so that you place purchase orders in time to avoid stockouts.
What about product-related costs like shipping, taxes, and duties? These expenses should figure into your calculations for how much inventory to order each time. Consider products with very low shipping costs. You may able to order those items more frequently. Conversely, if high shipping costs add significantly to your product costs, then you should explore what you can do to lower the impact of those costs. Is it less expensive to ship one large order rather than several smaller orders?
Not all products are equal
Not all products in your store need to have the same priority for replenishment. Consider using an ABC class analysis of recent sales. An ABC class analysis looks at each variant or product’s contribution to your revenue over the last 30 days. Alternatively, you could calculate the contribution to your profit instead of your revenue to maximize your return on investment.
To calculate the contribution of each variant to your total revenue, divide the variant revenue by the total revenue.
Variant contribution = variant revenue / total revenue
Then sort variant contributions from highest to lowest.
Finally, create a running total or cumulative sum of the variant contribution.
The variants contributing to 80% of your revenue are considered A class items. The next 15% of variants are B class, and the final 5% are C class items.
When determining replenishment priority, you can prioritize A class items so that you do not run out of stock and ensure that you replenish those items first. Remember, this will involve some level of overstock that goes beyond your ideal days of stock. B class items have next priority where you do not carry as much overstock. C class items could be items where you tolerate occasional stockouts – or even eliminate these items since they contribute the least amount to your overall revenue.
Not all locations are equal
If you’re using a third-party logistics (3PL) company to manage your fulfillment or if you’re selling on Amazon (Fulfillment by Amazon – FBA), then you can clearly see the cost of storing your inventory over time. As of February 15, 2019, FBA fees are changing. Click here to see updated FBA fee schedules. Similarly, 3PLs often charge based on how much space inventory takes up in their warehouses, and can add a long-term storage fee if items are around for too long.
Even if you’re handling fulfillment in-house, there is a real cost to storing your inventory. When managing multiple warehouses, look at each location or selling channel (as with FBA) to analyze the associated storage fees. Figuring in each location’s storage fees can help to show where you’re adding costs that may eat into your margins.
Risk tolerance, ROI on inventory investments, vendor considerations, and analyzing product performance can inform what the target amount of your stock should be for your business.