Can Reducing Inventory Really Improve Working Capital?

The year 2020 marked the highest-level Working Capital Index in 10 years resulting from the Covid-19 pandemic, reported J.P. Morgan. The findings highlight how real-world events impact inventory levels and the availability of working capital.

Working capital is defined as inventory, debts, cash, and cash equivalents. A business needs working capital to be able to run its business and withstand volatility in the economy.

In 2020 and 2021, real-world events had a significant impact on inventory levels and working capital, according to the report. First, in 2020, companies conserved cash as they cut down on expenses and halted capex and share buybacks. Then in 2021, as the pandemic receded and recovery ensued, demand spiked, causing the S&P 1500 companies to experience a 20% increase in sales and a corresponding reduction in inventories. While turnover due to sales is good, there were other more negative impacts on inventory. Combined with high demand, there were supply-side disruptions and logistics bottlenecks, leaving companies with less than desired inventory levels and the need to deploy working capital more effectively.

Finding the right balance between inventory and the other components of working capital is important. Overstocking — having too much inventory — reduces the working capital available for other types of current assets. The business won’t have enough left to extend credit to customers. Overstocking also results in increased carrying costs for inventory.

On the other hand, understocking is damaging as well. Having too little inventory can cause a loss of profit if the demand for the product surges. Let’s look at how optimizing inventory can increase working capital.

 

How can optimizing inventory increase working capital?

According to J.P. Morgan, “Companies can improve their working capital by effectively managing the individual components of their [cash conversion cycle] CCC via reducing inventory levels (decreasing DIO [days inventory outstanding]), extending payment terms with suppliers (increasing DPO [days payable outstanding]) and speeding up collections from customers (shortening DSO [days sales outstanding]). As a general rule, the lower the CCC, the better the working capital efficiency.”

Let me explain further.

  • Cash conversion cycle (CCC)

Cash conversion cycle refers to the number of days a company takes to convert inventory purchased to cash by selling products. It is an indicator of the efficiency of working capital management. Fewer CCC days represent higher working capital efficiency.

CCC = DSO+DIO-DPO

To maximize working capital efficiency, the company should manage all three categories:

  • Reduce debt period.
  • Reduce inventory holding period.
  • Increase credit period.
  • Days sales outstanding (DSO)

Days sales outstanding (DSO) is the average number of days a company takes to receive the money from goods sold. Basically, it’s the debt turnover ratio. The idea behind the concept is that working capital that is tied up in debts will not be available for buying inventory. Higher DSO will automatically reduce inventory as the company will fall short of money.

Depending on the industry you work in, allowing customers a few days to complete the payment is a normal practice. Sometimes, businesses even allow longer credit periods. The purpose behind extending credit is to increase sales. However, one should remember that it has an inverse relationship with the investment in inventory. Thus, the tact is in balancing the two.

  • Days inventory outstanding (DIO)

The number of days for which the company holds products before selling them is called days inventory outstanding (DIO). Obviously, having more turnover of your inventory indicates that you are selling products and converting your physical goods to cash. 

  • Days payable outstanding (DPO)

As the days taken by your customers to pay the outstanding amount affects the effectiveness of working capital utilization, so do the days you take to pay your creditors. If your creditor gives you more days to pay off your debt, you will be able to improve your working capital efficiency. You will be able to increase your inventory.

Generally speaking, getting the balance between inventory and working capital right includes tying forecasts into sales and operations planning. You should use statistical modeling and predetermined service levels to set appropriate inventory levels for every customer and every product. Reducing inventory can help an organization save precious resources and improve working capital efficiency. This is especially  true In an uncertain economic climate. Reducing inventory can help in the following ways:

