Inventory and Cash Flow: Freeing Working Capital
Every dollar in inventory is a dollar not in your bank account.
Key Takeaways
- •Inventory is the largest working capital investment for many businesses
- •20% of SKUs typically represent 80% of inventory value—focus there
- •Carrying costs run 20-30% annually (capital + storage + obsolescence)
- •Reducing DIO by 10 days can free hundreds of thousands in cash
For product businesses, inventory is often the largest single use of working capital. A company with $12M in annual COGS and 60-day DIO has roughly $2M tied up in inventory at any time. Reducing that to 45 days frees $500K.
The challenge is that inventory serves multiple purposes: it enables sales, buffers against supply disruption, and provides customer service levels. The goal isn't minimum inventory—it's optimal inventory.
The True Cost of Inventory
Inventory carrying costs go far beyond the purchase price. Understanding the true cost helps make better inventory decisions.
Components of Carrying Cost
The Hidden Cost
At 25% carrying cost, a $100,000 inventory investment costs $25,000 per year to maintain—whether you sell it or not. Slow-moving inventory bleeds cash continuously.
Key Inventory Metrics
Track these metrics to understand inventory efficiency and identify improvement opportunities.
Days Inventory Outstanding (DIO)
(Average Inventory / COGS) × 365
How many days of sales you hold in inventory. Lower is generally better, but stockouts are worse than carrying costs.
Inventory Turns
COGS / Average Inventory
How many times you sell through your inventory annually. Higher turns mean less capital tied up.
Example Calculation
Annual COGS: $12M
Average Inventory: $2M
DIO: ($2M / $12M) × 365 = 61 days
Turns: $12M / $2M = 6x per year
Inventory Reduction Strategies
Reducing inventory without affecting sales requires understanding what's driving current levels and attacking root causes.
Demand Forecasting
- Improve forecast accuracy: Better forecasts mean less safety stock required
- Reduce forecast horizon: Forecasting 4 weeks out is easier than 12 weeks
- Segment by predictability: Stable demand items need less buffer than volatile ones
- Customer collaboration: Get visibility into customer plans where possible
Supply Chain Improvements
- Reduce lead times: Shorter lead times allow lower inventory levels
- Increase order frequency: More frequent smaller orders reduce average inventory
- Supplier-managed inventory: Some suppliers will hold inventory until needed
- Multiple suppliers: Reduces risk of single-source stockouts
SKU Rationalization
- Apply 80/20 analysis: Focus on SKUs that represent most of inventory value
- Eliminate slow movers: Items that haven't sold in 12 months need liquidation plans
- Consolidate variants: Do you need 20 colors when 10 drive 95% of sales?
- Make vs. stock decisions: Some items can be made-to-order rather than stocked
ABC Inventory Analysis
Not all inventory deserves equal attention. ABC analysis helps prioritize where to focus optimization efforts.
| Category | % of SKUs | % of Value | Management Approach |
|---|---|---|---|
| A Items | ~20% | ~80% | Tight control, frequent review, accurate forecasts |
| B Items | ~30% | ~15% | Moderate control, periodic review |
| C Items | ~50% | ~5% | Simple rules, consider eliminating |
The C-Item Trap
C-items individually aren't worth much, but collectively they consume significant resources: purchasing time, warehouse space, management attention. Aggressively eliminate or simplify C-items.
Dealing with Slow-Moving Inventory
Slow-moving and obsolete inventory is cash that's essentially lost. Better to recover partial value than hold forever.
Liquidation Options
- • Promotional pricing to move units
- • Bundle with fast-moving products
- • Sell to liquidation buyers
- • Return to supplier if possible
- • Donate for tax benefit
Prevention Measures
- • Track aging by SKU
- • Set maximum inventory levels
- • Trigger alerts at 6-month no-sale
- • Require approval for new SKUs
- • Review slow movers monthly
A common rule: if inventory hasn't moved in 12 months, create a liquidation plan. Holding it another 12 months won't improve the situation.
Related Resources
Cash Flow Management Guide
Complete cash flow overview
Cash Conversion Cycle
Understanding working capital metrics
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