Inventory management is something that new e-commerce entrepreneurs don’t think much about when they’re getting started. But successful store owners quickly discover how important it is.
Inventory management involves tracking the availability of assets, raw materials and stock items from the source to the final destination.
If you hold too much inventory, then you’ll end up spending too much money on storage and carrying costs. If you purchase too little, then you’ll run the risk of not having enough inventory on hand to satisfy customer demand.
Keeping the right inventory levels is a balancing act. How much inventory should we keep on hand? When should we re-order? What happens if we run out of inventory? And what tools will we use to track inventory movement?
These are all questions you’ll need to consider when planning out your inventory management.
The basic idea is to track the availability and movement of inventory items from the manufacturer or distributor, warehouse, final retail sales location and sometimes to the customer or end user. The goal of inventory management is to make sure that a business has enough inventory on hand to satisfy demand, while minimizing costs from holding inventory.
This article will explore questions you’ll need to ask yourself and other considerations you’ll have to consider when planning out your inventory management system.
How to Determine How Much Inventory to Keep on Hand
One of the first questions you should ask yourself when doing inventory planning is how much inventory to keep on hand of each item.
Note that there isn’t a right or wrong answer on how much inventory to hold. The stock levels you decide to keep will depend on your risk tolerance, availability of space and many other factors.
Deciding on a reorder point or threshold
To prevent inventory from running too low, we need to decide on a reorder point for each item. Ideally, we will want to select a reorder quantity so that we will have enough inventory to meet customer demand most of the time while minimizing warehousing and inventory carrying costs.
The reorder threshold that we set will depend on demand for each item, storage capacity and other risk considerations.
Safety stock
Keeping extra inventory on hand can prevent us from running out of items in case sales of an item is higher than expected. The amount of safety stock we keep on hand depends on demand variability.
For example, let’s say my business sells gift baskets and we regularly sell exactly 100 each week. Furthermore, let’s assume that I know that with 100% certainty that we will continue to sell exactly 100 each week.
I can safely order 100 gift baskets from my supplier every week and keep no safety stock because I know exactly how much I need.
In reality, however, sales volume will vary. Let’s say that I sell an average of 100 each week, but the actual quantity sold can vary between 90 to 110. I can order 100 gift baskets from my supplier, but I’ll have to keep at least 10 gift baskets in my inventory each week in case we have a good week and we sell extra.
Factors that affect demand
Wouldn’t it be great if we could know exactly how much our customers are going to purchase in the future? Unfortunately, there’s no way we can predict the exact amount that customers will buy.
However, businesses can often estimate customer demand and prepare accordingly. Here are a few factors that we can use to predict future demand and pick the right reorder quantities:
1) Past buying patterns – Past buying patterns are perhaps the most common way that businesses plan their inventory levels. Sometimes sales are consistent from month to month and we can easily maintain the right inventory levels.
However, sometimes variability is higher and we will need to keep more safety stock on hand in case we get a sudden large order.
2) Seasonality – Seasonality can also affect demand. For example, more people buy snow shovels in the winter than during the summer. So if your business sells snow shovels, you will probably want to keep more inventory on hand during the winter and less during the summer.
3) Popularity trends and changes – Demand for an item can rise or fall over the long term. Teenage Mutant Ninja Turtles experienced a spike in popularity in 2014 and 2016 when the Ninja Turtle movies came out and related merchandise probably sold well in that time period as well. However, as interest declines over time, sales of such items can drop.
Keeping track of sales volume changes can help detect changes in popularity of an item. So be aware that items that are popular now may decline in popularity in the future and be prepared to adjust your inventory levels accordingly.
Risk considerations
What happens if you run out of inventory? Will you lose business? Or can you substitute the item with something else? Risk plays an important role in how you manage your inventory.
Here are a few factors that will come into play:
1) Demand variability – Demand variability is perhaps the most universal risk factor to all businesses that carry inventory. A sudden large order can quickly wipe out your available inventory and leave other potential customers without anything to buy.
When determining safety stock and re-order quantities, businesses usually calculate levels that allow them to keep enough inventory of popular items so that customers are able to purchase them most of the time.
2) Inventory turnover – Another important risk factor is inventory turnover. How quickly does an item typically sell?
If an item sells quickly and is popular, then it’s less risky to keep more of it on hand. Even if you order too much, you should be able to sell of any extra inventory in the coming months if the demand stays strong.
On the other hand, slow moving items are a bigger risk. If you order too many items, then they may sit in your warehouse for quite some time and incur more carrying cost than desired.
3) Perishable items – Are you selling items that are perishable? Perishable items are a bigger challenge to manage. You can’t keep too much safety stock or else it will spoil and go to waste if not sold.
4) Supplier reliability and consistency and supplier alternatives – How reliable are your suppliers? Do they always have inventory of the items you need? Or are there times when they will run out of inventory as well?
Also, do you have alternate suppliers that you can use if your preferred supplier runs out of an item?
You may find that you need to keep more inventory on hand if you have a supplier that is unpredictable.
5) Turn around time – Another important consideration is turn around time. Is your supplier close by and can you get the items you order within a day? If so, you may not have to keep as much inventory than if your supplier is half way around the world and it takes months to get your shipment.
6) Similar / substitute items – If an item goes out of stock, can you offer your customers a similar or substitute item? Will they be equally as satisfied if they have to select a substitute item?
If you can offer your customer a substitute, then you may be able to reduce the amount of safety stock you keep of a particular item.
7) Item profitability – The profitability of an item is another important consideration. If an item is low cost, has low carrying cost and has high profitability and demand, then it might make sense to have a lot of that item in inventory. If the opposite is true, then you may want to carry less inventory even if you risk running out of the item.
8) Carrying and storage costs – Carrying costs and storage costs are another risk factor. If the cost of maintaining inventory is high, then you will have to be more careful about ordering too many items. On the other hand, if carrying costs are relatively low, then it might make sense to order more just to be sure you can satisfy demand.
9) Opportunity cost – Do you have limited storage space? If so, then you may have to prioritize more popular and higher margin items over less popular items.
10) Other considerations – You may find that other considerations come into play when planning out inventory management. For example, inventory levels at the end of the year can affect how much you pay in taxes.
Key Takeaways
– The goal of inventory management is to keep enough stock on hand to satisfy demand while minimizing inventory holding costs, carrying costs and inventory risk.
– Forecast demand base on existing sales and seasonality. Be prepared to adjust quickly for changes in demand. Using known sales patterns and taking all costs into consideration, decide on safety stock levels and re-order quantities.
– Analyze risk factors such as demand variability and inventory turnover. Availability of substitutes, supplier lead times and reliability, item profitability and storage costs are other considerations that will come into play when deciding on optimal inventory levels.
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