Is it possible to simplify inventory costs into two categories? More importantly, when it comes to small business inventory, what are these two categories and which one is more costly? In order to answer these questions, think of your company’s cost to hold inventory without sales. In this case you’re likely thinking of your cost of money, the cost of inventory damage, obsolescence and the impact of ruined inventory. Holding inventory without sales is one of the cost drivers. The other includes the costs of losing sales because your company doesn’t have inventory, or has low inventory levels. Shocked to hear that losing sales is viewed by businesses as an inventory cost? Don’t be!
In most cases, not having inventory and losing sales as a result, is far more expensive than carrying too much inventory. The reason for this includes the direct cost of losing a sale and the consequences that follow. Losing a sale not only means losing gross profit, but could mean losing a customer, which in turn could mean losing market share. Granted, the impact of losing one or two sales is always manageable. However, the image it portrays to the market, and to customers, is something else entirely.
Customers know who has what they need and who doesn’t. Many of my own customers have rationalized that losing a couple of sales here and there is nowhere near as costly as holding inventory for long periods. In this case, they’ve chosen to ignore the impact of lost sales and have instead banked on the low costs of low inventory. Unfortunately, it’s never that easy. Low inventory doesn’t equal low costs.
The Reality of Low Inventory
In order to understand the impact of low inventory, consider what your small business must do when confronted with an important customer who needs product, and you lack the inventory to service them. Depending upon the relationship, you may pursue the following course of action.
1. High Pricing on Raw Materials and Finished Goods: First, you’ll rush parts into your warehouse from your supplier, who will likely charge a higher price for the rush order.
2. Expedited Freight Costs: Second, you'll pay an expedited freight bill to get those parts, which will increase your per-unit freight costs on incoming parts.
3. Cover Costs of Overtime: Third, you’ll probably have to pay overtime to warehouse employees in order to receive, open and repackage product.
4. Another Freight Bill to Your Customer: Fourth, you may then need to pay another expedited freight bill to rush the shipment to your customer’s location – especially if you want to salvage the relationship. Now, does low inventory really mean low costs?
Small business inventory management is full of pitfalls. Companies must find a happy medium between having too much or too little stock. Unfortunately, no amount ever seems to be just right. However, the intention here isn’t to imply that you should continually buy more than you need. Nor is it to say that you should always keep your inventory at its highest point. Instead, the idea is to provide you with an understanding that low inventory is just as costly as high inventory. In this case, neither situation is acceptable.
Inventory is a necessary evil. It costs money to hold and retain inventory for long durations. However, your small business needs inventory to capture sales and grow market share. In this case, understand that while inventory may cost money, you can't make money without it. To gain insight into how to better decide on inventory levels, please refer to the following post: Sample Excel Sheet for Freight Costing & Inventory Cost Reduction
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