  • Cash availability: As a business owner, you must know that when circumstances are rough, having available cash reserves will help you to navigate in an efficient manner. Cash is essential in salary/wages payment, machinery maintenance, and basic survival needs. If your working capital is tied up in inventory, you might not manage to convert it into cash instantly. Therefore, inventory reduction is advisable in these situations.
  • Debt reduction: Investing working capital in inventory will reduce the amount available for lending to consumers. In these times, when the world is facing rising prices of goods and services, one way to sell your goods is by extending credit to your customers. By providing more credit to customers, you can improve your turnover.
  • Reduction in payables: Borrowing from banks has become pricier in 2022 with increases in the federal interest rate. If you invest too much in inventory, you might have to borrow funds from banks and pay higher interest, taking on more financial risk. Secondly, suppliers may also charge higher prices for extending their credit to you. Having more inventory means higher payables. Reduce your inventory to optimize your working capital.

 

Optimize inventory with Cin7

Cin7’s inventory management system comes with analytical tools. The reports and forecasts provided by the software are accurate and reliable. You can get insights into your inventory and predict future scenarios. You can optimize your inventory levels to ensure minimum inventory without having to face stockouts.

In conclusion, your company should evaluate, calculate, and manage your working capital and inventory to optimize your operations in both the best and worst of times.

What Is SKU Rationalization and Why Is Everybody Doing it?

Big corporations like Procter & Gamble and Unilever are getting better performance from their inventory through SKU rationalization, so much so that the process is now trending across companies of all sizes.

But what is an SKU? Or, rather, what is a SKU? How do you even say it? SKU can be pronounced like the word “skew” or like its letters spelled out.

What does SKU stand for? SKU stands for “stock keeping unit” and is a unique code assigned to a product to identify and track information and related to that product: price, product options (or variations) and manufacturer. A SKU takes the form of a scannable barcode, like so:

What is the meaning of SKU in retail?

First and foremost, tracking inventory using its SKU code helps inform retailer purchasing decisions with regard to profitability. SKUs are also referenced to pick and pack orders and even make product suggestions to online shoppers. So SKU inventory management can tell sellers and shoppers a lot.

What is the difference between a SKU and a UPC? Unlike universal product codes (UPCs), SKUs are not universal, meaning that each retailer has its own set of SKUs it assigns to its merchandise, generally to group like items, categories and subcategories together for analysis. That’s how sites like Amazon are able to display similar items you might be interested in, based on the features indicated by that SKU meaning and other SKUs in the same category, sharing the same prefix.

Most POS systems allow you to create your own SKU inventory hierarchy based on what you want to track. For example, a shoe store would probably classify shoes first by customer type (men, women or children), then style (dress or casual), then color and possibly material. A larger operation may choose to get even more granular to facilitate more detailed reporting, particularly if it carries many similar SKUs.

SKUs are used for inventory and sales tracking, meaning they help stores know which products are selling quickly and when items need reordering. Ultimately, this will determine the product mix, which is where SKU rationalization comes in.

Organizations use SKU (or product) rationalization to decide which items to keep/order more of, reduce or eliminate in inventory based on historical sales data, weighing the cost of producing and stocking against the benefit of selling each product. Rationalization, in short, frees companies to spend time and money on the products that work best. SKU rationalization is a kind of inventory optimization.

From Proliferation to SKU Rationalization

There are more SKUs today than ever, especially in the retail sector. Yes, suppliers use SKUs too! As mentioned earlier, because they aren’t universal, vendors will have their own supplier SKU for any given item and will be interested in tracking different aspects of the supply chain than a retailer would. Scannable barcodes help vendors easily monitor the movement of inventory and can be used to track repairs, services and warranties.

But back to the topic of retail. One report states that grocery stores, for example, carried 7,000 SKUs in 1970, a figure that soared to more than 40,000 by 2014. This “SKU boom” is the result of companies matching products to more particular customer preferences. Variations, like a low-fat version of a food product or a limited-edition flavor, contribute to SKU proliferation, but so do shorter development cycles, which pile new inventory on top of old in anticipation of rapidly changing consumer tastes.

The problem is that more SKUs can mean an increased cost of inventory, specifically holding costs. Demand for a particular SKU may not be high enough to quickly clear inventory. Money spent to maintain a stock of goods in storage can amount to an extra 15% to 40% of product cost a year. That’s why having an inventory SKU system is key.

