Inventory Mastery: Avoiding Overstocking and Understocking

Editorial Note: We are an inventory management software provider. While some of our blog posts may highlight features of our own product, we strive to provide unbiased and informative content that benefits all readers.

Overstocking refers to having more inventory than necessary to meet customer demand. Overstocking ties up cash and increases costs for both operations management and holding rents. As a result, your profitability is reduced.

Overstock is also referred to as excess stock, excess inventory, stock surplus, or surplus inventory.

Understocking means that you do not have enough inventory on hand to meet customer demand. This can lead to lost sales and decreased customer satisfaction.

Both are bad for a business, and both can be avoided when store owners follow best practices to ensure optimized inventory levels.

By addressing the issues of overstocking and understocking, businesses can achieve a significant 10% reduction in inventory costs.

Difference Between Overstocking and Understocking:

Overstocking and understocking are common inventory management problems. Overstocking occurs when a business has more inventory than it needs, while understocking occurs when a business has less inventory than it needs. Both problems can be caused by poor inventory management and a lack of demand forecasting.

Ensuring the appropriate inventory levels is a challenging task for any business, regardless of industry. It requires businesses to maintain the right inventory levels, with no excess inventory or shortages. To achieve this, businesses need to have knowledge of inventory management and optimization, be strategic, and utilize smart tools.

Only in the retail business, “Worldwide losses due to overstocks at $471.9 billion and the losses due to out-of-stocks at $634.1 billion.”

Overstocking	Understocking
1. Overstocking is when there is an excess of inventory compared to customer demand.	1. Understocking is having less inventory than the customer demands.
2. Inventory that exceeds the safety stock level may be considered as overstocking.	2. If an item has less inventory than the safety stock level, it may be considered as understocking.
3. Overstocking ties up cash in unnecessary inventory and increases carrying, operating, and holding costs.	3. Due to understocking, businesses may miss out on sales, lose money, and damage their brand reputation.
4. Overstock can turn into dead stock.	4. Understocking can lead to stockouts in the near future.

Causes of Overstocking and Understocking:

There are several reasons for overstocking and understocking, but fortunately, most of them can be solved with some simple efforts. Identifying the reasons will help you solve the issue easily.

The most common causes of overstocking or understocking are:

1. Lack of knowledge about inventory management:

Many business owners and managers, especially those in small and medium-sized businesses, lack of knowledge about modern inventory management techniques. They may not be aware of or apply advanced inventory formulas, such as economic order quantity, safety stock, reorder points, demand forecasting, and inventory optimization. Instead, they may purchase and produce products based on their experience and intuition. This can lead to overstocking and understocking, which are common problems worldwide.

Nearly half of all retail businesses do not use inventory management software or rely on spreadsheets to manage their inventory. This is outdated and ineffective in preventing overstocking and understocking.

Unfortunately, many business owners and managers are not aware of the problems caused by overstocking and understocking.

2. Manual inventory systems:

In a manual inventory management system, inventory data is not organized properly. It becomes difficult to track inventory activities and customer demands accurately. Demands and trends are constantly changing, and it’s impossible to store and analyze all the data in your brain to forecast demands.

With pen and paper or spreadsheets, you can store data, but it’s not possible to properly track and process data to forecast future demands.

“Nearly 43% of small businesses either don’t track inventory at all or use manual tracking methods.”

3. Lack of data:

One of the main reasons for under- or overstocking is that businesses sometimes do not have enough data to analyze and forecast. Keeping data on paper or spreadsheets is not sufficient. Inventory management software organizes your data and automatically analyzes it to generate intelligent suggestions efficiently, helping you make quick and informed decisions.

Accurate data helps you predict demand accurately and discover trends, so you can make the necessary preparations to ensure adequate supply to meet demand.

4. Choosing the wrong systems:

A nenowned inventory management software may not have the features your business type and demands require. This could lead to the software providing inaccurate suggestions, resulting in overstocking and understocking.

5. Lack of management:

Even if you have a good inventory management system that matches your demands, you are still at risk if the system is not used properly. Staff who use inventory management software programs must manage and analyze data correctly.

You must reorder stock when it is time to do so, and reduce inventory when you receive alerts about excess stock. Cash Flow Inventory’s software has all the features you need to minimize overstocks and understocks easily and effectively.

6. Marketing failure:

If a marketing campaign fails, it can lead to a drop in demand for a product, which can lead to overstock. This is because the business has already produced or purchased the inventory in anticipation of demand, but the demand never materializes.

