Inventory risk is the probability of exposure to harm by the goods you own or are planning to sell. This article covers what it is and how to manage it.
Inventory management can present both an opportunity and a liability, often at the same time. As a retail leader, there is a short list of things that truly matter when it comes to thinking about inventory risk — increasing the value of the company by fulfilling your promise to your customers.
We believe that every decision a retailer or marketplace makes should be filtered through the lens of whether you’re accomplishing this.
Let’s dive in!
How inventory relates to your business objectives
Before we can talk about inventory risk, we have to break down the mandate of every retail and marketplace business and consider the overall goal.
Peter Drucker said, ‘The purpose of a business is to create and keep a customer’. Customers are the independent variable and the reason for a business’s existence. Too many retailers and marketplaces forget fundamental questions about their businesses, such as:
- Who is your chosen customer?
- What does your chosen customer value?
- What need(s) can they meet through you?
- What experience do you want to leave them with?
- Therefore, what is the customer promise?
- Finally, how will you remain solvent while meeting the promise?
Retailers and marketplaces that are able to express the answers to these questions with clarity, and in which every team member is aligned and aware of the purpose of their existence, consistently outperform those who don’t take the notion of customer promise seriously.
Before considering how to measure and manage inventory risk in your context, consider an exercise to write down your answers to the above questions. We’ve found it provides clarity about what inventory risks exist, which are ultimately just anything that detracts from the customer promise.
What is inventory risk?
Once you know what your customer promise is, you can identify the inventory risks that exist for your business. Without a clear customer promise, it’s not clear which risks become the priority to manage. Some customers want all your products to be in front of them, to touch, feel and hold. Others want their products to reach them as quickly as possible. How you manage inventory should closely relate to your customer promise, such that risk approaches zero over time.
To fulfill the customer promise, you need to have the right amount of the right products, in the right place, at the right time. And to increase the value of the company overall, you need to be able to buy and sell those products at the right price. This gives us a definition of the theoretical maximum state of inventory in a physical goods business: having the right amount of the right goods, for the right price, in the right place, at the right time. You can break down each of those components in relation to the customer promise, to figure out what ‘right’ means.
Inventory risk is essentially any deviation in theory or in practice from that definition. It involves some combination of the wrong goods (e.g. products customers don’t want to buy), wrong price (e.g. at thin or negative margins), wrong place (e.g. poorly distributed) and wrong time (e.g. stale or irrelevant products). The decisions you make on each of these factors will determine how much inventory risk you bear.
The theoretical maximum state of inventory in a physical goods business: having the right amount of the right goods, for the right price, in the right place, at the right time.
How to manage your inventory risk
Risk management ultimately comes down to decision making. High quality decisions reduce the risk and volatility involved in fulfilling your customer promise.
We believe there are many ways to manage inventory risk depending on your context, but also that some have come up fairly consistently across Convictional customers to expand on here.
To have the right goods is to have what you need to fulfill the customer promise. Some customers value curation, in which case the right goods have to be filtered according to your taste and what customers looking for from your store. This happens through merchandising. Curation decisions have the biggest impact by far on making sure the right goods are available to customers.
Here are some questions to ask to get to the bottom of what ‘right goods’ means in this context:
- If I walked through my customer’s house or place of business, what would I see?
- Am I aiming to satisfy a basic need (e.g. groceries) or sell an experience (e.g. art)?
- Do you have the right voices at the table on my team speaking on behalf of customers?
- What kind of products would my chosen customer describe as the perfect gift?
- What jobs is my customer trying to accomplish for themselves through my products?
- What SKUs go together and complement the products I am known to be selling?
Once you have answers to these questions, a picture of what catalog is going to best fulfill your customer promise becomes clearer. The answers to these questions can then be turned into principles (e.g. ‘My customer values a premium product, even over saving money’). These principles can then be used to make choices about any future product selections.
The risk in making wrong catalog or merchandising decisions is a lack of freshness and differentiation. Value is added for your customer when your assortment addresses the answers to the questions above. A failure to do so can ultimately devalue your store’s offering and put you under the risk of being irrelevant and out of touch with your customers. This is by far the biggest risk i.e. the risk that the inventory you choose will not end up holding relevance to your chosen customer.
