The Trade-Offs of Carrying Too Much or Too Little Inventory

Inventory management is a balancing act because inventory levels significantly impact a company’s profitability, operational efficiency and cash flow. While having too much or too little inventory can seem like opposite ends of the spectrum, both situations introduce unique challenges and trade-offs.

The Impact of Carrying Too Much Inventory

Carrying too much inventory may provide a sense of security since you’ll always be able to fill customer orders, but it comes with several hidden costs:

1. Higher Carrying Costs

Storage costs, insurance, depreciation, and obsolescence add up quickly. The longer inventory sits idle, the more expensive it becomes to maintain… especially if you’re paying a 3rd party warehouse for storage services.

2. Tied-Up Cash

Excess inventory ties up cash that could be used for other business priorities such as product development, marketing, or hiring additional staff. In my experience with several companies, I have seen the issue of excess inventory restrict cash flow so much that it becomes difficult to pay suppliers. When you can’t pay suppliers, they tend to stop shipping you the parts you need. Essentially, while you sit on too much inventory of the SKUs you don’t need, you struggle to obtain the SKUs you actually do need.

3. Obsolescence and Spoilage Risks

For industries dealing with perishable products, excess inventory increases the risk of spoilage or obsolescence, leading to write-offs and profit losses. Food is the easiest example of inventory that spoils, but even products like dish soap, product labels and rubber gaskets can only sit on the shelf for so long before they degrade. They have longer shelf lives than food, but they still require planning to ensure they are used up before they expire.

4. Operational Inefficiency

Managing large quantities of inventory can lead to inefficiencies in warehouse operations, such as increased time spent locating and handling items.

The Impact of Carrying Too Little Inventory

While maintaining lean inventory can reduce storage costs and have a lower impact on cash flow, it poses risks that can disrupt operations and customer satisfaction:

1. Stockouts and Lost Sales

Running out of stock can result in missed sales opportunities, frustrated customers, and potential damage to your brand’s reputation since it’s now very easy for customers to post complaints and bad reviews to the internet.

2. Higher Expedited Shipping Costs

To fulfill urgent customer orders or replenish stock quickly, companies may incur expensive expedited shipping fees, especially when they find they have to ship by air to shorten shipping times.

3. Production Disruptions

For manufacturers, insufficient raw materials can halt production lines, resulting in lost productivity and increased operating costs. Efficiency is also reduced when the production team finds they have to keep shuffling their schedule because of missing parts.

4. Loss of Competitive Advantage

In industries with high competition or extreme urgency, failing to meet customer demand on time can drive customers to competitors. For example, if you manufacture crucial parts for mining equipment, you cannot be out-of-stock. Since the cost of mining equipment being out-of-commission because the equipment needs a part replaced, if you don’t have the part, the mining company will likely call your competitor because they need a replacement part within 24 hours.

The Balancing Act: Finding the Sweet Spot

Balancing inventory levels requires a thoughtful approach and data-driven decision-making. Here’s how people navigate the trade-offs:

1. Forecasting Demand

Leverage historical data and market trends (if available) to predict future demand as accurately as possible. Incorporate seasonality into your model if you have specific months where you experience much higher demand.

2. Adopting Inventory Management Systems

Use inventory management software, warehouse management software or combined with data visualization tools to track stock levels, monitor inventory turns and know your cost of inventory at any time. Even if you’re a smaller business operating with a tool like Shopify or Big Commerce, those tools can be used to do proper inventory tracking.

3. Classifying Inventory (ABC Analysis)

Segment inventory into categories based on value and demand quantities. Focus more closely on high-priority items (Category A) to avoid overstocking or understocking of your most important SKUs.

4. Building Supplier Relationships

Establish strong relationships with suppliers to ensure you can get faster lead times in case you have an urgent need for stock. In the world of inventory, the unexpected will always happen. Flexibility and reliability offered by your suppliers is very valuable.

5. Monitoring Key Metrics

Track metrics such as inventory turnover, carrying costs, stockout rates and the cost of inventory to identify inefficiencies and adjust inventory strategies accordingly.

Conclusion

Carrying too much or too little inventory impacts not only a company's bottom line but also its ability to serve customers effectively and its ability to pay suppliers. The key to striking the right balance lies in understanding demand patterns, leveraging technology, and continuously refining inventory strategies. By carefully managing these trade-offs, businesses can optimize inventory levels, improve cash flow, and maintain a competitive edge.