7. Poor supply chain:

Businesses may experience understocking, even after reordering on time, if suppliers delay deliveries. This can lead to missed sales and decreased profits.

Good relationships with reliable suppliers can help businesses to ensure optimized inventory.

8. Demands changing:

Demands can change for various reasons, including unexpected fluctuations. Therefore, it’s essential to track the factors that affect demand.

Some factors, such as seasons and occasions, are common for specific businesses. Others may be unpredictable, and you need to use your experience and knowledge to identify and manage them effectively.

9. New products:

Businesses face the challenge of ensuring the right inventory levels for new products because of the uncertainty involved. It is difficult to predict the impact that new products will have on the market, and forecasting demand for new products is largely speculative.

However, pre-launch market analysis and analysis of the performance of similar products in the past can help businesses get a better idea of potential demand.

10. Fear of stock out:

You may order too much inventory because you’re afraid of running out, which can lead to overstocking. But with proper inventory management knowledge and smart tools, you can prevent this.

11. Lack of production facility:

In the manufacturing industry, manufacturers may face understocks when they cannot produce finished goods to keep up with demand due to limited production facilities.

Ensure maximum utilization of production facilities. This will help you to minimize understocks. If the facilities are not sufficient, consider developing them to meet the demands.

12. Lack of Funds:

Understocking can happen when a business doesn’t have enough money to buy the inventory it needs. To fix this, the business may need to free up cash by selling less popular products and using the money to buy more popular products. The business may also want to consider investing in new funding to grow the business.

13. Industry-specific challenges:

When it comes to overstock, there are some industry-specific challenges where historical data is pretty useless. Demands depend on various unexpected factors that are hard to measure and forecast demand for the future.

For example, in fashion houses, it’s difficult to forecast demand for items where designs and fashions are constantly changing. Customers always demand new styles, designs, and colors, making it challenging to predict which ones will be successful and which ones will fail. However, there are specific methods for every sector to predict demand. In these sectors, they apply these methods to mitigate the risk of overstocks and ensure good profitability to recover the losses of failed items.

Perishable and expirable product businesses face another challenge where products will completely spoil after a definite period, and they have to forecast as accurately as possible. Excess inventory will completely spoil.

Effects & Consequences of Overstocking and Understocking:

Regardless of the cause, the effects and consequences of overstocking and understocking are clearly dangerous. You may have products, but no sales, or you may have customers but no products, resulting in a disconnection between demand and supply.

Problems of overstocking:

The problems of overstocking are multifaceted. Overstocking locks your capital in unnecessary stocks, increases operating and holding costs, and reduces profit margins. Perishable and expirable products will expire or spoil, resulting in capital loss. For healthy business growth, inventory optimization based on demands is essential. Instead, having stocks with no demand and sales orders with no stocks creates a frustrating situation that makes it hard to ensure long-term sustainability.

Due to overstock retailers lost billions of dollars each year. Tyco Retail Solutions found from a study that retailers worldwide lose $362.1 billion annually. So, how does overstock impact your business, let’s take a look?

1. Locked your capital:

When you spend money to purchase inventory, you won’t be able to reinvest that capital unless you sell the product. Therefore, you should avoid tying up your capital in excess inventory. Instead, you need to purchase inventory based on the demands to avoid having excess or less inventory.

Overstocking locks up capital in unnecessary stocks. This can limit a company’s ability to invest in new products, technologies, or marketing initiatives, potentially resulting in missed growth and expansion opportunities.

2. Increased Cost of Goods Sold(COGS):

Handling excess inventory requires extra funds for carrying, holding, and managing warehouse storage. Increasing inventory storage costs means decreasing profitability and falling behind in the competitive market.

1. When a company has too much inventory, it may require more storage space, which can result in higher warehouse or storage facility rental costs.
2. Overstocked items can create clutter and reduce the efficiency of storage facilities, making it difficult to find and retrieve items when needed. This can result in increased labor costs and reduced productivity.
3. Overstocked items may require additional insurance coverage to protect against theft, damage, or obsolescence.
4. Overstocked items can result in increased maintenance costs, as they may require additional cleaning, pest control, or climate control to keep them in good condition.
5. Overstocked items can tie up financial resources that could be used for other business expenses, such as marketing and product development. As a result, the company’s financing costs may rise.

