Although it sounds obvious, carrying too much inventory can be expensive. Really expensive. Not just in hard costs but also opportunity costs, especially for young companies.
At Kickpay we see many companies fall into this trap so we wanted to put together a post to highlight why companies purchase too much inventory and the negative consequences of doing so with some real world examples.
Why companies need extra inventory
The principle behind purchasing extra inventory is built on a solid foundation. Companies shouldn’t run out of stock, ever. It’s bad for multiple reasons:
If you are out of stock, many of the sales you would have made have been lost since clients 1) can’t purchase it or 2) are unwilling to purchase and wait for inventory to arrive back in stock.
Poor customer experience:
Amazon Prime means there are now a huge amount of consumers (over 100M) who expect purchases to be delivered within 2 days or less. If you can’t hit that goal due to inventory shortages it will be a black mark for customer service.
It’s clear that running out of stock is a position every company wants to avoid, but there is a stark difference between having a reasonable amount of buffer stock and having so much extra it has a negative impact on the company.
When extra inventory is too much inventory
There are a few main reasons why companies go from having a reasonable amount of excess buffer stock to protect against out of stock situations to having so much inventory it is impactful to the business:
This is the most common cause. With earlier stage companies (<$10M in annual revenue) the final purchasing decision often comes down to the company founders, who, by definition, are extremely optimistic (it takes a special kind of optimism to start a company). This can mean they often rely on the most positive sales expectations for marketing and sales channels.
Minimum Order Quantities (MOQs):
Manufacturers often have a requirement on the minimum number of units that need to be ordered. There isn’t a huge amount the company making the purchase can do about this (outside of finding a new supplier). Generally this is only applicable to very early companies since after the first few production runs, orders will be higher than the MOQ. Apparel and footwear companies can be the exception here since every size and color variant may be subject to their own MOQs.
Sales deals that break down:
Buying inventory with the expectation that a large sales deal (perhaps with a retailer) will close only for the deal to fall apart will leave you with excess inventory. This is rare due to the growth of Direct to Consumer sales channels; companies now rely less on retail distribution. The companies that do rely on these channels will generally have the deal closed before purchasing the inventory.
At this point let’s show an example of a client that bought too much inventory.
The client wanted to buy 4 months of inventory leading into their busy season, including some buffer units to ensure they didn’t go out of stock (smart move) but they ended up buying 3x too much.
They purchased $420,000 worth of inventory (COGS). Of that, they only sold $140,000 worth of COGS during the 4 month period. It took a total of 8 months to sell the entire amount.
In figure 1 you can see the value of inventory they had in stock (blue line) vs the value of inventory they would have needed to cover 4 months of sales (red line).
The $280,000 worth of excess inventory is capital that could have been invested in other aspects of the business. We’ll explore where that money could have been better spent below.
How excess inventory impacts your business
Let’s look at two ways in which purchasing excess inventory can negatively affect the trajectory of your business: hard costs and opportunity costs.
The tangible out of pocket expenses incurred by the business when holding too much inventory.
Companies that need to release new product lines frequently, or are seasonal, run the risk of buying too much inventory and then not being able to sell the excess units once they are outside of their expected selling period.
Companies frequently turn to liquidators to sell the excess inventory. However, this can come at a high cost. Most liquidators will purchase the inventory for 3% – 5% of the retail price.
In our example from figure 1, the $280,000 of excess inventory may be worth ~$1,100,000 (using a 4:1 COGS to retail price ratio). Meaning the liquidation value is somewhere between $30,000 – $55,000. Let’s be optimistic and say we get $55,000. That would mean we are taking a loss of $225,000 ($280,000 in inventory costs – $55,000 from liquidator) on the excess inventory.
In the most extreme example, perishable goods can create extremely high costs due to purchasing excess inventory.
If the inventory has a shelf life / “sell by” date (such as food products) and the date is exceeded the inventory is generally destroyed for health reasons.
In the example above, that would have been a $280,000 hit to the company’s margins.
Inventory storage fees
Using Amazon FBA’s storage fees as an example, we can see in Example 1 the client could have paid over $30,000 in excess storage fees.
$280,000 in excess inventory = 2,800 units @ $100 COGS.
(20” L x 10” W x 10” H) dimensions (estimation) * 2,800 units = 3,200 cubic feet of storage.
3,200 cubic feet * $2.40 / cubic foot per month * 4 months = $30,720 (using the higher Q4 storage fees).
These costs would grow even more to ~$22,000 / month for units that haven’t been sold in over a year. See Amazon’s long term storage fees.
By having large volumes of capital locked up inventory it means that the company is missing out on other opportunities to spend cash to grow.
Inventory lenders can unlock capital tied up in inventory but they will only be able to finance what they think can be sold in a specific timeframe. In the example in figure 1 the client wanted to buy 4 months of stock, which was calculated to be ~$140,000 worth of inventory. The extra $280,000 of inventory was considered excess and financed directly by the client.
What else could the client have spent that $280,000 on?
Sales and marketing
Putting a portion of the $280,000 into profitable sales and marketing channels would accelerate the sales rate of the business, meaning they would be increasing revenue while proving they can sell more units during the 4 month sales period. This, in turn, would lead to higher or cheaper financing options for the next round of inventory.
New product development
Most product companies need to be constantly developing new versions and product lines to stay relevant. This R&D isn’t cheap or fast.
The $280,000 could be put into developing new products that previously weren’t financially possible, or accelerating the current development timeline to leapfrog competitors. This may take the form of hiring extra talent or testing out new suppliers.
Hopefully this gives some visibility about the areas in which buying extra inventory can act as a hindrance to product businesses beyond the out of pocket cost of the inventory.
Companies should avoid going out of stock, but they shouldn’t go so far in the opposite direction that their growth will be affected by having too much inventory.
Growth can be affected not only from hard costs, such as excess storage fees or liquidating old inventory, but also from opportunity costs, like not having the available capital to invest in sales and marketing channels or new product development.
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