Brand Rationalization

The world’s second-biggest home products provider, Procter & Gamble (think Crest toothpaste and Gillette shaving products) consolidated or exited 61 brands over the past 18 months. While these brands represented 6% of P&G’s profit in that time frame, rationalization improved overall cash flow by lowering days inventory outstanding (DIO), also known as days sales of inventory (DSI), from 78 to 58. DIO is an efficiency metric that indicates the average number of days a company holds inventory before selling it. Industry-specific, this ratio should be used to compare competitors over time.

Unilever, the world’s number-three home-product provider, 10 years ago found that the variance of SKUs in their UK and Ireland operations accounted for 20% of their inventory but contributed only 5% to their sales. The company has since made it a goal to reduce SKUs by 20%, a complex job for a company with 50,000 SKUs in many markets around the world.

While rationalization is most commonly used among manufacturers and retailers with tens of thousands of brands, products and variations in their inventory, experts say it’s becoming a trend across companies of all sectors and sizes.

The bottom line: If you can determine which SKUs you can do without based on your analysis of sales data, you can increase your cash flow and have more resources on hand to focus on the products that perform best.

Invisible Inventory: Is the “Unknown” Killing Your Business?

Lost, obsolete or overstocked inventory drives up costs and destroys margins. Without inventory visibility, you won’t know your business is suffering until it’s too late.

Any product-focused company that lacks inventory visibility is asking for trouble. Consider the money that goes into a company’s inventory. There’s the cost of purchasing products, of course, and there are the capital and operational expenses of making products if you’re a manufacturer. Finally, there’s the expense of warehousing stock until it’s sold.

This all represents a significant investment that you can only hope to recoup when you sell your products. So you might go as far as saying that losing track of your inventory is the same as being reckless with your money.

This is no exaggeration: A lot can happen to your inventory that will prevent you from recouping that investment if you don’t catch it in time. Inventory shrinkage is a big one, collectively costing US retailers billions of dollars every year in lost, damaged and obsolete products. Beyond that, without inventory visibility, you can miss things that contribute to a business slowly choking to death, like:

  • Understocked products
  • Low product sales
  • Inactive sales channels
  • Overstocked products

These result in lost customers, decreasing revenue, increased warehouse and labor costs, and lost time correcting inaccurate inventory counts. All of this can be avoided if you understand the obstacles to visibility and the ways to get around it.

Get in the Know: What Is Inventory Visibility?

Visibility is having accurate and up-to-the-moment information about how many products you have to sell, where those products are located and what those products are costing you. True visibility extends from the time you purchase something (a finished good or the materials to make a finished good) to the time you sell those finished goods. True visibility lets you track all your inventory as products move through your supply chain, which includes:

  • Purchases
  • Components/materials and production jobs
  • Branch transfers and other stock movement

Stock Movement: Keeping Your Eye on the Ball

The common thread here is movement: products entering inventory at purchase, changing locations within a warehouse or between branches, and leaving inventory at the time of sale.

It isn’t enough to be able to say, “I have x number of y products,” because, over time, those products will move. Let’s pretend that you keep your inventory in a single warehouse, for example, and you only sell through Shopify. Over time, you can easily lose sight of your actual stock counts. If you were to move older products to another part of the warehouse to make space for new inventory, products could get lost in the shuffle. Your stock counts will become a nightmare, and you’ll end wasting hours and hours trying to reconcile what you think is in your inventory with what you’re finding in your warehouse. (Click here for a real-world example.)

The more products you sell and the more locations you keep inventory, the higher the risk of misplaced goods and wasted time trying to make everything align. Going back to the idea that inventory is a huge investment, trying to figure out what happened to your stock is almost like trying to remember where you buried your money after forgetting to draw a map. You’ll be left wondering how you even got to that point in the first place.

Why Do Companies Lack Inventory Visibility?

