Understanding and managing your inventory is one of the most critical factors in business success. Yet many entrepreneurs fail to answer such basic questions as "What items are the winners and losers?" and "How often does inventory turn over?" Don't make this mistake. Management education expert Ashok Rao believes that companies can increase their profitability 20 to 50 percent or more through careful inventory management.
There is more to inventory control than simply buying new products. You have to know what to buy, when to buy it and how much to buy. You also need to track your inventory -- whether manually or by computer -- and use that knowledge to hone your purchasing process.

Maintaining Enough 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, 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.
One way to protect yourself from such shortfalls is by building a safety margin into basic inventory figures.

Avoiding Excess Inventory

Avoiding excess inventory is especially important for owners of companies seasonal product lines, such as clothing, home accessories, and holiday and gift items. 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.
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.
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 are usually the first signs of serious financial trouble ahead. According to 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.
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 the products. Companies that respect this "80-20 rule" concentrate their efforts on that key 20 percent of items.
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.

Tracking Inventory

A good inventory tracking system will tell you what merchandise is in stock, what is on order, when it will arrive and what you've sold.
While manual methods may have their place, most entrepreneurs these days find that computerizing gives them a far wider range of information with far less effort. You can even control inventory right at the cash register with point-of-sale (POS) software systems. POS software records each sale when it happens, so your inventory records are always up-to-date.
Features to consider in a POS system include the following:
  • Ease of use. Look for software with a user-friendly graphical interface.
  • Entry of sales information. Most systems allow you to enter inventory codes either manually or automatically via a bar code scanner.
  • Pricing. POS systems generally offer a variety of ways to keep track of pricing, including add-on amounts, percentage of cost, margin percentage and custom formulas. For example, if you provide volume discounts, you can set up multiple prices for each item.
  • Updating product information. Once a sale is entered, these systems automatically update inventory and accounts receivable records.
  • Sales tracking options. Different businesses get paid in different ways. For example, repair or service shops often keep invoices open until the work is completed, so they need a system that allows them to put sales on hold.
  • Security. In retail, it's important to keep tight control over cash receipts to prevent theft. Most of these systems provide audit trails so you can trace any problems.
  • Taxes. Many POS systems can support numerous tax rates -- useful if you run a mail order or online business and need to deal with taxes for more than one state.
Every business is unique; you may find that none of the off-the-shelf systems meets your requirements. Industry-specific POS packages are available. In addition, some POS system manufacturers will tailor their software to your needs.