08 Oct How to Reduce Inventory Costs in 7 Steps (2021)
Reducing inventory costs is vital to profitable retailing. More expensive than real estate, merchandising, or even labor — inventory is the largest investment your company makes.
But getting the biggest return on that investment, especially in today’s tough retail environment, requires a more nuanced, data-driven approach to inventory management than most retailers are used to.
Below, we’ll describe 7 guaranteed inventory reduction ideas in some detail. But first, let’s take a look at what reducing inventory really means, and why it matters.
What does reducing inventory levels really mean?
When the top floor sends word that you need to reduce inventory levels, you don’t just cut your inventory indiscriminately. There’s more to it.
You need to consider retail key performance indicators (KPIs) that are based on average inventory costs — such as turnover and gross margin return on investment. Reducing your inventory costs will improve KPIs.
So what happens when you slash inventory across-the-board?
You end up with less inventory of your top-performing products — which will hurt other KPIs like in-stock percentage and profit per transaction.
The real problem is not having too much inventory.
It is that having too much of the wrong products in the wrong places, and not enough of the right products where they sell the best.
The definition of inventory reduction is not just moving excess inventory. It also means preventing excess inventory in the first place — while increasing inventory of better-selling SKUs.
The trick lies in striking the right balance between competing demands.
Why reducing inventory costs matters
The way you manage the inventory investments for your stores, warehouses, and distribution centers determines your success as a retailer. Get it right, and your profitability soars. On the other hand, holding too much inventory has far-reaching consequences across your entire organization.
Excess inventory imposes financial burdens on the company.By throttling your cash flow, the money locked up in slow-moving products is money you are not spending on more profitable SKUs. And at the end of the sales season (or at the end of a product’s lifecycle), markdowns you set to clear out excess inventory can easily wipe out the product’s lifecycle profitability.
Beyond the financial impact, excess inventory has a real, physical impact on the organization. Your stores and warehouses have limited shelf space. As unsold boxes pile up, they consume shelf space that could be holding better-selling products.
Customers are also affected by excess inventory.
When retailers consistently make inventory mistakes, their customers will make the situation worse. They quickly learn to time their purchases for the inevitable markdowns rather than buying products during the main lifecycle. A retailer’s brand image can also suffer when customers, unable to buy the product they want, see stacks of uninteresting products on the shelf.
Disappointed customers, anemic cash flow, and unprofitable markdowns have further knock-on effects on your business. Vendor relationships suffer. Your ability to market your brand atrophies.
To avoid the death by a thousand cuts caused by excess inventory, you must reduce your inventory costs.
How to reduce inventory costs
In a business textbook, reducing inventory costs is simple.
All you have to do is buy the right product at the right price and deliver the right quantity to the right location at the right time. When retailers execute this perfectly, store employees will place a product on the shelf seconds before the customer steps into the aisle.
However, in today’s highly dynamic environment, this is easier said than done.
To bridge the gap between theory and practice, retailers invest in processes like demand forecasting, merchandise assortment planning, purchasing, logistics, warehousing, inventory allocation, inventory replenishment, and price optimization.
Each process has inherent uncertainties. The decisions team members make to deal with these uncertainties can undermine your ability to reduce inventory costs.
It is much better, for example, to guarantee customers can buy the product they want by keeping more buffer stock on hand than it is to risk lost sales. Multiply this approach across hundreds or thousands of SKUs and you tie up significant amounts of cash.
Throughout the inventory management process, you can apply a few fundamental strategies that will help tame your inventory costs.
How to Reduce Inventory:
1. Forecast your true demand instead of your sales
The primary reason retailers carry excess inventory is because they do not accurately estimate customers’ true demand for their products.
As a result, their forecasting processes either bring in too much product or bring in too little product.
For example, if you sold through your entire 2,000-unit inventory of MacBooks last year, then you do not know what the demand really was. You might have been able to sell thousands more had you had them in stock. Without knowing the true demand, your order this year will probably repeat last year’s mistakes — just by basing decisions on last year’s sales numbers.
Or maybe you are an apparel retailer that sold 8,000 blue t-shirts last Summer and only had to mark down 5% of the inventory before the Fall season. That may seem like a decent result. But if your forecast for next Summer does not factor customer tastes shifting from blues to yellows, you will wind up ordering far too much of the wrong product.
Looking at past performance only gets you so far.
Seasonal buying patterns, shifts in the competitive landscape, assortment changes, and other factors influence what and when customers buy. Forecasting true demand requires analyzing hundreds of variables for each SKU at each store.
An accurate demand forecast can open up many new strategies for lowering your inventory costs.
2. Employ the Pareto distribution in merchandise assortment planning
Merchandise assortment planning defines your customers’ perception of your brand. It determines what product categories you assort. And it governs how much money you have to spend on inventory.
Ironically, merchandise assortment planning also contributes to high inventory costs.
Planners and buyers would like to think that their products are all above average. In reality, only 20% of your SKUs will account for 80% of your profit. Many SKUs in a lineup are really only there to offer customers a varied and full assortment to choose from in any particular category.
A jewelry retailer, for example, may know that most of their sales are generated by the top 15 ring styles. But giving customers the feeling that they “have a lot to choose from” requires carrying 50 more styles that rarely sell.
So you should treat your top performers differently from your supporting players.
Leverage planning analytics to identify which of your products are top performers, and which are supporting players — and then optimize the balance between assortment depth and assortment diversity.
