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Retailers need to sell as much as possible. That means knowing how much inventory to stock, but without having to cut prices or offload surplus items. But the retail business fluctuates by nature and demand changes from day to day and week to week. So, is there a good way to figure out how much inventory to carry?
It’s complicated. In retail, it’s generally considered better to manage your inventory so that you sell out, rather than have leftover stock cut into your storage space. On the other hand, you want your inventory to match consumer demand so that you make as much revenue as possible, without having to mark down prices.
Key considerations for carrying inventory
As any retailer knows, the cost of inventory involves much more than just the price per unit. Purchasing, transporting and holding inventory all have separate (and variable) costs.
These are the critical aspects of product inventory to keep in mind when forecasting how much stock to carry:
Cost of inventory
This seems simple, but the cost of the products you sell will be the biggest factor in determining how much inventory you’re able to purchase at a time.
Storage space, seasonality and shelf life
Holding inventory is a major expense for many retailers, especially for inventory that requires climate control or special storage conditions.
The cost of storage space also factors into how much inventory you’re able to carry. Depending on the availability, cost and convenience of storage in your area, you might need to strategize against your products’ shelf life. For instance, the inventory at the farmer’s market has a different turnover rate than an appliance store.
Knowing how much it costs you to pay for storage space and how long your products can be stored will help you make orders as far in advance as possible.
Bulk orders vs. batch orders
Next, think about how many products you can realistically sell and decide whether to order your products in bulk or by batch.
Smaller orders might incur an upcharge from suppliers. But if you aren’t confident you’ll sell enough units of a product to justify a bulk order, it’s usually worth it to only buy what you know you can sell, rather than being stuck with excess. And depending on your products, you might save on orders by reducing the number of variations or sizes you offer. That’ll also make taking inventory easier, since there will be fewer stock-keeping units or SKUs, to keep track of.
Boutique and specialty retailers might specifically focus on small-batch products, which makes bulk ordering difficult or impossible to do. If this is the case, you might be able to save on ordering by forming relationships with your suppliers, even if you can’t pre-order or bulk order a specific product.
Five rules for determining how much inventory to carry
Taking inventory shouldn’t just be an annual, quarterly or even monthly activity. Get in the habit of regularly checking on inventory and making adjustments to forecasts throughout the month. And if you use the same unit of measurement every time, you’ll be able to calculate estimates with greater accuracy and consistency.
With reliable cost estimates, you can reap the benefits of increasing or reducing orders on products appropriately and optimize your entire inventory management process.
1. Count something every day
Taking inventory every day might seem like an unnecessary annoyance. But there are a few good reasons for working inventory into your daily routine.
For starters, product discrepancies and shrinkage can slip through the cracks if you’re only doing inventory on an infrequent or irregular basis. Taking stock of products every day — or week, if that’s more doable for you — helps you identify recurring trends. That might make it easier to predict how you should order.
A product that consistently sells out is probably already on your radar. But paying close attention to subtle patterns can help you identify where you can adjust product orders or expand selection. Inventory management systems (IMS) can be useful for tracking and reporting on sales and automating things like stock monitoring and order fulfillment. A software solution makes sense if you sell on multiple online platforms, because you can manage each channel through one consolidated inventory.
Until your business is simply too large to run without automation, good records and regular inventory checks will keep you informed about your inventory and ahead of demand.
Units matter. The units you use to count inventory and estimate cost might be different than the manufacturer’s and customer’s methods. For example, you may purchase your stock by weight, count inventory by product (or “eachs”) and sell by the crate. Even if using multiple measures makes sense for your business model, try to find a standard you can use for financial calculations and recording inventory. It’ll make your calculations much more accurate.
2. Know your industry
Different types of products have different rules of supply and demand. Fashion, for example, is a tough business for getting rid of old inventory — and even with the same product, different sizes and colors might sell out completely or not at all.
Changing trends in your industry or fluctuating commodities prices might prevent you from planning inventory orders more than a few months in advance. In that case, pay attention to the sales volume of different types of products, even if you aren’t re-ordering the exact same items.
3. Risk vs. reward
If you’re considering ordering new or additional inventory, consider whether the potential rewards (aka profit) outweigh the risk (of investing in items you won’t end up selling).