Often decisions about how much of an item to purchase goes without the same consideration that retailers give to choosing their goods. That’s usually not a problem because choosing the right goods is more important than how many of them you have. Once that decision has been made, though, it’s important to think about how much to order, and how to distribute those units throughout the different offline and online customer touch points.
To evaluate the amount to purchase, consider the following:
- How often does my customer purchase this category of product?
- What is the typical quantity of product purchased?
- Is my supplier an expert on packaging the right amount of product?
- How many customer touch points does this product belong in?
- How does the quantity of units on a purchase impact margins?
- What supply chain constraints or opportunities exist that affect this product?
- What impact does it have on my customer to have too little (scarce inventory) or too much (excess inventory)?
Making decisions about the right amount of product originates in a deep understanding of product packaging. Often, you can ask your supplierto make recommendations about packaging that are appropriate for your customer. How often products are being purchased can determine reorder timing, and bulk discounts can significantly margin and cost pricing (more on that below).
Once you have determined what the ‘right product’ for your chosen customer is, it’s important to consider the economic side of the equation in your balance sheet. If there is no way to sell the product to your customer at a price at a healthy positive margin, you risk going out of business eventually (insolvency). Asking the right questions about the purchase price (e.g. unit cost), physical logistics (e.g. landed cost) and customer price (e.g. retail or resale price) will resolve this and provide a model that can be used to consider overall financial risks from pricing.
Here are some example questions you can use to develop your own economic risk model:
- What alternatives exist for this product, and what are their cost levels?
- How does my customer evaluate the value of this item?
- Are there any service level expectations to consider (e.g. shipping)?
- What is the conventional margin for this product and how flexible is it?
- What impact does quantity purchased have on the input cost?
- How much of the cost is supply chain effort vs. the manufactured cost?
- If the purchase is not urgent, could cost trade offs be made on shipping?
Once you have answers to these questions, it becomes clear what products present the most economically sound opportunity to resell them to your customers. There are various ways both from within the product itself (e.g. considering alternatives) and around the product (e.g. considering service level expectations) that could affect the economic model of the product. We recommend including the costs of all related enabling technology and investments to get the total picture of how much upfront and ongoing capital will be required to sell your products.
Modern customers want products to be available across every channel, also known as omnichannel. This requires significant offline and online technology and process investments to enable it. But just because customers may want every product you present to them available in every channel, you don’t have to have every product physically on hand to be able to provide that experience. It’s possible that simply having access to every product fulfills the promise without having to hold that inventory physically.
Ask yourself the following to figure out what ‘right place’ means for your customer:
- Does my customer expect to walk out of the store with this product?
- Is the experience improved or harmed by shipping the product to their house?
- Does the customer expect to be able to purchase various similar products at once?
- What other types of adjacent stores might be appealing or complementary (e.g. mall)?
- Where in the store is the product most expected or likely to sell?
- How will my product be discovered by customers online?
A clear definition of what ‘right place’ means both online and offline will make it possible to ensure that customers are able to satisfy their needs without too much frustration. Everyone knows the experience of seeing an item available for sale in a store that is far away but none available locally, an unfortunate missed opportunity to create a customer with products that have already been curated (e.g. right product) and paid for (e.g. right price). Giving thought ahead of time to your definition of ‘right place’ will serve to minimize the risk of misplaced inventory.
Providing products to customers at the ‘right time’ is a more immediate type of relevance than decisions about the right goods. Timing comes down to a variety of situational and domain specific factors that could impact what your customer wants and why. Some needs, like hunger, happen over and over again. Other needs, like picking up extra supplies while away on vacation, are one off. Finally, seasonality plays a major role in all forms of product resale, where certain products are relevant only in certain periods (e.g. gifts peak prior to Christmas) but also even for extremely short periods of time (e.g. something goes viral on TikTok).
Consider some of the following questions to build a definition of ‘right time’:
- Based on my customer’s jobs-to-be-done, how does timing affect relevance?
- Does my customer change their behavior seasonally?
- How do short term influences (e.g. social media, culture) affect my customer?
- Does my product have terminal relevance, like groceries and perishable goods, or favor one-time purchases?
