Many entrepreneurs tend to overbuy inventory to take advantage of quantity discounts especially if the merchandise is imported abroad, or when they project their sales targets too high for a forthcoming holiday season. While this could be financially beneficial, the risk of loss could be greater than the potential rewards.

Losses from overstocking happen when inventory is purchased from the supplier on credit and you are unable to pay on time, forcing you to borrow cash from your relatives and friends often at high interest rates. When payment of the loan becomes due, you are pressured to raise cash by cutting your selling price to get rid of your inventories. This cycle could go on without you noticing that you are incurring real losses from interest costs and lower gross profits. It could then lead to a serious cash flow problem.

Every entrepreneur, regardless of size of business, needs to understand the importance of efficient inventory management. When we say efficient management, it doesn’t mean that inventory must be kept low at all times; doing that could actually result in losses to your company in terms of lost sales and missed opportunities. Instead, what it means is that there should be a system that could enable your company to balance its inventory requirements.

Here are some tips on how to manage your inventory better:

1. Always consider the average turnover period of your products.

Some items move quickly, others move only after some time. Because different items are bought by different buyers, not all of your merchandise would have the same inventory turnover. You can compute your inventory turnover by dividing your cost of sales by the average inventory. The cost of sales is the cost of the products you sold during the period; the average inventory is the average of the beginning inventory and ending inventory.

For example, assume that your sales for the month was P500,000 and that your cost was about 40 percent of it, or P200,000. If the balance of your inventory at the start of the month was P100,000 and your inventory at the end of the month was P75,000, your average inventory would be P87,500. To compute for the inventory turnover, you simply divide P200,000 by P87,500, which gives you 2.29 times. This figure means that you sold more than twice your average inventory during the month.

2. Manage the lead-time of merchandise delivery.

You can determine your ordering day by deducting the lead-time from your turnover period. If it takes five days for your supplier to deliver after you place your order, you can compute the ordering day by deducting 5 days from the turnover period of 13 days to give you 8 days. In this example, you can order your merchandise every 8th day of the average turnover period. This way, you can receive the new purchases at a time when you expect your old inventory to be sold out.

3. Use the turnover period as a basis for ‘terms’.

Ideally, the payment terms should be at least equal to or greater than your turnover period. Under this example, you can negotiate with your supplier that you will settle your account after 15 days. In this scenario, you need not shell out cash to purchase the inventory. Instead, after you dispose all of your inventories in 13 days, you can use the proceeds from your sales for some other purpose.

Different industries have different turnover periods. There are situations when the payment term is less than the average turnover period. When you know your inventory turnaround time, you can have a rough idea of how to negotiate your terms so you can properly control and manage your inventory level. If you are just starting in the business and you still don’t have any idea of your turnover period, it may be good to establish benchmarks by spending some time researching and determining the industry average turnover period. You can then use this as basis for your negotiations with your supplier.

4. Benchmark your actual ratio with the industry.

The industry average turnover period is also a good performance measure. If you are underperforming against the industry standard, you may need to consider reducing your inventory level. You can do this by eliminating slow-moving products and obsolete items or by simply increasing your sales.

When you are familiar with the behavior of your inventory levels, you have the advantage of managing your inventory level more efficiently. You can anticipate changes in product demand ahead of time and at the same time control your costs and manage your cash flows better. Indeed, creating an efficient inventory system is the ultimate key to business success.



Henry Ong is an entrepreneur, investor, researcher and business columnist for more than 20 years. He holds double degree in accountancy and applied economics, a Registered Financial Planner (RFP) and Certified Management Consultant (CMC). Follow him on twitter @henryong888