That’s the attitude Jean Grant, the purchasing manager for U.K.-based online retailer Find Me a Gift, takes when she’s restocking her business’s inventory, which includes of thousands of products.
Decide first: Risk or reward? Which is most important to your business: limiting your risk in terms of stock investment or capitalizing on the potential rewards of purchasing stock in larger quantities? Is secured, lower-priced stock-holding most important to your business or is it minimizing the investment and maximizing your flexibility to adapt to changing demands?
Investing in more inventory might mean bigger profits but only if you can actually sell those products. To make an informed decision about additional quantities or new products, it’s important to determine how much you can afford to spend.
4. Innovate your inventory
Finding a new way to finance your inventory might mean finding a new inventory source altogether.
For example, innovating inventory with 3-D printing is one way entrepreneurs avoid traditional supply chains. Handmade, recycled and vintage products are all alternative sources to a wholesale merchandiser and might even make your products more interesting to consumers.
5. Crunch the numbers
Yes, you can calculate how much inventory to carry — you just need to use the right formula.
By using a formula to calculate inventory turnover, you’ll get consistent estimates for how much you need to purchase and how often. Feel free to use different calculations to get an idea how different variables could influence your costs. Just keep in mind that calculations only reflect the factors that you input, not a complete picture of your inventory costs.
Start by experimenting with the three following inventory calculations:
Inventory turnover ratio: One of the most common ways to calculate inventory turnover ratio is to look at sales (or you can use the cost of goods sold) divided by average inventory.
Simply put, this shows how quickly you sell out of your stock. But this calculation can also indicate sales strength, alert you to excess inventory if the ratio is low or if you’re under-ordering if you have a high turnover ratio.
You can compare this number to national averages to get a general idea of inventory turnover for your industry. Consistent turnover of full-price inventory indicates that it might be time to expand your offerings.
Inventory value (retail method): You can use the retail method of calculating inventory to know how much your inventory is worth. This calculation converts the retail value of your inventory to a cost value. This approach doesn’t require you to take physical inventory and can be useful for financial projections and accounting.
Days sales of inventory: The number of days it takes your inventory to sell — measured as DSI —shows how long it takes a business to turn its inventory (like inventory turnover ratio). This calculation is particularly relevant in the context of your industry because turnover varies for different products. For example, ice cream has a lower days inventory than freezers.
To get this value, simply divide Inventory by Cost of Sales, multiplied by 365 (days). For more help calculating your DSI and cash conversion cycle, you can check out an online calculator.
Crucial inventory calculations from an industry expert
Any of those three calculations will give you an idea of how much inventory you can stand to carry and at what cost. But you can also take a look at these approaches suggested by Matt Warren, the CEO of Veeqo, an inventory management system. Warren offers these two calculations as the best ways to make sure you never have too much or too little inventory.
1. Safety stock
Seasonal changes in sales volume are typical of the retail industry and you might stand to make a sizable profit if you’re prepared with safety stock (or, simply, additional inventory for popular products).
Safety stock is worth considering if you sell products that have event-based increases in demand, like team merchandise and emergency weather necessities. If you’re looking for a place to start, try searching sales records for unexpected increases during certain times of year or specific products.
Here’s Warren’s suggested calculation:
Take an average of your top three days’ sales volume over the previous month/quarter/year.
Subtract the average daily sales volume for the same period.
Safety stock = (Sales volume of top 3 days/3) – Average daily sales volume
2. Reorder point
If you know which products you reorder each month or quarter, establish a “reorder point” when inventory is running low. That way, you’ll avoid long periods with low or no stock for top-selling items. It’s also a good idea to track how long it takes your suppliers to fulfill purchase orders so that you know how far in advance to place new orders.
Take the average number of days (lead time) between ordering items and having these items ready for sale.
Multiply this by your average daily sales volume over the past month/quarter/year.
Then add your safety stock number.
Reorder point = (Lead time x Average daily sales volume) + Safety stock
This calculation shows you the exact point to place a new order to continue fulfilling orders, without going into safety stock.
Margaret Spencer, a former Fundera contributor, wrote this article.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.