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How to manage inventory? : Problems of excess inventory

Ruchi Gandhi

| Updated: May 18, 2020 | Category: Finance & Accounting

How to manage inventory?

Paying attention to your sales data and inventory details is very crucial for the smooth running of your business operations. The objective of inventory control is to strike a balance between sufficient stock and over-stock. The stock maintained by a business entity at a particular point in time should be sufficient to meet the production requirements so that uninterrupted production flow can be maintained at all times.

An insufficient stock would not only halt the production process but shall also cause a loss of revenue and goodwill. On the other hand, inventory requires some funds for the purchase, storage, maintenance of materials with a risk of obsolescence, pilferage etc. A trade-off between stock-out and over-stocking is required.

How holding excess inventory impacts your business?

When a business is besieged by situations where its stock is lying idle in the warehouse, the business will face the following repercussions:

  • It takes up precious backroom or shelf space.
  • It ties up your working capital.
  • It deters you from re-investing in your business or buying things you actually need.
  • It comes with the cost of carrying excess inventories. These are relatable to the costs for holding/ carrying of inventories in store. It includes the cost of funds invested in inventories (i.e. interest income foregone on funds blocked in inventory), cost of storage, insurance cost, obsolescence etc.

Some steps or methods to liquidate excess inventory

If a business entity has a surplus of merchandise in the warehouse or store, there are a number of steps which can be taken by such entity to liquidate them. Some of these ways are listed below:

  • Bundling of Slow-moving inventory:

Grouping of items and selling them together is an effective strategy adopted by small manufacturers and retailers to deal with the problem of excess inventory held in store. Not only does it aim to accelerate sales but can also differentiate your business from the competition prevailing in the market. Grouping of multiple items together holds the ability to add a sense of creativity in your sales and, thus, attracts customers. For example, businesses can offer a discount to the customers if they choose to buy the products in bulk.

  • Option to return the goods:

It can also be checked with the vendors if the merchandise is returnable to them in exchange for credit or new merchandise. Exploring this option can work if the business shares strong and healthy relationships with the suppliers or vendors.

  • Discounting:

Lowering the prices in respect of excess stock or holding an overstock sale is one of the most common methods to weed out the excess ones. What comes with this is the opportunity to gain new customers to help achieve regular sales in the future. Not only can discounting clear off excess stock items, but it can also lead to growth in the customer base.

  • Refreshing and re-marketing:

Difficulties in selling a product may not always be linked to the product itself. It may often happen that the inventory is not getting sold because of the positioning plan or marketing strategy you follow. Therefore, re-merchandising and re-positioning the old inventory may work to the benefit of enterprises. For example, placing those items in more places in the shop; displaying them towards the front of the store and then have the same products placed at every other noticeable place in the shop.

  • Promoting:

Some businesses would rather not prefer to adopt the strategy of deep discounts since they form an opinion that it will only make them lose money. Thus, they can strengthen their promotions and seek to drive in some sales out of the excess goods lying idle. This might not give you back the full profit, but atleast it can let your business gain some momentum. For example, to get the surplus items moving, some promotional incentives may work, such as offering free product returns or a buy one get one sale. Similarly, free shipping and customer rewards can also prove beneficial in getting rid of excess inventory. Amazon prime’s free shipping model is a popular one in rewarding the customers.

  • Freebies, giveaways or incentives:

Another measure can be to turn the surplus stock into gifts. This can be done by using products as an incentive for customers to attract their friends and family. For example, giving offers such as “Get a free item when you refer a friend”.

  • Diversion of inventory into new products:

If the excess raw materials or components can be used in other product lines or at other plants, then this could be a very good option as well. Companies have known to have created entirely new products based on scrap and unsold stock. For this, the inventory might need some rework and bear conversion costs. For example, automobile machinery spare parts may be re-used in the manufacture and sale of ‘home appliances’ product line.

  • Check out online marketplaces:

Although quite a lot of time and effort can go into launching your products on ‘online merchandise sale websites’, they offer great avenues to help you move surplus stock. Some popular ‘online merchandise sale websites’ are eBay, Amazon, Flipkart, etc. However, it should be borne in mind that these platforms carry their own rules and fees.

  • Donation and tax exemption:

Another option can be to give up the excess inventory as donation or charity and obtain tax deductions on that account. For example, contributions made to certain relief funds and charitable institutions are allowed to be claimed as a tax deduction under Section 80G of the Income Tax Act.

  • Resorting to selling to a liquidator:

Inventory liquidators or liquidation companies take the products out of your business and sell them in bulk. But one should be thoughtful in fixing the prices on liquidation as this get some revenue back to refurnish the business in future. Inventory liquidators can even auction your products.

