ComplianceDecember 22, 2020

How to establish a practical inventory management system

Effective inventory management eludes many small business owners who often assume only large competitors can create a well-oiled inventory machine. But with some organization, assessments and periodic adjustments to inventory practices, entrepreneurs can improve cash flow and gain valuable insight into their business.

To keep their eyes on the prize as they build their businesses, entrepreneurs often forego a multitude of "niceties" like slick marketing materials or formalized procedures for everyday tasks. But classifying "developing an inventory management system" as something to accomplish once your business has grown can stymie your company from increasing positive cash flow and predicting inventory needs.

Establishing and optimizing an inventory management system will demand some time up-front as well as periodic upkeep. But the investment reaps good returns. To help you streamline the inventory management process and save money without sacrificing your customer experience, try following these guidelines for optimizing inventory management.

Tracking inventory and sales data

The old saying "you can't improve what you can't measure" exemplifies the backbone of a sound inventory management system. If you haven’t yet started keeping thorough records, there's no time like the present. As you create this records system, consider how it will accommodate the most vital inventory components:

  • sales orders — documents comprising your customers' purchase orders (requests for your product or service) in a format tailored for your business
  • bills of materials — documents stating the inventory components (and hopefully labor) required to complete products or services
  • work orders — if you're involved in manufacturing, you're probably familiar with these documents that include products' details and their respective bills of materials

You likely already have a system for recording transactions that include sales orders (we hope). But most entrepreneurs haven't taken the time to complete bills of materials, and for good reason: They are time-consuming. But, in the end, the benefits far outweigh the costs. 

Bills of materials are considerably easier to create for a retail storefront than for, say, a restaurant. In the foodservice industry, one sales order can relate to multiple bills of materials which, in turn, can require a few primary components and many others in small amounts. If you fall into the latter camp, determine the quantities of various invoice items needed for the appropriate bills of materials. 

If the hotcakes at your diner are selling like hotcakes, including the exact quantities for all ingredients on the bill of materials allows you to determine how much inventory you'll need for a day, a week, etc. once you analyze your sales orders during a set time period. 

The system you use to record all of this data should allow you to enter information easily and generate reports without extensive programming knowledge. You can solve this through:

If your business requires little inventory, a homemade spreadsheet solution will suffice. If, however, your business requires an extensive inventory and you're not an Excel expert, the latter two options are a better bet. 

Analyzing the data and improving inventory management

Once you have detailed sales and inventory records available, you can run a variety of ratios to spot waste and improve your cash flow. In many cases, a cursory glance at your inventory records compared to your sales numbers will indicate if your inventory is properly accommodating sales. But to properly evaluate your inventory practices, complete these inventory management analyses and ratios.

Average inventory investment period. To determine the length of time needed to convert money used to purchase inventory into sales, divide your current inventory balance by the average daily cost of goods sold. If you don't know the average daily cost of goods sold, divide your annual cost of goods sold amount by the number of days you were open for business during the appropriate year.

Example: If your average inventory investment period is 100 days, it will take 100 days for something in your inventory to convert to sales. Any steps you can take to reduce the number of days (like ordering less inventory or offering trade discounts for prompt payment) means more money in your cash flow.

Inventory-to-sales ratio. Understanding how your investment in inventory corresponds to your monthly sales amounts will reveal recent spikes in inventory. Divide your inventory balance by sales for the month to find your inventory-to-sales ratio. Perform this ratio every month to see if the ratio is increasing or decreasing.

Tip: An increasing inventory-to-sales ratio means you're investing too much in inventory and/or your sales have dropped. A decreasing inventory-to-sales ratio means your investment in inventory is decreasing in relation to sales and/or your sales are increasing.

Turnover Analysis. Perhaps the most useful inventory management exercise, this analysis can help you discover if your investment in a particular inventory item or group of items requires modifications. And here is where your inventory recordkeeping will really pay off. In order to perform turnover analysis, you'll need to know:

  • the number of inventory items currently in stock
  • the number of inventory items used or sold during a set period (usually 30 or 60 days)
  • the number of inventory items that remained in stock during the set period

Example: Your turnover analysis reveals you have 200 pounds of flour in stock, you used 185 pounds in the last 30 days and 90 pounds remained in stock during that 30-day period. In this case, your flour inventory requires no adjustment because you're using a majority while keeping enough in reserves.

The analysis also reveals you have 432 cans of tomato sauce, used 157 cans in the last 30 days and 313 cans remained in stock during that 30-day period. When it comes to tomato sauce, you're ordering roughly three times more than your business uses in a 30-day period.

Remember the golden rule of inventory management: The more inventory you have on hand, the less cash you have on hand. And while, in theory, you can always liquidate excess inventory in order to boost your cash reserves, there's not always a market to purchase your inventory.

Taking the time to maintain and evaluate your inventory frequently will allow you to adjust inventory investment as your business evolves while helping your cash flow remain positive

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