There are many possible reasons brands lose track of their stock. Generally speaking, though, a lack of visibility tends to come down to inadequate inventory management. To be more specific, the way they track inventory doesn’t automatically include purchases, sales and other activity that impacts the big picture; nor does it track information in real time, which means that the information they have about their inventory is neither complete nor up to date. Here are two common examples:

1. They use manually updated spreadsheets.
This is one of the biggest reasons for lack of visibility. Small companies that sell few products and have low sales can manage fine with spreadsheets. With even a little growth, however, spreadsheets can get out of date quickly, giving you a lack of visibility of what’s really in your inventory. Reported stock levels will not match reality, and a company may not realize it’s time to reorder and restock.

2. They manage sales channels and inventory separately.
If a company with a Shopify store adds Amazon Seller to their channel mix, for example, it will now have at least two places to track inventory, plus their spreadsheets or siloed inventory software they use as a “master.” The information in their master inventory will only be as accurate and up to date as the people who manually collate and update that data. If the information is even a little off, the company could end up selling customers a product that isn’t really available.

Inventory visibility cannot be an estimate of the products you think you have. It must be the actual inventory based on current sales (as seen in the two examples above) and any other activity that impacts real stock levels and locations, such as purchases, which increase inventory, and branch transfers, which move products to different locations.

How to Achieve Inventory Visibility

True stock visibility requires the accurate recording of everything that happens to products in your inventory as it happens. This includes purchases, sales, stock transfers, returns and any workflow that changes inventory quantity, location and/or cost. To that end, visibility can only be achieved if all that data is integrated with, and tracked in, a central inventory master, including:

  • All purchases that increase your inventory of components and finished goods
  • Production jobs that lower component inventory and increase finished goods inventory
  • Sales orders, through any channel, that reduce your inventory
  • Dispatched orders that reduce stock on hand and change order status
  • Purchases and sales that adjust inventory at each stock location
  • Stocktakes that confirm or adjust inventory at each stock location
  • Stock transfers decreasing inventory in one location, increasing inventory in another

The key to visibility is to integrate all that data so that you can track products in real time as they move through your supply chain, affecting stock levels and inventory value along the way.

The Benefits of Inventory Visibility

Integrating that data allows a product-focused company to:

  • Reduce data entry and eliminate related errors
  • Eliminate the use of redundant software and portals
  • Increase order accuracy
  • Maintain optimal inventory levels/reduce overall storage costs
  • Fulfill orders faster and increase order transparency
  • Build customer satisfaction and drive future purchases
  • Increase forecast accuracy for improved inventory planning
  • Reduce losses due to obsolete inventory

The Shortest Path to Visibility

Companies that use spreadsheets, software or portals to manage orders, inventory and stock movements will have difficulty achieving visibility. Theoretically, you could attain visibility by cobbling together those portals and spreadsheets, provided you can afford the time and price tag of extensive, customized development and programming. This is one of the advantages of cloud-based inventory solutions: They are built to integrate, quickly and affordably, with other software and services. That integration allows data to flow between solutions freely and in real time, and the more ways it integrates vital inventory data, the higher and more comprehensive the visibility.

Book a free, no-obligation demo below, to learn more about how Cin7 gives product companies complete, real-time inventory visibility.

Inventory Basics: What Is Inventory Management?

Welcome to Inventory Management Basics. Here, we’ll be looking at exactly what inventory and inventory management are and why they’re so important.

We’ll also provide basic definitions of the different types of inventory.

What is inventory?

The most basic definition of inventory is the materials or “things” your business owns. These can be tangible (products and raw materials) or intangible (e.g., software). In most cases, when we refer to inventory, we simply mean all the materials the business has kept in stock—to sell. But, in some cases, it can be inventory that’s not intended for sale, such as fixtures and fittings. These kind of items are generally counted for financial and/or insurance purposes and are known as maintenance, repair, and operating supplies, or MRO goods (definition below).