3. Loss of products:

Overstocking can result in deadstock, or inventory that has been sitting on the shelves for an extended period of time and is unlikely to sell. This can result in significant losses for a business because the longer items sit in inventory, the less valuable they become. Overstocked items may become obsolete or reach their expiration date, rendering them unsalable in some cases.

Excessive stock can turn into deadstock, meaning inventory that has been sitting on shelves for an extended period of time and is unlikely to sell. This can result in significant losses for a business since the longer items sit in inventory, the less valuable they become. Overstocked items may become obsolete or reach their expiration date, making them unsalable in some cases. If possible, businesses can return deadstock to their suppliers, sell it at a discounted price, or destroy it to reduce holding costs.

Problems of understocking:

Understocking, or insufficient stock, is obviously a potential disaster for any business. Let’s take a look.

1. Loss of Trust:

Customers are the soul of a business. It’s hard to gain customers in this competitive world. But losing them due to understocking is really frustrating. Having sales orders, but no stock to fulfill, clearly means missing out on sales and ultimately losing profit, along with shaken customer loyalty.

Understocking can lead to decreased customer satisfaction, as customers may have to wait longer for products to be available or may be unable to find the products they need. This can result in negative word-of-mouth and a loss of customer trust.

Understocking can also result in missed lead times, which can impact a company’s ability to deliver products on time and meet customer expectations. This can lead to delays, additional costs, and decreased customer satisfaction.

2. Loss of Money:

Losing sales means losing money, while your competitor gains it. If a business is unable to meet customer demand due to understocking, it can result in lost sales and frustrated customers who may take their business elsewhere.

Sometimes, in order to fulfill demand and maintain customer loyalty, a business may resort to excessive buying and shipping, which can increase costs and reduce profit margins.

Overstocks tie up cash and take up storage space that could be used for new products and opportunities. Conversely, understocks lead to lost sales. Accurate estimation can help prevent both overstocks and understocks.

Businesses That Have Been Affected by Overstocking and Understocking:

Here are some examples of businesses that have been affected by overstocking and understocking:

1. Toys R Us filed for bankruptcy in 2017 after years of declining sales. One of the factors that contributed to the company’s downfall was overstocking. Toys R Us had a large inventory of toys that were not selling, which led to increased costs and decreased profits.
2. Barnes & Noble has also been struggling in recent years. One of the reasons for the company’s decline is understocking. Barnes & Noble has not been ordering enough books to meet customer demand, which has led to lost sales and frustrated customers.
3. Gap has also been affected by overstocking and understocking. In 2015, the company had to mark down millions of dollars worth of clothing that was not selling. This led to a loss of profits and damaged the company’s reputation.

These are just a few examples of businesses that have been affected by overstocking and understocking. By avoiding these mistakes, businesses can improve their inventory management practices and improve their bottom line.

How to Minimize Inventory Understocks and Overstocks:

There are several ways that help you to optimize inventory levels.

The following steps can reduce your risk of overstocking and understocking. Implementing better stocking practices ensures that your stock levels are based on demand.

1. Select the right strategy:

Each business has its own unique policies, and it’s important to choose the right demand forecasting strategy that matches your business for accuracy. For example, for an apparel or clothing business where items are not sold year over year, historical demand forecasting may be less effective. However, for businesses selling the same items (most of the time) year over year, such as those in the drugs, pesticides, and hardware industries, historical demand forecasting or ABC analysis can be very effective. Therefore, it’s crucial to choose the right strategy that is tailored to the specific needs of your business.

a. Historical demand forecasting: Historical demand forecasting is a predictive analysis of demand where data is analyzed for previous preferred periods to forecast demand for future periods. It’s very effective for businesses that sell the same items year over year, with new items introduced in small amounts.

b. Open to buy(OTB): Open-to-buy is a business strategy used by retailers to calculate how many products to buy based on demand, stock on hand, on order, on receipt, on delivery, and overall inventory in transit.

c. ABC analysis: ABC (Always Better Control) analysis is when items are categorized into A, B, and C based on their importance. ABC analysis follows the 80/20 rule that 20% of your products contribute to 80% of your revenue.

• A = Items that are in the top 20 percent of products. These items generate most of the revenues and profits for your store. They get the most priority when it’s time to restore items.
• B = ‘B’ is the medium priority item that gets sold consistently but is not as category ‘A’.
• C = The lowest priority items get a small number of sales but need to keep these items as a regular business.

d. Reorder point: It refers to the level of inventory at which a company should reorder more stock. The reorder point is calculated based on the lead time for the supplier to deliver the products, the rate of demand for the products, and the desired level of safety stock.

