Inventory management

Why it matters

For a product business, inventory is usually the largest asset on the balance sheet and the largest drain on cash flow. Reducing stock by a quarter without losing sales can release more cash than months of profit. In the other direction, a stock-out on a popular item sends customers to a competitor and some of them do not come back. Getting inventory roughly right is one of the highest-return operational skills an owner can learn.

Know what you have, accurately

Every inventory decision rests on knowing current stock levels, and in many small businesses that number is wrong. Goods are received without being entered, items are used for repairs or samples without being recorded, and the annual stocktake produces a write-off that nobody can explain. The fix is a single system of record, usually the inventory module of your accounting or point-of-sale software, and a rule that nothing moves in or out without being recorded.

Replace the painful annual stocktake with cycle counting: count a small portion of your items every week, prioritising high-value ones, so every item is counted several times a year and discrepancies are found while they can still be explained.

• One system of record, connected to sales and purchasing where possible.
• Receive goods against the purchase order, checking quantity before entering.
• Record every movement, including samples, breakages and internal use.
• Cycle count weekly; investigate variances immediately.

Not all stock deserves equal attention

In almost any inventory, a small share of items accounts for most of the value moving through the business, and a long tail of items accounts for very little. ABC analysis simply ranks items by annual sales value and sorts them into three groups. A items (the top few, often around a fifth of the lines) carry most of the value and get tight control: frequent counts, careful reorder points, close supplier management. B items get moderate attention. C items (often half the lines or more) get simple rules and infrequent counts, because managing them closely costs more than it saves.

The exercise takes an afternoon with a spreadsheet and changes where you spend your time for years.

Set reorder points and order quantities

For each A and B item, calculate a reorder point using the formula above and set it in your system so it flags when stock falls to that level. The order quantity then depends on supplier minimums, freight economics and shelf life. A simple approach is to order enough to cover the period between orders you want (say four weeks of average usage) rounded to the supplier’s pack size. More sophisticated economic order quantity formulas exist, but for most SMBs the difference is small compared with getting the reorder point right.

Review reorder points at least quarterly and before known seasonal peaks. Daily usage in November is not daily usage in February for many Australian retailers.

Watch turnover and ageing

Inventory turnover tells you how many times a year you sell through your average stock: cost of goods sold for the year divided by average inventory value. A higher number means stock is converting to cash quickly. The right figure varies enormously by industry (a bakery turns daily, a jeweller a few times a year), so compare against your own history and your trade’s norms rather than a universal target. Days of inventory is the same idea expressed as days: 365 divided by turnover.

Alongside turnover, run an ageing report: which items have not sold in 90, 180 or 365 days. Slow and dead stock should be cleared, bundled or returned rather than left to tie up space and cash while it loses value.

How to get inventory under control

1. Choose one system of record Use the inventory features of your POS or accounting software and make it the only place stock is tracked.
2. Do a full count to reset One accurate baseline count, then move to weekly cycle counting.
3. Run an ABC analysis Rank items by annual sales value and sort into A, B and C groups.
4. Measure lead times and usage For A and B items, record actual supplier lead times and average daily usage.
5. Set reorder points and quantities Calculate and enter them in the system; let it tell you when to order.
6. Clear slow and dead stock Run an ageing report and act on anything unsold past your threshold.
7. Review monthly Turnover, ageing, stock-outs and variances. Adjust reorder points before seasonal peaks.

Real-world example

A Perth bike shop stops running out of its best sellers

Swan Cycles carries about 1,400 product lines and holds roughly $210,000 of stock against annual cost of goods sold of around $630,000, a turnover of about three times a year. The owner regularly runs out of popular inner tubes and chain lube while the back room holds helmets in colours nobody buys. An ABC analysis shows 260 lines produce most of the sales value; the inner tubes are A items.

For the best-selling tube size, average usage is 6 a day, the supplier’s lead time is 7 days, and the owner decides on 3 days of safety stock after checking that deliveries have been up to 3 days late. The reorder point is (6 × 7) + (6 × 3) = 60 units, and she orders in packs of 100 to cover roughly two and a half weeks. She repeats this for all A items, sets reorder alerts in her POS, and clears $38,000 of helmets and accessories that have not sold in a year through a promotion. Six months later, stock-outs on A items are rare, stock on hand is down to about $165,000 and turnover has risen to nearly four times a year, releasing around $45,000 of cash.

Common mistakes

• Trusting inaccurate stock numbers Reorder points and reports are useless if the system says 40 and the shelf holds 12. Fix recording discipline and cycle count first.
• Ordering on gut feel Feel is biased toward recent memory and favourite products. Use usage and lead time data for anything that matters.
• Treating all items the same Managing 1,400 lines equally is impossible. ABC analysis focuses effort where the money is.
• Ignoring dead stock Slow stock does not get better with age. Clear it, even at a loss, to recover cash and space.
• Chasing bulk discounts A 10 per cent discount for buying a year’s supply rarely beats the cost of the cash, storage and obsolescence risk.

KPIs to track

• Inventory turnover Cost of goods sold ÷ average inventory value. Compare against your own history and industry norms; rising is good.
• Days of inventory 365 ÷ turnover. How many days of sales your stock represents.
• Stock-out rate How often a customer wants an A item you do not have. Track it; a low figure justifies the stock you hold.
• Stock accuracy Share of cycle counts that match the system. Aim for the high nineties on A items.
• Aged stock value Dollar value of items unsold past 180 days. Keep it falling.

Frequently asked questions

How much stock should I hold?

Enough to cover usage during supplier lead time plus a buffer for variability, item by item. There is no universal figure; the reorder point formula and your turnover history are the practical guides.

Do I need inventory software?

If you hold more than a few dozen lines, the inventory features of your POS or accounting package will pay for themselves in time and accuracy. Dedicated inventory systems matter when you have multiple locations, manufacturing or online channels to sync.

How is inventory treated for tax?

Trading stock is generally accounted for at year end, and the ATO has specific rules and simplifications for small businesses. Ask your accountant how the rules apply to you and check the current thresholds.

What is the difference between safety stock and minimum stock?

Safety stock is the buffer above expected usage during lead time; the reorder point is the level that triggers an order. Many systems call the reorder point the minimum. The important thing is that whatever you call it, it is calculated rather than guessed.

Key takeaways

• Stock is cash on a shelf; holding the right amount is one of the highest-return skills in a product business.
• Accurate stock records come first; without them every other calculation is wrong.
• Use ABC analysis to focus tight control on the items that carry most of the value.
• Set reorder points from real usage and lead time data, and review them before seasonal peaks.
• Watch turnover and ageing monthly, and clear dead stock rather than letting it sit.