- What shelf life does my product have? Is it susceptible to factors like shrinkage the longer it's stored?
- Is this an impulse purchase (e.g. ordering from the couch late at night)?
- What impact does missing the right timing have on my inventory?
- How much lead time should I factor into placing purchase orders to renew my stock levels?
Overall, giving thought to timing and the impact it has on your customer will allow you to make sure that customers are presented with the things they need when they actually need it.
Types of inventory risks
Now that we’ve defined each element of inventory risk (e.g. right goods, right price, right place, right time) , we can articulate the possible risks that can emerge in each area. This is not necessarily an exhaustive list, but they are the most common ones. We typically observe six major categories of risk that need to be considered and managed in a retail context:
- Lack of Freshness: retailers choose the wrong products and become irrelevant to customers.
- Lack of Differentiation: retailers choose the same products as everyone else and don’t have a distinct brand ethos.
- Lack of Contribution Margin: retailers over or under invest in parts of the business that lead to poor cash flow and financial risk.
- Lack of Available Stock: retailers don’t have enough product to satisfy demand (poor inventory levels), which leads to stock-outs
- Lack of Accurate Forecasts: retailers don’t forecast demand accurately, and they end up over or under buying products
- Lack of Financial Flexibility: retailers make financial investments in one part of the business, which leads to cut budgets for other programs.
How dropship programs reduce your inventory risks
Inventory risks can come from changes in consumer demand, over or under investment in stock, and excess financial exposure.
But you can reduce all of these risks with one core strategy: dropship programs.
Dropship programs enable retailers to reduce the inventory they keep on hand, while expanding their product assortment to fulfill their customer promise. Dropship gives retailers more inventory control without the costs of adding SKUs.
Our early experience has been that retailers and marketplaces commonly over or underinvest in certain supply models, which affects their ability to adequately fulfill their customer promise. Dropship in particular is underexplored as a model to protect against these inventory risks.
1. Keep your catalog fresh
Freshness in your catalog comes down to supplier onboarding velocity. The faster you can onboard new suppliers, and add additional items from existing ones, the more fresh your catalog can be. There is no upper bound for the impact that faster supplier onboarding can have on freshness.
Being able to respond to a TikTok trend and having a product on-site the same day when it is beneficial to do so can make a huge difference to your customer promise. There’s no way to do that if you have the hard requirement of holding goods physically in person, which is why we often recommend stretching your supply models to include dropshipping. Dropship might not be the best supply model for all cases, but maximizing for freshness requires dropship.
2. Be different by partnering with new brands
Catalog differentiation can be a challenge if you use methods of supplier enablement that themselves aggregate products. An example of this would be using distributors. Distributors erode differentiation while solving for other important considerations like catalog expansion. Having an offering that is unique is what makes customer relationships durable in the long term. Being different ultimately requires supplier enablement methods that increase differentiation.
One way to approach differentiation is to carry products from sellers that have had less conventional success than those carried in all mass market channels. Discovering a new product or brand that you love is an experience that customers remember across verticals, and that requires making bold decisions to partner with less widely distributed supplier partners.
It is possible to experiment with new, less widely distributed brands and suppliers without taking on significant inventory risk through dropship. Brands can be added to the site and included in marketing to test their viability before expanding the relationship with bulk purchases and in-store merchandising.
Convictional’s supplier enablement platform makes it really easy to do this. Brands can connect their ecommerce store directly to Convictional’s platform — we offer direct integrations with Shopify, WooCommerce, and BigCommerce. They can then choose which products you want to test for your partnership before syncing them to your store.
3. Expand your contribution margin by keeping supply flexible
Every aggregator engaged in reselling products has a central purpose and that is to create value and retain that value in the form of contribution margin. The business model stops making sense where contribution margin is constrained and where it is not possible to make sustainable contribution margin. A lack of contribution margin directly affects cash flow and long term solvency. The goal is to maximize contribution margin, not margin percent or margin per unit.
To address the need to maximize contribution margin, it’s important to consider the fully landed (e.g. products are at point of sale, either virtually or physically) and loaded (e.g. other additional fees and costs required to bring products to a sellable state are included) costs. When you’ve done that, a clear picture emerges about the right way to optimize between different supply models and catalog options.
