Thursday, September 12, 2013

SOP Friday: Inventory Management

There are a handful of things that can kill your cash flow and your profitability. One of them is inventory. Assuming you are not a store front, you need to keep inventory under control. There are three ways that inventory can kill you.

Note: I assume here that you are not running an actual store, so you don't need shelves full of inventory.

Many of us are creatures of habit. That means we do things the way we've always done them. Or we learn from someone else but don't really know why it's done that way. But that's the way we do it, so that's the way we do it.

With inventory, we used to keep quite a bit of stuff on hand. When I started my business in 1995, hard drives failed. So we kept a few hard drives on hand. We built our own systems, so we kept power supplies and memory on hand.

Intel P2 with MMX - Form Factor from Hell
But there were different kinds of hard drives. IDE and at least three kinds of SCSI. And they all cost a lot of money. There were also different kinds of power supplies. Yes, the form factor didn't change that often, but you still had to keep something on hand for the installed base. Memory has always been a quickly-shifting world.

In all of these - plus modems, mother boards, network cards, CPUs, CPU Fans, etc. - we found ourselves with current stock and outdated stock. And when a specific form factor simply disappeared, we were stuck with 1-2 items that we would never sell. So now we had 10 or 12 memory chips, a couple of small hard drives, some ribbon cables, 5-6 various fans, and lots of other little stuff that would never sell.

Every once in awhile we'd gather up all the old crap that was "brand new" but out of date and donate it to Goodwill or the local Indian reservation's ewaste program. Parallel cables. 5-Pin DIN keyboards. DAT3 tapes. Memory, memory, memory.

The first way that inventory kills your profit is tying up cash. Inventory costs money. A little here. A little there. Pretty soon you have $2,000 invested in things you will never sell. Of course you don't know you'll never sell them. They were originally "cost of goods sold." But they were never sold.

Now you see $2,000 worth of stuff go to the ewaste program and realize you could have bought yourself a really nice stereo instead!

In everything you buy for your business, you need to have a Return on Investment (ROI) calculation. Some things are true expenses, like office supplies. Some things are Cost of Goods Sold (COGS). But when you buy things for resale and never sell them, that's a write-off.

The second way that inventory kills your profit is that it has to be paid for with profit, not just money you have lying around. Let's look at some detail.

Let's say you have an EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of 10%. That means that you have to sell $100 worth of product to buy $10 worth of inventory. But wait. We were looking at $1,000 or $2,000 worth of inventory. That means you're tying up the profit from $10,000 or $20,000 worth of sales!!!

You need SOME inventory. Just be real clear about how much.

The third way that inventory kills your profit is returns and RMAs. Even if you get pre-paid for hardware and software, there will always be the occasional return. Returns cost a time, and that's money. Whether it's the client who changed their mind or the product that arrived dead, you have to do whatever it takes to make it right.

You should calculate over time how much you spend on returns. It is not zero. So realistically, what do you spend on returns?

We have found that making clients prepay for everything has dramatically reduced returns.

In addition, we found that selling brand-name business class hardware with a three-year warranty has essentially eliminated RMAs (return merchandise authorizations) and DOAs (dead on arrivals).

So ...

This is not a policy or procedure that you need to talk about with all employees. But among the administrative and office staff, you should make it clear that you will work to keep inventory as low as possible.

It's a horrible feeling to realize that you spent good money on something that you need to throw away. But if you're conscious of the fact that you're doing this, it will help you realize that you need to minimize it going forward.

Comments welcome.

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About this Series

SOP Friday - or Standard Operating System Friday - is a series dedicated to helping small computer consulting firms develop the right processes and procedures to create a successful and profitable consulting business.

Find out more about the series, and view the complete "table of contents" for SOP Friday at

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Next week's topic: Getting Started: Naming Your Business


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