It is perhaps the biggest myth in supply chain management; that to reduce inventory costs you should keep inventory levels low.

After all, there is a difference between not tying up too much capital in inventory and incurring substantial costs when faced with shortages. Here’s how to reduce your inventory costs, while still maintaining the necessary stock levels you need to succeed.

Understand Why Businesses Reduce Inventory Levels

Before venturing into the costs of shortages, it’s best to understand why businesses decide to reduce inventory levels. These decisions are based primarily on carrying costs, ones that are exacerbated when sales don’t meet forecasts and a store is left with too much product on its shelves.

First, there is the cost of capital that increases over time. Second, there are costs that include pilferage. Third, there are costs defined by expired, outdated or “out-of-date” inventory. Finally, there are costs defined by freight, counting, storage, handling, and inventory damage, in addition to monthly rent and electricity. All of these play a role in a company’s unwillingness to hold inventory and they are exacerbated when sales volumes are low. However, what happens when sales volumes inexplicably trend upwards and the company comes face-to-face with a shortage? That’s correct, you lose out on potential sales and revenue.

Inventory well-stocked on a pet store shelf.

Define Your Costs Associated With Inventory Shortages

First, why do you have inventory in the first place? Ultimately, you need inventory in order to sell products, generate gross profit, increase revenue, and keep customers happy. Inventory is needed because you want to maintain your store’s reputation as the go-to destination for specific items. You also want to keep competitors away from your most important customers! Maintaining the trust of your customers and keeping your customer retention rate high, requires you maintain healthy inventory levels.

Costs are incurred during shortages because of what your shop must do to rectify an inventory shortage. Think about what happens when a customer enters your store to make a purchase, only to find that the desired item is out of stock. Depending upon how important that customer is, and how urgent their need is, you’re likely to absorb the following two costs.

First: You’ll go back to your own vendors and ask for an expedited delivery of the item. That vendor may be able to ship immediately, or they may just decide to include a surcharge for servicing your company ahead of others. Regardless of whether you’re covering delivery charges on your own account, or your customer is including delivery to your facility in their price, your company is guaranteed to cover higher freight costs. After all, you need that shipment immediately and anything other than next-day delivery won’t suffice.

Second: Getting that all-important parcel to your customer often involves additional costs. For instance, what do you do when your customer expects you to cover delivery for not having a product ready when promised? If you failed to live up to your customer’s expectations, then you’ll have additional costs to fulfill their order.

SEE ALSO: Here is How to Keep Your Customer Retention Rate High

Both of these are quantifiable costs of shortages. Businesses that experience these costs understand just how detrimental a shortage in inventory can be. However, your costs due to shortages don’t just include the above. In fact, your costs are much higher if you aren’t able to keep an order. After all, if you lose a sale, then you don’t generate revenue, ultimately losing out on profit. In the end, that lost sale means the possibility of losing a valuable customer. In the end, the most successful businesses understand the cost associated with inventory shortages. They understand that inventory is needed in order to properly fulfill the needs of their customers, while the costs of a shortage are sometimes higher than the costs of carrying extra inventory.

In order to gauge your business’s ideal level of inventory, while still reducing inventory costs, be sure to track any amount of lost profit or lost customers that result from any shortages. In the end, you’ll find your costs of shortages can be just as high as the costs of excessive inventory counts.

Yamarie Grullon

Yamarie Grullon has years of experience creating helpful & engaging content for small business owners. As Director of Content Strategy at ShopKeep, a leading iPad Point of Sale System, Yamarie provides merchants with practical advice on all things related to business or point of sale.