As a new startup, you’re likely well aware of how inventory costs money and how those costs can quickly add up—affecting your cash flow—the longer you go without orders.
However, did you know that it also costs your company money when you encounter zero inventory counts?
In fact, in many cases, the costs of not having products to sell can be higher than if you had too much to sell.
Industry Week recently commented on how the impact of globalization on supply chain networks has made supply chain management increasingly complex:
“A variety of factors—ranging from cost structures, tax laws, skills and material availability, new market entry and others—have driven companies to redesign and reconfigure their supply chains continually. The consequent increase in complexity of market, channel, supply networks and distributed facilities has rendered related planning more intricate and complex.”
Minimizing risk within your supply chain is ultimately about understanding these two aforementioned costs and working toward a balanced inventory, one where you have what you need to close immediate orders, but not so much that your costs of inventory erode profit, or negatively impact your cash flow.
Finding that balance isn’t easy.
However, it becomes easier when you take the time to itemize all the costs of inventory in their appropriate categories. This is looking a little deeper than the bottom line number you’ll see on your balance sheet on the “inventory row.” But if you’re not already reviewing your financial statements monthly, now is a good time to start. This article on balance sheet analysis will help you get started.
Understanding the costs that surround inventory, beyond the simple cost of purchase, will empower you to better manage all the vendors across your supply chain.
So, how are these two cost categories broken down? One category is the costs associated with high inventory and low order volumes. The other is costs associated with low inventory and high order volumes. From there, you can start to think about strategies to reduce costs.
The cost of high inventory and low order volumes
Inventory requires capital.
Each time you borrow money in the form of loans or business credit lines, you are financing inventory and must cover that cost until your customer pays for their orders—accounts receivable. This is the first cost of inventory. When you keep inventory on hand for long periods, your inventory costs start to increase.
Another cost includes damaged inventory due to mishandling, poor transportation, or poor storage of inventory within your warehouse.
Becoming obsolete is another cost.
This happens when you have inventory that is no longer required or in demand by your customers. However, this doesn’t simply involve finished goods. Raw materials, work-in-process, and semi-finished inventory can easily become obsolete, thereby forcing you to sell it for a discount.
Damage and theft are additional costs, as are the costs of insurance, the costs of freight to get product and materials, the costs to manually count inventory, and finally, the costs of storage and handling.
All of these aforementioned costs increase when you encounter low order volumes, or, put differently, low sales.
In fact, you’re more likely to have issues with damage, inventory becoming obsolete, and pilferage during periods of low sales. This is because your employees are required to handle that inventory more often, thereby increasing the risk that damage will occur.
The cost of low inventory and high order volumes
You incur several hidden costs when you encounter high demand but have low inventory counts.
After all, without inventory, you can’t make sales.
Therefore, the first cost of low counts is lost revenue. If you encounter enough periods of high demand, but don’t have the inventory to close sales, then you’ll lose enough orders to lose customers. Eventually, you’ll see your market share erode.
While losing sales is never a good thing, sometimes it’s actually what companies do to salvage the sale and the customer relationship that is worse.
This is because some companies will rush shipments into their warehouse in the hopes of saving the sale. Doing this means they’ll incur higher freight fees and surcharges from vendors who are forced to push the company’s order ahead of others.
Then, once that shipment arrives, the company will incur additional costs in the form of overtime as they unpack, inspect, and or repack the product. These costs are even higher for manufacturers.
5 essentials of supply chain management
So, given the fact that inventory is a cost when counts are high and low, what can you do to better manage your supply chain?
1. Don’t put all your eggs in one basket
First, understand that you’ll be relying upon multiple vendors in multiple locations.
Some of those vendors may be overseas, which is why having a backup stateside is essential. This is especially the case when your primary overseas vendor is not delivering on time.
As Ryan Vinyard, engineering lead for Highway1, stated in an interview with Line//Shape//Space, clear communication with vendors is a critical component of managing supply chain risk:
“Putting the time into documentation and communication is key. I can’t tell you how many prototype builds I’ve gotten to the end of and it’s, ‘Hey, we’re going to have that part today, right?’ and the response is, ‘Oh, I thought one more week was okay.’”
A good rule is to have at least two to three approved vendors, with at least one stateside, for any raw material or product you sell. This ensures you have ample time to cover shortages.
2. Start using vendor-managed inventory agreements
You’ll need to protect yourself during high and low sales periods by using vendor managed inventory (VMI) agreements like blanket orders, volume purchases, consignment inventory, or kanban agreements.
VMI agreements are excellent tools to help you better manage risk within your supply chain because they require that your vendors hold inventory until you’re ready to take a shipment. This helps to reduce all those aforementioned costs of financing, damage, obsolescence, and theft, because that inventory won’t be in your warehouse until you need it.
VMI agreements work when you have a solid backlog of sales or when you are confident in your future sales forecasts. Essentially, you’re promising your vendors a certain volume over time. In exchange, they’ll offer you better prices, faster delivery, and may just give you more favorable payment terms.
3. Sell some inventory at a lower price
Accept the fact that there will be times where you’ll need to sell inventory at a lower market price.
There’s nothing wrong with liquidating inventory if you’re thoroughly convinced that your market no longer wants it, or that holding the inventory is too much of a risk.
Again, the longer that inventory remains at your facility without sufficient order volumes, then the more likely it is to become obsolete, damaged, or stolen.
4. Negotiate on prices
Don’t be intimidated by the prospect of having to negotiate pricing, and most importantly, don’t limit those negotiations to price alone.
You should negotiate payment terms, volume rebates, and rewards, in addition to pushing for delivered pricing. In this case, it’s a question of using your volumes and economies of scale to your advantage.
Conversely, make sure you’re invoicing your clients quickly and doing everything you can to get paid in a timely fashion—in other words, reduce your accounts receivable balance—especially if you’ve borrowed money to finance inventory costs. When your accounts receivable are too high for too long, you’re just asking for a cash flow problem. The sort where you’re making plenty of sales, shipping plenty of inventory, but you’re not getting paid—so there’s no cash in the bank to pay your bills.
Remember, every dollar you reduce in supply chain management costs goes right to your bottom line.
5. Stick with trusted vendors
Finally, be willing to stick with a trusted vendor.
Do not abandon your best vendors the moment a competitor of theirs comes along with a lower price. Good vendors are hard to come by.
Building a long-term relationship is critical to reducing risk in your supply chain. It’s fine to be aware of what the market pricing is, but starting over with a new vendor can easily backfire.
If needed, come up with a list of internal criteria that defines how vendors get approved, which vendor gets the majority of your business, and finally, how long you wait before switching vendors.
There is no easy solution to managing risk within your supply chain.
There are guaranteed to be times where communicating with overseas vendors costs your company an important on-time delivery. After all, managing vendors in a different time zone, and who speak a different language, is by no means easy.
However, it’s not about eliminating risk entirely, but more about mitigating risk by having multiple options. Be sure to do your homework, and always be aware of the two main categories of inventory costs.