Small Business Inventory – To Manage Or Not to Manage

What does small business inventory have to do with profitability?

Most small business owners are not inventory management experts and they shouldn’t be. Most of them possess some special skill or knowledge and build their business upon it. At the beginning, it is usually rather simple, even if they sell products – the range of products is small and it’s relatively easy to keep track of them.

But when things go well and their business grows both in size and complexity, problems emerge. And many of those problems will have to do with inventory.

Challenges with small business inventory
You see, most tasks having to do with management and control of a business can be performed relatively easily on a small scale. A program like QuickBooks can help you keep your books in good shape, especially if you hire a skilled and experienced bookkeeper.

But even good bookkeepers rarely have to deal with issues of setting up small business inventory, calculating margins, analyzing product mix, etc. At this point a small business has developed enough to need a higher level of skill: a part-time Controller.

Small business inventory control is absolutely crucial to long-term survival, not to mention profitability. I know many businesses who don’t even have the most basic information about their more complex products – their total cost. Sure, they know how much it costs to buy each component. But once their products get complex enough to require any assembly, that transparency is gone. If QuickBooks isn’t properly set up to track assembly items, their cost will not be known.

“Does that matter”, you may ask? Well, if you want to know your margins, yes, it does.

Small business inventory – margin basics
These days many small businesses struggle with their cashflow. They come to me and ask “why am I not making any money?” “Well, let’s see”, I say, and start looking at their financials.

It’s pretty easy to isolate problem areas with the expenses, the overhead, etc, but it will all mean nothing, if we don’t know the margins. The product margin is simply the price less the cost. If the cost isn’t known, we won’t know the margin. It’s very simple:

Sales less Cost of Sales = Margin
Margin less Expenses and Overhead = Net Profit

And as I said before, once a business starts selling more complex products, their costs are no longer known, if QuickBooks (or any other software a business may be using) isn’t set up to properly keep track of them.

Small business inventory – product mix
Even when you know your margins, do you know what they mean? Do you also look at the mix? ‘What is product mix?”, you may ask.

Well, imagine you have two products:

- Product A costs you $1.00 to make and sells for $2.00
- Product B costs you $1.00 to make and sells for $5.00

Which one is more important to you? It’s not as simple as it may seem. What if the demand for Product A is a 100 greater than demand for product B? What if you can sell a lot more of Product A than you will ever be able to sell of Product B?

If during an average month you can sell 100 Products A and 5 Products B, Product A is generating more margin:

Product A
Sales Price: $2.00
Cost of Sales: $1.00
Margin: $1
Qty sold: 500
Total Margin: $500

Product B
Sales Price: $5.00
Cost of Sales: $1.00
Margin: $4.00
Qty sold: 5
Total Margin: $20

Now things get more interesting. You may want to know a lot more – how much overhead is needed to generate that high margin? Is it even worth it? If it is, maybe you should focus much more of your energies and resources on Product B? Since these products are so diametrically different, maybe we should track their profitability even below the margin level?

Perhaps we need to allocate some of the expenses which can be directly attributed to them so we see their “contribution margin”? Without that information, how can we possibly make the right decisions?

And now imagine that you now have 50-1000 products, all with different margins and different sales levels…

Small business inventory – summing up
All those considerations cannot even be entertained until you know your product costs. You won’t be able to make any intelligent decisions about your inventory mix, advertising, personnel etc. until all this is easily calculated and monitored on a regular basis.

And remember – without accurate costs, your net profit cannot be accurate, either. That’s why I always say to my clients:

“Accurate financial information is power!”