How to Optimize Inventory to Maximize Profitability

Profitability is about more than sales, but that tends to be the focus when it comes to keeping your margins healthy. How can I sell at a higher price? Is there additional value I can provide that commands a higher price? Are there new products I can sell?

The reality is that there are a limited number of levers to pull when it comes to increasing profitability via sales. The operational side of the business, however, is prime territory for optimizations to improve profitability. Of particular focus is inventory.

Whether your business sells goods online or in-store, inventory plays a role in many profitability metrics. Honing in your inventory strategy can have massive impact on your bottom line. Whether you are measuring your profitability by gross margin, return on invested assets, operating income, or otherwise, inventory is key to your success.

Inventory Should Be an Asset, Not a Liability

Inventory initially shows up on the asset side of a balance sheet.

This makes sense. You sell your inventory. You believe in the value of your inventory. You believe customers want and will pay a price for your inventory. It makes sense that your inventory would add value to your company. However, if mismanaged, or misunderstood, inventory can become liability. Whether the liability comes with ongoing costs tied to the inability to sell inventory, or the inventory literally devalues over time, inventory is a risky asset.

When the time comes that inventory simply cannot be sold (e.g. a perishable good expires, a technology release is made obsolete by new releases, etc.), the inventory that started as a business asset becomes an inventory write-off. The amount written off is simply the dollar value of the inventory that can no longer be sold. It is at this point that inventory becomes a liability.

To keep inventory working as an asset for your business, start with a strategy.

Pull vs. Push: Finding a Profitability-Driven Inventory Strategy

Now that you understand that inventory can be both a profit-driving asset, or a profit-draining liability, how do you choose an effective inventory strategy?

Two common inventory strategies prevail in the inventory management space : push and pull. If you deploy a push inventory strategy, you inventory products before they are demanded by customers, in hopes that such inventory will attract buyers and enable you to quickly fulfill orders. On the flip side, a pull inventory strategy waits to either make or inventory products until customers demand or order the products.

Source: Dilbert.com

While the Dilbert cartoon above states a seemingly obvious solution to an inventory problem, it highlights one of the most common intracompany battles regarding inventory. Your sales side of the business desires unlimited supply of every product you sell. However, the procurement, supply, or merchandising side of your business is given the directive to manage inventory down, and only inventory what can be sold. So, what’s the solution? Are push and pull inventory strategies compatible with each other?

While push and pull inventory strategies seem completely counter to each other, in reality, most companies utilize a hybrid between the two. The hybrid arises out of balancing elements of both mindsets into a single strategy, focused on profitability. If your business is established, you have some indication of what products sell, and at what rate they sell. Ratios such as average inventory, inventory turns, and days on hand are all inventory metrics that help you understand your inventory. All such inventory metrics rely on historical data as a predictor of future behavior.

Sales can help identify deviations from historical behavior and help guide inventory strategies for the future. While push and pull strategies are helpful to understand, you will most likely deploy a combination of the two based on the costs of inventory to your business.

4 Alternative Inventory Strategies to Keep Costs Low and Margins High

Beyond balancing out traditional push vs. pull inventory strategies, you can always consider alternative inventory strategies that to reduce the drain inventory can be on your profitability.

1. The Just-In-Time Inventory Strategy

The goal of the just-in-time inventory strategy is to carry as little as inventory as possible to meet sales.

While small businesses might attempt to walk this fine line because of capital constraints, just-in-time is used by some of the most sophisticated companies in the world. Apple is known for utilizing this strategy. Apple’s CEO, Tim Cook, commented: “Inventory is fundamentally evil. You kind of want to manage it like you’re in the dairy business. If it gets past its freshness date, you have a problem.”

To successfully implement this strategy, you must be all over your inventory from both the demand and supply side of your business, and you need to have a keen understanding of how long it will take you to procure product from suppliers, manufacturers, or other partners you depend on. Data is essential and a good inventory management system is required.

2. The Zero-Inventory Strategy (i.e. Dropshipping)

Dropshipping is a zero-inventory strategy that allows you to focus completely on sales and services. The inventory is handled by a third party, or is delivered straight from your manufacturer/supplier to your customer. This is increasingly popular for e-commerce companies. Plenty of cash-strapped startups have launched with a dropship model and never left it.

Dropshippers who utilize third parties to facilitate the movement of products were historically limited to larger companies who could afford to hire third party logistics providers (3PLs). These days, dropshipping is offered by companies like Amazon (Fulfillment by Amazon) and e-commerce platforms like Shopify make it easy to work with fulfilment centers.

3. The Consignment Strategy

Consignment is another option to keep costs low. In a consignment arrangement, you don’t own the product you inventory. Rather, you inventory the product as a service to a third party. Once a sale of the consigned inventory is made, the product is shipped from your inventory, but you had zero days on hand associated with such inventory. A consignment model may be appropriate if you sell a variety of goods from various manufacturers and are looking to shift costs associated with traditional inventory methods.

4. The Demand-First Strategy

Finally, backordering might be an option if you can create pent up demand for your good. Electric car maker, Tesla, is probably the most popular backordering story today. With most of its releases, Tesla builds up long wait lists for models before it begins production. This might seem ideal. What could be better than having a confirmed sale for every product you make?

There are two major risks associated with a backordering-only story. First, by not having the product your customer demands, you risk pushing the customer to a more readily available source. Secondly, by purposely having no inventory, you cannot fully test what the market might demand. You will always be limited to those who are willing to wait for your product. Backordering certainly limits the downsides of inventory, but it requires a product high in demand with little competition.

Inventory Is a Balancing Act

Inventory is one of the most classic double-edged swords in business. While inventory may seem simple and boring on its face, inventory is a critical piece of your business strategy. A successful inventory strategy could mean the difference in make or break for your company. A single inventory strategy may not work forever. Your strategy will most likely evolve as your business matures. And rest assured, you will never outgrow the need for a good inventory strategy.