On the other hand, too much of a focus on contribution margin optimization can also hurt retailers by moving risk to other parts of the business. For example, a retailer concerned only with contribution margin may make the mistake of investing too heavily in physical stock, at the expense of financial agility. They still have to store, transport, and deliver that stock to individual customers.
Dropship gives retailers the flexibility to maximize their contribution margin as another supply model that they can leverage in their inventory mix. When you apply the right supply model to the right SKUs, you can benefit from an expanded contribution margin across your business.
4. Reduce your dependence on available stock
Supply chain risks exist that are external to the business but still present inventory risk. Solving supply chain issues can be complex but come down to a few consistent factors. One of the most common ways that supply chain issues can happen is when there is a gap between where products physically are and the opportunity to sell them (e.g. proximity to the point of sale).
Dropship presents a unique opportunity to bring the point of sale to the customer because the physical product can be manufactured and transported in bulk quantities that benefit from economies of scale, and then sold directly from facilities and shipped directly to customers. As long as sufficient stock exists at the point of origin of the products, this can significantly increase the probability that at any given time a customer is able to meet their need for a product.
Having multiple supply models like dropship in addition to wholesale is critical to weather major disruptions, such as the ongoing global supply chain crisis. When you combine that with supplier enablement, you reduce your dependence on any one supplier and diversify your risk across multiple suppliers, increasing your ability to satisfy your customers.
5. Avoid the problem of inaccurate forecasting
Financial planning and analysis (often called FP&A) is the approach most companies take to ensure that the right amount of goods are purchased. It is often a challenge to be able to predict how much stock you need to satisfy all your customers every year, and there is often volatility in the amount of products that will be consumed. In normal conditions, it is often possible to arrive at an approximation of what your customers will want by looking at demand, seasonality, top of funnel marketing indicators, behavior and other signals.
By leveraging dropship for your product assortment, you can create a flexible program that spans both dropship and wholesale supply models. Products can be purchased wholesale to maximize the margin potential of products likely to sell through, and those purchases can be complemented with dropship assortment for sizes and colorways that don’t have as much demand. The combination reduces the likelihood that you’ll purchase stock in excess.
6. Free up your financial resources to grow your business
Financial flexibility is often underestimated. Retailers often use industry standard financial models that provide for healthy ratios of physical inventory purchases. This form of financial modeling is often inflexible, and misses the potential opportunity cost for marketing. Any capital tied up in the form of inventory ultimately reduces the financial flexibility of the company as a whole, and in particular reduces the discretionary working capital that exists to double down on marketing programs.
In the event the company has marketing programs that are working, it can be productive to be in a position to shift spending into those programs that are working. If no programs are working, then you probably need to worry about your assortment mix and whether you’re choosing the right products to begin with.
But in the majority of cases, some marketing programs do ultimately work. Being able to significantly invest in those programs is a counter-intuitive way to get more leverage on your capital than tying it up purchasing inventory. It can often make more sense to sell lower margin dropship products backed by a successful marketing program than to physically store the products at the point of sale and lose the opportunity to spend on the appropriate marketing support.
Convictional helps you reduce your inventory risks
Dropship programs address the consumer demand, forecasting, and financial risks that comes with storing inventory in a retail business. The path to proving out the business case of your dropship program is with supplier enablement. After all, if you can’t onboard your suppliers and get them live on your store quickly, how will your dropship program generate a return on investment?
Convictional’s supplier enablement platform helps you launch and scale your dropship programs in days, not months:
- Onboard your suppliers with one-click integrations via Shopify, BigCommerce, and WooCommerce. Flat file CSV upload and x12 EDI integrations are also accepted.
- Provide self-serve custom onboarding flows to your suppliers. Give them all the details of your dropship program without sending dozens of emails back and forth.
- Give your suppliers the ability to manage order and product information directly in their ecommerce store instead of a new portal that they have to manage 24x7.
Convictional can help you launch brands as quickly as Indigo, The Fascination, and The Helm. To learn more about how Convictional can help you reduce your inventory risks through a dropship program, get in touch with our team today!