Inventory could include anything from raw materials to finished products. Your inventory could consist of things your business makes, or things you order from someone else.

Holding inventory can help you serve your customers better, and it can help you maximise profits and lessen risk. However, holding inventory also has other implications. It’s important to think through the pros and cons.

Pros

Pros of holding raw materials.

• You always have everything on hand to make your products.
• You can quickly respond to changes in demand.
• You’re less affected by supplier delays or stock outages.
• You can take advantage of price changes and bulk discounts.
• You can reduce admin time and costs by making fewer orders.

Pros of holding completed products.

• You never miss out on a sale.
• Your customers don’t have to wait.
• You can go on sale quickly to increase cash flow or challenge competition.
• You can make good use of quiet times by preparing and storing what you’ll sell in busy times.

Cons

Cons of holding inventory.

• You tie up working capital, meaning less cash for other things.
• You need to pay the cost of storage and insurance.
• You’re responsible if anything gets damaged.
• You’re responsible if anything becomes obsolete — for example, due to changes in fashion or technology.
• You may need to keep records and conduct stocktakes.

If you’re not sure whether your business would benefit from inventory, consider the following things.

How valuable are your items to your business?

Some raw materials or completed products are more important to hold as inventory than others. High-value items might be crucial to hold as inventory, but you may prefer to stock less or none of your low-value items.

To decide which items to hold, categorise them by value.

• High-value items — the 20% of items that generate around 80% of sales.
• Medium-value items — the 30% of items that generate about 15% of sales.
• Low-value items — the remaining 50% of items that generate only 5% of sales.

Are you making to stock or making to order?

If you can accurately forecast customer demand — or you’re consistently matching customer demand — you might consider a make-to-stock model. This is when you make and hold items as inventory so you can always meet customer demand.

Alternatively, if you’re usually creating bespoke or customised items, you might consider a make-to-order model. In this case, you can’t really predict customer demand, so you probably can’t hold many (or any) completed products. You may need to hold fewer raw materials too.

Not sure which production model works best for your business? Use our tool to assess your current production profile and how it serves customer needs.

Size up your production

Are you selling products or services?

Most businesses provide a mixture of products and services (whether they realise it or not). You probably do too. Understanding exactly what you’re selling may help you decide whether inventory is useful for your business. Use our tool to reflect on the product and service elements of what you provide, and where the most value is.

Are you providing a product, a service or a mix of both?

If you do decide to hold inventory, it’s important to know how much to hold and how much it will cost you. Too much or too little inventory can be expensive. Ordering wisely can save you money or free up money for other things. It can also save you time and effort.

To order wisely, you first need to calculate:

• the annual demand for the inventory
• the cost of ordering the inventory
• the cost of holding the inventory.

Once you’ve done your calculations, use the tool further down this page to find out the best amount of inventory to order each time. The tools shows you the best balance between having enough stock and keeping your costs low.

Annual demand

Annual demand means the amount of inventory you’ll need each year to satisfy your customers. Calculate demand for a specific inventory item by looking at your sales data. How much of that item did you use in the last 12 months? Do any trends exist? Are you likely to need more or less of that item in the coming 12 months? Factor in anything that might affect sales, such as more marketing, reduced opening hours, or new competitors.

Measuring current demand

Predicting future demand

Ordering costs

Ordering costs include both time and money invested in ordering and handling inventory. For example:

• time to place the order
• time to track the order
• time to receive the order
• time to put the order away
• admin fees from the business you place your orders with
• the cost of shipping the items to you
• the cost of any insurance needed for the shipping process.

Calculate any time costs in dollar terms (based on the hourly rate of the staff members doing the ordering).

Holding costs

Holding costs include:

• rent for the space to store the inventory
• the cost of insuring the inventory
• interest on borrowing money to buy the inventory
• the cost of any inventory that gets damaged or goes out of date.

You may feel that storing your inventory doesn’t really cost you anything, because you had some free space already.

But think about what you could be doing with that space if you didn’t use it for inventory. You might be able to do something significantly more valuable with it. Try listing all the possible ways you could use the space to provide value for your customers. Could you make money from it? If so, how much? Space used to store inventory does cost you — both in dollars and in opportunities.

This tool will help you calculate the best amount of inventory to order each time. You can use the tool for anything you order regularly.

You’ll need to gather some information before you start:

• the total units of inventory you think you’ll need for a year (annual demand)
• how much it costs you to place each order
• how much it costs you to hold the inventory.

The tool will use your information to calculate the best amount to order. You can also use the tool to explore the effect of changes to your order size. This tool will give you the savings you could make in dollar amounts if you order the best amount of inventory and also tell you the impact of this change on your cash requirements.