Measures to ensure proper management of inventory

As excess inventory can tie up a lot of capital and storage space, it is pertinent to avoid having surplus inventory in the first place and also to prevent the chances of dreaded stock-outs at the same time. Hence, to ensure this, the businesses must follow a streamlined strategy as follows:

Step 1: Analyse the causes:

In order to address the problem, the cause of improper inventory levels must be found out. Sometimes businesses may encounter the problem of excess inventory owing to reasons beyond its control. Some of these factors can be a sudden change in what is trending in the marketplace; demand forecasts not turning out to be as hoped, etc.

Step 2: Accurate demand forecasting:

It is essential to foresee the accurate demand of inventory items to ensure that proper inventory control system is in place. Answering whether the demand is consistent, seasonal or occasional and assessing its trend helps to gauge the right amount of inventory needed to be held by a company.

Step 3: Appropriate classification of inventory items:

Relative classification of inventory items can be done by a number of techniques such as ABC Analysis, Fast, Slow and Non Moving (FSN), Vital, Essential and Desirable (VED), and High, Medium and Low (HML). Through the VED method, the classification of items into three categories depends on the basis of their criticality for the production function and final product.

Items are classified as vital when their unavailability can interrupt the production process and cause a production loss to the company. Items under this category are strictly controlled by setting re-order level. Items are classified as essential when their unavailability may cause sub-standardisation and loss of efficiency in the production process. Items under this category are reviewed periodically and get the second priority. Items are classified as desirable when they are optional in nature, and their unavailability does not cause any production or efficiency loss. Items under this category are generally kept for disposal.

For each category of inventory items, the management should devise specific strategies and assess separate re-order levels and minimum stock levels.

Step 4: Improve stock ordering:

Ordering the right products by keeping your customers’ needs in mind is indispensable to ensure proper inventory management. For this, it is important to keep an eye on how products are moving and to observe how customers are interacting with your merchandise. For example, the average normal usage of a material component A is 50 units per week.

Step 5: Set re-order level of stock:

It signifies ‘when to order and how much to order’. This is the level at which fresh order should be placed for the replenishment of stock. It is that level of inventory which signifies that before the material ordered is received into the stores; there is sufficient quantity on hand to cover both normal and abnormal consumption situations. Suppose the maximum usage of a material component A is 75 units per week and the maximum time to get an order from supplier to the stores is 6 weeks. Therefore, the re-order level will be 450 units for the business at which it should place a fresh order (whenever the stock reaches this level).

Re-order level (ROL) = Maximum Consumption × Maximum Re-order Period

Step 6: Know the Minimum Stock Level:

It signifies ‘atleast how much to stock’. Every business entity must determine the minimum level of stock required by it. It is the lowest level of material stock, which must be maintained in hand at all times so that there is no stoppage of production due to non-availability of stock. Suppose the average normal time taken to get an order from supplier to the stores, known as lead time, is 5 weeks. Here, the minimum stock level that must be maintained all the times for material A would be 450 units – (50 units × 5) = 200 units.

Minimum Stock Level = Re-order Stock Level – (Average Consumption Rate × Average Re-order Period)

Step 7: Know Maximum Stock Level of the business:

It is important to then determine the maximum level of stock for a particular business. It signifies ‘up to how much to stock’. It is the highest level of quantity for any material/inventory item which can be held in stock at any time. Any quantity of stock beyond this level leads to an extra amount of expenditure due to engagement of fund, cost of storage, obsolescence, etc.

Suppose the minimum usage of a material component A is 25 units per week, average quantity ordered through a purchase requisition is 300 units and the minimum time to get an order from supplier to the stores is 4 weeks. Here, the maximum stock level would be (300 + 450 units) – (25 units × 4) = 650 units.

Maximum Stock Level = Re-order Level + Re-order Quantity – (Minimum Consumption Rate × Minimum Re-order Period)

Step 8: Set the level of buffer stock:

In any business, some quantity of stock may be kept for the contingency to be used in case of sudden orders. This stock is known as buffer stock.

Interpretation of Inventory turnover ratio

The calculation of inventory turnover ratios for different items of raw materials and comparison of such turnover rates acts as a useful guiding tool for measuring the inventory performance. A high inventory turnover ratio indicates that the material in consideration is a fast moving one. On the other hand, a low turnover ratio is an indicator of over-investment and locking up of the working capital funds in inventories. Inventory turnover ratio can be computed by using the following formula:

Inventory Turnover Ratio = Cost of materials consumed during the period ÷ Cost of average stock held during the period

Where, Average stock = 1/2 (opening stock + closing stock)

Takeaway

Excess inventory poses a threat to a company’s bottom line. Lack of proper management of materials’ inventory is often caused by poor demand forecasting and replenishment policies or not properly tracking the life-cycle stages of a product. It is essential for businesses to follow some appropriate strategies while placing orders and make the right purchasing and marketing decisions.

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Ruchi Gandhi

A CA together with MBA (Fin) and M Com, she relishes taking interest in insightful writing in the domain of taxation and finance. She has gained experience as a full-time author and has also served an accounting role in industry.

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