Inventory management can be a complex concept with innumerable moving parts, like supply chain issues that cause inventory shortages.
For retailers building a plan from scratch or overhauling an old one, creating an inventory management system is crucial. Even if you start with a manual system, it's important to put one in place.
The day-to-day of inventory management and planning can be different for each retailer. But the components you need to build a scalable inventory management system are generally the same.
Part of an inventory management system is tracking what comes into your warehouse or store, as well as what leaves through online or in-store sales. We'll look at five components to consider which can make inventory management and planning easier for your retail business.
5 Parts of a Scalable Inventory Management System
1. Forecast Demand
Part of creating a business plan is figuring how much money your business will make over the next quarter, year, and five years. To do this, you’ll need to forecast demand or create sales projections. Projections help you determine how much inventory you should buy or make to fulfill your forecast.
Creating sales projections becomes easier once you've started selling. Your sales history can also help you forecast how many units you’ll sell in the future. Looking at bestsellers and accounting for business growth can help you determine how many units to produce in the future. It's also a good idea to look at retail industry forecasts as a whole to better understand the market you're in.
A formula that I like to use when forecasting is the sell-through rate formula. Comparing the amount of inventory a retailer receives from a manufacturer or vendor to what is actually sold is your sell-through rate and is usually expressed as a percentage.
Here is the sell-through rate formula:
Units sold / Units Received into Inventory x 100 = Sell-Through Rate %
300 (units sold) / 550 (units received) x 100 = 55% (sell-through rate)
Looking at sell-through rates can help you identify sales spikes and opportunities. It’s a way to assess if you're getting a good return on your inventory investment.
A sell-through rate of 5% might mean you have too many units on hand, your product price is too high, or there’s a lack of interest from the customer. On the other hand, a sell-through rate of 80% might mean you have too little inventory on hand or your product price is too low. In the best-case scenario, a very high sell-through rate might mean you have a bestseller on your hands. If that's the case, you can try to make more inventory as soon as possible.
2. Inventory Turnover
Inventory turnover measures how fast a retailer sells through its inventory and needs to replace it. The faster you "turn" your inventory, the more inventory you will need in a year.
The turnover rate formula gets used during a specific period of time:
Number of Units Sold / Average Number of Units = Turnover Rate
Example: 1,000 (units sold in one month) / 500 (average number of units produced in one month) = 2 (Turnover Rate)
According to the Small Business Chronicle: "The average merchandise turnover in the retail clothing industry for the 12-month period ending June 2011, was 3.91. This means that the average clothing retailer sold out its entire inventory 3.91 times during this 12-month period."
With a healthy turnover rate, you can prevent inventory from sitting in your warehouse or stockroom for too long. And you can avoid disrupting your cash flow.
3. Open To Buy (or OTB)
Inventory planning can help you manage the cash flow of your business. One way to do this is by using an open-to-buy system for your inventory plan.
Open-to-buy is a purchasing budget created by a retail store during a certain time period for future orders. Direct-to-consumer brands can also use an OTB plan to determine how much inventory to manufacture during a specific timeframe. Creating an OTB budget will help you decide how much inventory you can buy or manufacture without hurting your cash flow.
OTB is also the process of planning product sales, purchases, and inventory turns. You don't have to set the turns at the same level for every product or category in your store. Some products sell slower and some sell faster. With an open-to-buy system in place, you can manage your product categories and classifications and plan turns for each.
Here is the OTB formula:
Planned Sales + Planned Markdowns + Planned End of Month Inventory - Planned Beginning of Month Inventory = Open-to-Buy
Look at this formula for one month — Sept. 1st - Sept. 30th:
$15,000 (planned sales)
+ $250 (planned markdowns)
+ $17,000 (planned end of month inventory — Sept. 30th)
- $25,000 (planned beginning of month inventory — Sept. 1st)
= $7,250 (Open-to-Buy)
This article has a sample six-month OTB plan that can help you manage your inventory plan.
Please note: These values are placeholders to show calculations. They’re not necessarily representative of plans that you should aim for.
4. Cycle Counts
The most controllable expense in retail is inventory. Poor management of your inventory can result in false metrics and can cause inventory shrinkage.
Inventory shrinkage refers to the amount of inventory lost in the course of doing business. There are many ways to "lose" inventory, including:
- Receiving errors
- Entering the wrong SKU in the POS
- Improper handling of a refund or exchange
Avoiding shrinkage is an important component of running a retail business.
One way to check your inventory for loss is to manually count your inventory. But a complete physical inventory count might cost you time and money. Instead, you can do cycle counts. Count a part of your inventory each month.
For example, if you have a clothing line, in September you can count all your tops and fix inventory errors to ensure that you don't run out of stock. In October, you can count all your bottoms and continue to fix your inventory errors as you go. This will ensure that your inventory levels are where they need to be and your POS is correct.
5. Build Strong Vendor Relationships
Finding a vendor or manufacturer that wants to be your partner is difficult. But building strong relationships can directly affect your financial success as a retailer. Being open with your manufacturers about your data, like margins and turn rates, can help you build stronger relationships.
A manufacturer or vendor who is a partner can be a huge asset for retailers. Focus on vendors who have open stock inventory and can fill-in your orders as needed. On-demand manufacturing is also a great way for direct-to-consumer brands to manage inventory. With on-demand manufacturing, you can react to your customer demands instead of warehousing inventory.
Too much inventory in your warehouse and in-store costs you money. A true partner will help you manage your inventory in a way that benefits your cash flow.
FURTHER READING: Learn more about how retailers can save money with on-demand manufacturing.
Moving Forward With Scalable Inventory Management
When it comes to inventory management, planning is key. Getting stuck with stale inventory is a retailer's worst nightmare. Old inventory is like cash in jail. Start with a plan that feels manageable for you. It will most likely change as you scale. But having a good foundation will set you up for inventory management success.