Holding inventory has pros and cons
Inventory can be the largest asset that some businesses own.
Holding inventory can help you:
- serve your customers better
- maximise your profits
- minimise your risks.
However, holding inventory also has other implications so it’s important to think through the pros and cons.
Pros
There are many pros of holding raw materials:
- You always have everything on hand to make your products.
- You can quickly respond to changes in demand.
- You’re less affected by supplier delays or stock outages.
- You can take advantage of price changes and bulk discounts.
- You can reduce admin time and costs by making fewer orders.
And there are pros of holding completed products:
- You never miss out on a sale.
- Your customers don’t have to wait.
- You can go on sale quickly to increase cash flow or challenge competition.
- You can make good use of quiet times by preparing and storing what you’ll sell in busy times.
Cons
But there are cons of holding inventory too:
- You tie up working capital, meaning less cash for other things.
- You need to pay the cost of storage and insurance.
- You’re responsible if anything gets damaged.
- You’re responsible if anything becomes obsolete – for example, due to changes in fashion or technology.
- You may need to keep records and conduct stocktakes.
Decide if your business would benefit from inventory
How valuable are your items to your business?
Some raw materials or completed products are more important to hold as inventory than others. High-value items might be crucial to hold as inventory, but you may prefer to stock less or none of your low-value items.
To decide which items to hold, categorise them by value:
- High-value items: the 20% of items that generate around 80% of sales.
- Medium-value items: the 30% of items that generate about 15% of sales.
- Low-value items: the remaining 50% of items that generate only 5% of sales.
Are you making to stock or making to order?
A make-to-stock model is when you make and hold items as inventory so you can always meet customer demand.
You might consider a make-to-stock model if you either:
- can accurately forecast customer demand
- are consistently matching customer demand.
Alternatively, if you’re usually creating bespoke or customised items, you might consider a make-to-order model. In this case, you can’t really predict customer demand so you can’t hold many (or any) completed products. You may need to hold fewer raw materials too.
Are you selling products or services?
Most businesses provide a mixture of products and services, whether they realise it or not. You probably do too. Understanding exactly what you’re selling may help you decide whether inventory is useful for your business.
Calculate demand vs ordering and holding costs
If you do decide to hold inventory, it’s important to know how much to hold and how much it will cost you. Too much or too little inventory can be expensive. Ordering wisely can save you money or free up money for other things. It can also save you time and effort.
To order wisely you first need to calculate the annual demand, and the cost of ordering and holding the inventory.
Annual demand
Annual demand means the amount of inventory you’ll need each year to satisfy your customers.
Calculate demand for a specific inventory item by looking at your sales data:
- How much of that item did you use in the last 12 months?
- Do any trends exist?
- Are you likely to need more or less of that item in the coming 12 months?
Factor in anything that might affect sales, such as more marketing, reduced opening hours, or new competitors.
Ordering costs
Ordering costs include both time and money invested in ordering and handling inventory. For example:
- time to place and track the order
- time to receive the order
- time to put the order away
- admin fees from the business you place your orders with
- the cost of shipping the items to you
- the cost of any insurance needed for the shipping process.
Calculate any time costs in dollar terms, based on the hourly rate of the staff members doing the ordering.
Holding costs
Holding costs include:
- rent for the space to store the inventory
- the cost of insuring the inventory
- interest on borrowing money to buy the inventory
- the cost of any inventory that gets damaged or goes out of date.
Space used to store inventory does cost you, both in dollars and in opportunities. You may feel that storing your inventory doesn’t really cost you anything, because you had some free space already. But think about what you could be doing with that space if you didn’t use it for inventory.
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