The Risks of Having Too Much and Too Little Inventory

Think of made-to-stock inventory management as a bet. To determine how much inventory to maintain in stock, your company considers several factors: current customer demand, anticipated trends in consumer demand, the health of the local, national, or international economy, anticipated trends in the local, national, or international economy, the current cost of raw materials and labor, anticipated costs of raw materials and labor, storage capacity and costs, seasonal concerns, technology, competing uses of cash, and inflation. Your company then projects sales for the coming year. When your company spends cash to make or buy inventory, it is wagering that its sales projections are, indeed, accurate. The cost of the bet? The money spent to make or buy the goods in addition to the opportunity costs of what that cash could have generated had it not been tied up in inventory.

This post provides brief views about the risk that company could face when having too much and too little inventory. Read on …

 

The Risks of Having Too Much Inventory

Conventional wisdom says inventory ought to be managed like cash. What this means is that companies must determine exactly how much inventory they need and stock just enough. Indeed, for the past decade, American businesses have struggled mightily to reduce inventories. In 1997, for example, the typical U.S. manufacturer held just 1.2 months’ worth of inventory in stock. That’s 20 percent less than it did in 1993 and 40 percent less than in 1990. These efforts have freed up approximately $82 billion in extra cash.

Still, while 57 percent of U.S. companies have lowered their inventories, 43 percent are carrying the same amount or even more than they did five years ago, according to a recent survey by the consulting firm KPMG Peat Marwick and the University of Tennessee. What’s the harm in overstocking? Overstocking can lead to:

Illiquidity – Ironically, the reason companies ought to manage inventories like cash is because inventory is not like cash. It’s less liquid. Tying up too much cash in raw materials, work in progress, or finished products could be detrimental to your company’s cash flow.

Markdowns – Companies that overstock must generally mark down their prices to move merchandise. For instance, fashion is constantly changing. A retailer that stocks too much of last year’s styles won’t be able to move that merchandise unless it slashes prices. Obviously, this cuts into profits. On the days immediately following Christmas, you can tell which stores overstocked inventories based on the after-Christmas sales. A store that has to slash prices 40 percent, 50 percent, even 60 percent clearly got it wrong.

Obsolescence – Overstocking is an especially dangerous proposition for technology-oriented companies. For instance, imagine you work for a computer maker that overstocked PCs that ran on Intel’s 486 micro-processing chip. Once PCs with Pentium or Pentium II chips hit the market, all of those extra computers in your warehouse became virtually worthless.

 

Building in Cushion:

Despite concerns about overstocking inventory, many companies order a few more finished goods than are necessary. They refer to these as safety stock. Safety stock offers some protection should there be delays in future inventory deliveries, or if some of the goods in stock are damaged.

 

The Risks of Having Too Little Inventory

Under-stocking can be just as dangerous. If your company under-stocks its inventory, it runs the risk of:

Missing out on sales – A company cannot sell what it does not have in stock. Our example with Phil’s Grocery Store illustrates this point.

Missing out on favorable prices – On occasion, companies can secure better prices by buying sooner rather than later. For instance, starting in 1994, coffee companies that didn’t build up their inventories paid for it dearly as coffee prices soared more than doubling in the subsequent three years. In some cases, having just enough inventory is tantamount to having too little.

Missing out on discounts – Often, companies that buy raw materials, component parts, or finished products in large quantities can secure discounts from their suppliers. Companies that stock too little or even just enough of these goods run the risk of missing out on these price breaks. Also, companies that place large orders infrequently, rather than small orders frequently, can reduce shipping and clerical costs.

Losing consumer loyalty – If your company consistently under-stocks what customers want, it runs the risk of losing their future business.

 

The Pros and Cons of Just-in-Time:

While just-in-time inventory control helps companies maintain their liquidity, some companies that have used it have been burned. For instance, newspaper companies that purchased newsprint back in 1993 on a just-in-time basis saw prices more than double over the course of the next two years. Therefore, by stocking just enough inventories, they were forced to buy newsprint at higher costs. It’s also a problem if something ”takes off”, as when Oprah announces her book club selection.

 

In addition to knowing how much inventory to stock, your company must also determine how much inventory to purchase at a time. For instance: there are those who believe companies ought to place several small orders for inventory throughout the year, rather than one large order. Obviously, by placing several small orders, your company can monitor its use of inventory as the year progresses and order just enough. However, the incremental approach tends to be more expensive.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

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