How Much Inventory Your Small Business Should Hold
Your small business should hold enough inventory to cover your customer demand, but not too much that the cost of that inventory financially cripples your small business.
So there's a number out there that you want to hit. The job of your optimized supply chain is to find that number using data that is inaccurate and sometimes wildly inaccurate. Think of your supply chain leaders as Indiana Jones and your inventory target as the Lost Ark. Your supply chain leaders are trying to find the Lost Ark and all they know is that it might be somewhere in Africa. There are several drivers that can help get you there.
Customer Demand Management
Customers typically give you an idea of what they want using one of two tools: orders and forecasts.
The good news about orders is that they come with some level of financial obligation from your customer to you. The bad news is that Some customers may not care that they have a financial obligation to you and will try to cancel or change orders. And that's because your customer, just like you, has some hotshot supply chain pro who is trying to figure out how to optimize inventory. And sometimes that means changing orders that you've already placed, which can mean:
- Increasing an order
- Decreasing an order
- Pulling in an order (i.e. expediting)
- Delaying an order
- Canceling an order
And so Customer Demand Management isn't as simple as taking your customer's orders and fulfilling them.
Forecasts are even more suspect than orders. Forecasts typically don't have any financial obligation tied to them. For instance, your customer might tell you, "I forecast that I'll order 100,000 units of your product next year." And then they might order zero units of your product from you and you would have no recourse if you spent a ton of money making 100,000 units to sell to them.
Here's the other thing you need to understand about forecasts; they're always wrong. They are either going to be off by one or off by ten or off by a million — but they will be wrong. It's not very wise to do any sort of planning by using your customer's forecasts.
Blanket orders are your customer's way of telling you that they have a high enough degree of confidence in their own internal forecasting that they're ready to make a long-term financial commitment to you.
Instead of the 100,000 unit forecast above, let's say your customer placed a blanket purchase order for 100,000 units and within that blanket purchase order, it said it would buy 10,000 units every month for ten months. That gives you the financial leverage you need to start to build your inventory of 100,000 units, instead of 10,000 units at a time.
By building 100,000 units, you can optimize production schedules and raw material purchases and help drive unit costs down. But you're also spending the money to build higher volumes of inventory and no blanket purchase order is bulletproof.
Managing Customer Demand
The trick to customer demand management is using what you know to know your customer's demand better than they do. Your customer might give you forecasts or purchase orders or even blanket purchase orders, but you should only use those as data points to do robust demand planning.
By combining the data you receive from your customers, you can also use other factors to help you with your demand planning:
- Historic Actual Shipments: What’s your customer’s order versus forecast history?
- Seasonality: (is your customer planning for the holiday rush?
- Competitive Landscape: Have your customer’s competitors launched similar products that will impact your customer’s actual demand?
- Marketing/Sales Promotions: Are there any discounts or “buy one, get one’s” coming up that will drive demand increases?
If you’re able to manage your customer demand, it will give your small business a leg up in figuring out exactly how much inventory to hold.
Internal Lead Time
If a shipment arrived from your supplier at 8 AM this morning, how long will it take you to convert the products into a ship-able item and then get it out the door?
Let’s say you don’t know the answer to that question. That would mean that you don’t know what your internal lead times are. Several factors impact this including:
- Receiving time.
- Put away time.
- Inspection time.
- Production cycle times (if any).
- Shipment processing time.
All of that might take you an hour — if all you’re doing is opening a box from UPS, making sure it’s what you ordered and putting into an envelope for your customers — or it could take you weeks (if you have detailed product inspections and value-added production that you do).
Either extreme is okay — as long as you know what it is and you plan your inventory accordingly. If your internal lead time to process 100 pieces is a week and your customer orders 100 pieces of your product twice per week, you need to have enough inventory on hand to cover a week’s worth of customer demand (i.e. 200 pieces).
Supplier Lead Time
When you order a product from your supplier, how long does it take for that product to reach your dock (or doorstep or offsite mailbox or wherever your small business receives deliveries)? There are two ways to know this:
- Ask your supplier.
- Keep track of your supplier’s performance.
If your supplier tells you they can deliver to you in four weeks but you’ve been keeping track of their performance and because of production issues, shipping delays, hang-ups at customs and other unexplained delays, you’ve really been receiving their deliveries in eight weeks, guess what? They deliver to you in eight weeks.
So, if your customers order 200 pieces from you every week and your suppliers deliver to you in eight weeks, you’re going to need to order 8x200 pieces from your suppliers. Maybe you can place a blanket order on your suppliers and have them deliver to you weekly.
And if, as in the above example, your internal lead time is a week, you need to add that to what you have in your supply chain. That’s 1,800 pieces of inventory in your supply chain at any given time to meet your customer demand.
Cost of Goods and Carrying Costs
How much does your inventory cost? And how much can you afford to buy and hold? In the above example, you might be tempted to order more from your supplier than just those 1,800 pieces. If there are supplier delays or customer demand spikes that you want to protect against? Having extra inventory on hand is one way to ensure you have enough unless you can’t afford it.
Your cost of goods (i.e. how much the product you sell actually costs you) is just one measure of what you’ll have to pay. There are also inventory carrying costs — warehouse space and insurance, for example — to consider. You may want to carry more, but you want to make sure that the cost of your inventory isn’t so great that it outstrips the revenue that you’re bringing in on those sales.
What’s the Right Inventory Number?
When you’re holding the right amount of inventory, you’re able to deliver to your customers what they want, when they want it — and spend as little money as possible getting that done. Are you delivering on-time? Are your customers getting what they want? Are your small business finances healthy? Yes? Great? No? Then you’re not holding the right amount of inventory.