How much inventory is too much? This can be a complicated question for some companies, especially those who sell a lot of different products. If a company does not have enough inventory they will lose out on sales, if the inventory sits in the back room too long it will cost the company a lot of money. Luckily there is a happy medium. While each business is different and the amount of inventory needed depends on the industry, the season, or if the product has an expiration date there are some general rules that every business can live by. Below are some key formulas to help you determine how much inventory is the right amount of inventory your business to carry.
Inventory Turnover Rate
To determine your inventory turnover rate Cost of Goods Sold (COGS) is divided by the average cost of inventory on hand. Ex: A t-shirt company has costs of goods sold of $120,000 in one year and the average cost of inventory on hand is $10,000. $120,000/$10,000=12. This means the inventory turns over on average of once a month. This would be a great way to determine how much inventory to keep on hand if the same amount of t-shirts is sold every day of the year. Unfortunately this is not the case, the same amount of t-shirts could be sold during a month from Black Friday to Christmas as is sold during the first four months of the year. In this situation the company would run out of shirts during Christmas time and not have enough room to store shirts in March. Inventory turnover rate shouldn’t be the only way to decide how much inventory should be carried but it is a good start.
Inventory Turnover Days
Inventory turnover days are calculated from the inventory turnover rate and can give businesses a better idea on how much inventory a company should have. To calculate inventory turnover days, you divide 365 by the inventory turnover rate. For the above scenario you would divide 365 by 12. The above scenario would have inventory turnover days of 30.4.
No business is the same. Having inventory turnover days of 30 could work for a t-shirt company but not for a grocery store that mainly sales perishable goods. They may need inventory turnover days of less then a week so that none of the goods go bad. While occasionally being short on a certain product could cost you a couple sales it can be better for a business then if they have products sitting on the shelves or in the backroom for months at a time. Adjusting inventory turnover days for busy and slow months has been a proven way to finding a happy medium between carrying to much and too little inventory year round. Need help figuring out how much inventory your company should carry? Contact NOW CFO for a free consultation today.