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e. Economic order quantity: Economic order quantity refers to the optimal quantity of an item that is better to purchase in order to meet its demand while minimizing its holding and storage costs. It’s important for businesses where holding and storage costs are a big factor in profit margin.

2. Choose the right system:

You must use a modern inventory management system to manage your inventory. There are many inventory management system providers, each with different functionalities and specialties. You have to choose one that better meets your demands based on your business size, type, and category.

3. Follow-up trends:

Sometimes unexpected trends can cause a dramatic change in your demand for various reasons, where demand can rapidly increase or decrease. Businesses should follow the trends and have the ability to predict future trends and make preparations for the future.

4. Audit your inventory regularly:

Regularly audit your inventory and follow up on the key performance indicators, including average inventory, inventory turnover ratio, and average days needed to sell inventory.

1. Average inventory: Average inventory is the average amount of keeping inventory for a month over a year.
2. Inventory turnover ratio: Inventory turnover ratio = average inventory/cost of goods. A higher ratio refers to a strong sales position and a lower one to weak sales. The inventory turnover ratio may differ from industry to industry, but typically the optimal range is between 2 and 4.
3. Average days need to sell inventory: The average number of days it takes to sell an inventory. It also differs from industry to industry, but the lower, the better.
4. The balance between marketing and supply: Based on business marketing and its performance demand can increase or can decrease. A healthy business must have good co-ordinations among all departments of sectors including marketing and supply.

Many businesses fail to balance marketing and supply, but you don’t have to be one of them. You have to ensure the right growth rate between marketing and supply. When you have strong marketing, you get more orders and have to ensure more supply to keep your business healthy and avoid overstocks and understocks.

5. Re-arrange stock levels among all locations.

If you have multiple sales centers, it opens up a great opportunity to distribute inventories among the locations because customers’ demands and market trends vary from location to location. While in one location a product item may be overstocked, in another, it may be understocked. So, rearranging stock levels can mitigate the effects of overstock and understock.

Here are some additional tips for avoiding overstocking and understocking:

1. Set clear goals for inventory levels: What level of inventory do you need to have on hand to meet customer demand?
2. Track your inventory levels closely: This will help you to identify when you need to order more inventory or when you need to reduce your inventory levels.
3. Use inventory management software: Inventory management software can help you to track your inventory levels, set reorder points, and identify areas where you can reduce your inventory costs.
4. Review your inventory levels regularly: As your business grows and changes, you may need to adjust your inventory levels. Make sure to review your inventory levels regularly to ensure that they’re still meeting your needs.

By following these tips, you can avoid overstocking and understocking and improve your inventory management practices.

Advantages of overstocks and understocks:

Overstock and understock are detrimental to any business. They both have disadvantages and no advantages. If you say that when you are ill, you can take a rest and don’t have to work, that is an advantage of being sick. But when it comes to overstocking and understocking, there are no advantages to either situation.

How to Deal With Overstock or Excess Inventory:

How do you deal with overstock even after taking preventive measures?

Overstock ties up cash and prevents you from taking advantage of new opportunities due to lack of capital. Additionally, overstock occupies valuable warehouse space and incurs costs for rent and operations.

To get rid of overstock you have to sell it, return it to the vendor, or donate it to charity.

1. Take campaigns to make sales.

The best way is to increase sales, and for this, you have to implement creative strategies and campaigns, including bulk selling, discounted pricing, buy one get one free offers, adding value by converting to new products, and so on.

2. Return to the vendor.

Another option is to return the excess inventory to the vendor and refund the money. This is usually only possible if you bought the inventory from a wholesaler or other type of supplier. They may be willing to take the inventory back or give you a credit for future purchases.

3. Donate.

The final way to get rid of excess inventory is to donate it, which frees up warehouse space and reduces rent costs. This is a good option for inventory that cannot be sold or returned to the vendor.

Conclusion:

Overstocking and understocking are common issues all over the world, regardless of the type, size, and location of a business. Both are two sides of the same coin. If you want to avoid overstock, the risk of facing understock increases.

On the other hand, if you want to avoid understock, the risk of facing overstock increases. You have to maintain a safe line where both risks are mitigated. Advanced inventory tools can help you to measure the safe line for a certain product based on demand analysis.

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