Inventory can be listed as either an asset or a liability. If a business has lots of inventory, it can convert that inventory into revenue by selling it. Conversely, having too much Inventory can also end up costing the business if that inventory doesn’t get sold.

What are the 4 basic types of inventory?

Inventory can be classified into four main types:

  • Raw materials are ingredients or components used to manufacture a finished product. A brewer, for example, will use grain, yeast and hops as ingredients in the fermentation process to produce a volume of beer.
  • Work in progress (WIP) represents inventory in production and not yet ready for sale, for example, beer still in the process of fermenting.
  • Finished goods are products in your inventory that are ready to be sold to your customers. This inventory type is common to all companies that sell products.
  • Maintenance, repair and operating supplies (MRO goods) are used to support production processes and infrastructure. Such goods are usually consumed during production but are not part of the finished product. Examples include lubricants, coolants, janitorial supplies, uniforms, gloves, packing materials, tools and office supplies, including computers.

Are there other types of inventory?

Yes. Inventory can be further classified by the purpose it serves.

  • Buffer inventory, or buffer stock, is the amount of stock you hold as a precaution against stock-outs and is also sometimes called safety stock. Buffer stock has two benefits, nonstop production and increased customer satisfaction. While these benefits come with increased carrying costs, being able to deliver finished goods at a moment’s notice may be worth it.
  • Transit inventory refers to raw materials, WIP, finished goods and MRO being moved from from location to other for any purpose. Long distances can mean that inventory is in transit for anywhere from days to months. Also known as goods in transit.
  • Anticipation inventory or anticipatory stock is raw materials or finished goods kept in anticipation of demand based on past or seasonal trends or current events that are expected to drive price hikes. Traders are most likely to use this strategy.
  • Decoupling inventory is an inventory of parts between machines (i.e., one machine feeds parts to the next machine), allowing sequential, dependent processes that typically run at different speeds to stay in sync, as machinery is generally always running, other than when it’s being serviced. Decoupling inventory serves to regulate production flow.
  • Cycle inventory is inventory a seller cycles through to fulfill regular sales orders and results from ordering in batches or lot sizes to optimize carrying costs versus machinery setup costs, rather than ordering material only as needed. Part of on-hand inventory, or stock on hand, which includes all items the seller has in its possession, cycle stock equals total stock on hand minus safety stock.

What is inventory management?

When we refer to inventory management, we mean the theories, processes and tools involved in controlling inventory at each stage, from sourcing to storing to selling. The core purpose of inventory management is to make sure that you have the right amount of stock on hand at the right time—at the right cost and price. What is an inventory management system? An inventory management system describes the processes and tools used, physical and/or digital, to track, record and analyze inventory movements and sales performance across the supply chain. Cin7 is an example of a cloud-based inventory management system that uses an integrated software platform to efficiently perform all of these tasks.

Why is inventory management important?

Because to run a successful product-focused business, you need to have enough inventory to sell, to satisfy customers and meet market demand. Systematic and transparent inventory management is therefore critical to a business’s bottom line. For instance, it costs money to store inventory, so inventory managers or other stakeholders try to determine the minimum amount of space required to store the maximum amount of inventory.

There are many metrics used to determine whether or not the business is doing a good job of managing inventory. One of these metrics is inventory turnover ratio. Generally, the higher the ratio, the better it is for the company, because it means that inventory isn’t sitting idle on warehouse shelves, where it doesn’t make money and in fact costs money. Rather, it is being used in production or sold in stores.

For more information, including basic inventory formulas, metrics and accounting methods, see our resources page What is inventory management?

From a product perspective, inventory management’s importance lies in understanding what stock you have on hand, where it is in your warehouse(s), and how it’s coming in and out of your supply chain.

Clear, real-time inventory visibility helps you:

  • Reduce costs
  • Optimize fulfillment
  • Excel at customer service
  • Minimize loss due to theft, spoilage and/or returns

From an organizational perspective, inventory management provides insights into your financial standing, customer behavior, sales trends, product development and potential business opportunities.