Why and How to Reduce the High Cost of Too Much Inventory

Cause: High inventory causes excessive inventory obsolescence, pilferage, maintenance, insurance, and taxes.

Effect: This results in lower gross margin.

Consider the expenses that you incur due to purchasing, holding, and selling merchandise in your business. These may include freight in, storage costs, insurance expenses, external or internal theft, obsolescence, spoilage, and taxes.

Studies have shown that the annual additional cost of holding excess inventory can be 25 percent to 32 percent. For ease of calculating, let’s round that off to 30%.

How else might this "excess inventory" be affecting your profits? 

Cause: Lower gross margin causes pressure to get sales volume up, bringing on higher selling and advertising expenses.

Effect: This results in lower operating profits.

When you hold more inventory than you need, your income statement suffers in two ways—a lower gross margin (see #1) and increased operating expenses. Both of these lower your operating profit.

If you are carrying an excess level of inventory, you will incur additional and probably unplanned selling and advertising expenses in order to sell the excess merchandise. These added expenses will lower operating profits.

For instance, if you are spending 4 percent of your sales on advertising costs for which 25 percent is devoted to moving out excess inventory, the saved one percent of your sales volume (25 percent of 4 percent) becomes increased profits.

Cause: High inventory causes poor cash flow, thus pressure from suppliers. 

Effect:  This results in excessive debt servicing.

With every sales transaction, cash is generated, which drives the system. Cash is used to purchase inventory and pay expenses.  When inventory is sold it is converted to either cash or receivables, which eventually turns to cash.  The faster this cycle turns, the more efficient and expedient is your use of your investment.

But when your inventory is too high, your excess cash is tied up in inventory—cash that could be used to pay suppliers. When suppliers don’t receive payments on a timely basis, you will feel the pressure to pay or have your supply terminated. As you juggle to keep them satisfied, you will inevitably wind up at your banker’s doorstep. 

Hopefully you have a good banker who will inform you of the destructive cycle that is beginning. If your banker loans you money, he or she will also want to improve your inventory control to squeeze the excess cash out of your inventory. 

This problem may appear temporary, but it may not be. The loan is a short-run solution: it will not eliminate the long-run problem.

Cause:  Excessive debt servicing causes increased interest expense.

Effect: This results in lower operating profits.