Bottom line: reducing inventories of your supporting players frees up inventory dollars to buy more of your top performers.
3. Leverage data to perfectly time your purchasing and allocation
The right timing has as much to do with inventory success as the right quantity.
You can never afford to be late with your purchase orders. But buying too early can be equally painful as inventory sits on the shelf and your cash flow dries up.
Timing has other effects further up the supply chain.
For example, shippers often charge by the pallet or container. Timing your orders to consolidate shipments from vendors and distributors lets you reduce your transportation costs. Consolidation and shipping timing also applies to products flowing from your distribution centers to your stores.
Having a solid demand forecast will help in this category as well.
Vendors often offer bulk deals to get you to place larger orders or assort new products. While tempting, these deals can end up costing you more in markdowns. An accurate demand forecast will tell you whether the deal and the timing is a good combination.
If you’ve never sold the product, the demand forecast will arm you for your vendor negotiations as well. Rather than buying everything upfront, you can talk your vendor into a pilot project with the option to buy more of the product should demand exist.
4. Optimize your logistics, warehousing, and safety stock
Whenever possible, integrate your vendors into your supply chain processes.
This will help ensure you receive the right products at the right time. You will get better visibility into how your product moves through the supply chain, while minimizing the costs associated with volatile vendor lead times.
Advanced retail analytics can combine data from your vendors and your demand forecast to minimize safety stocks.
Most retailers over-do their inventory buffers.
This is especially true for the 80% of SKUs that generate 20% of the profits. By measuring true sales rates at each store, advanced analytics recommends more appropriate safety stocks and builds them into your purchase orders.
5. Automate your replenishment process
Automating your replenishment process goes hand-in-hand with our previous point about vendor integrations.
That’s because advanced analytics can automatically suggest reorder quantities, timing, and more — optimizing and automating your replenishment at the same time. By minimizing the need for human intervention in the daily grind of replenishment, your team can shift their focus to more value-added tasks.
For example, you can spend more time working with your promotional planning team.
Too often, the disconnect between inventory planning and promotional planning leads to empty shelves and disappointed customers. If your inventory analysts are planning for normal replenishment levels, your stores won’t be ready for the promotion’s sales uplift. The units you sell at a discount will be the same ones you would have sold at full price.
Last-minute rush orders may “save” the promotion. But those small-quantity orders are more expensive and more expensive to ship. Integrating promotional and inventory planning ensures that you execute both plans and maximize the promotion’s return.
Informed by your demand forecasts and real per-SKU-per-store sales-thru rates, the automated orders that advanced analytics enables will get you closer to that textbook just-in-time inventory.
6. Proactively transfer inventory to avoid markdowns
Inventory imbalances require costly solutions. Retailers often find themselves in a scenario where a popular item is out of stock at one location while simultaneously overstocked at another — where demand is lower.
Sure, you can make small-quantity purchases to restock stores where a product sells better than expected, and mark it down at the stores where it sits unsold.
But a much cheaper option is to rebalance your inventory through inter-store transfers.
Unfortunately, inter-store transfers typically are initiated by store managers reacting to inventory issues after they happen. More often than not, these reactions are triggered by an unhappy customer standing in front of an empty shelf.
Advanced analytics and retail AI let you take a more systematic, proactive approach to stock balancing as sales at different stores slow and accelerate.
This type of system automatically suggests opportunities for the most profitable inter-store transfers, ahead of time. By replenishing stores with inventory you have already bought, you reduce your inventory exposure.
7. Optimize inventory by optimizing price
Price and demand are inextricably linked. When you can sell 1,000 units at $10, you might be able to sell 2,000 units at $8.
This means that you can use the data provided by your demand forecast and advanced analytics to create lifecycle pricing strategies for your products.
You can shape demand and optimize profitability by deciding, in advance, each product’s initial, regular, promotional, and closeout pricing. This is especially critical for low-margin SKUs since their inventory typically costs you a lot more.
And if you are introducing a new product, you can use lifecycle pricing plans to identify the best balance of demand, sales-thru, and profitability.
Retailers often launch a product at a higher price and gradually lower the price until sales and profit reach an acceptable balance.
You can avoid costly new-product-pricing decisions by keeping the higher price in most stores. Using advanced analytics, explore pricing alternatives in test markets before rolling out the optimal pricing company-wide.
Taking a smarter approach to pricing will help you make better markdown decisions at the end of the product lifecycle.
Sure, an across-the-board 70% discount policy may clear your excess inventory. But is 70% that much more effective than a 50% discount? What about 40% or 20%?
If you can’t answer that question — you are likely leaving lots of money on the table.
Taking a more nuanced, data-driven approach can free your cash flow while avoiding excessive markdowns.
Bottom line: the biggest reduction in inventory can only come from unified inventory management
You can implement these seven inventory reduction ideas one at a time, but they are all interrelated.
The biggest reduction to inventory cost will come from a nuanced, unified approach. This is where a retail AI and advanced analytics platform will save you time and money — by optimizing your inventory management with limited human interaction.
With Retalon, you will only invest in inventory that sells. Better yet, you will maximize the return on that investment.
If you would like to know how you can get started, you can check out this free Inventory Management Software Buying Guide that lays out the tips for finding the right vendor, common pitfalls to avoid, and what you will need to do to prepare your organization for an advanced inventory management system to begin with.