Inventory consists of raw materials, unfinished goods that require further processing and finished goods awaiting shipment to customers. Excess inventory usually means that supply is outpacing demand, which could be because of changes in customer buying patterns, increased competition and economic conditions. Excess inventory is bad because it usually results in product obsolescence, cash-flow problems and reduced profitability.
Obsolescence is one of the negatives of excess inventory. Companies cannot sell obsolete items or use them to manufacture other goods. For example, technology changes in the personal computer space mean that older components, such as floppy drives, are obsolete and part of excess inventory. Similarly, certain apparel items and fashion accessories become obsolete in the retail industry. Storage costs, insurance, freight and other expenses associated with excess inventory add to the cost base. According to The Retail Owners Institute, an industry information website, the additional cost of holding excess inventory is between 25 and 32 percent annually.
Excess inventory could result in cash-flow problems. Businesses use the cash proceeds from sales to pay for inventory. However, excess inventory does not generate cash or receivables, which means that a company might not have enough cash for operating expenses. This could lead to additional borrowing, which increases interest expenses and reduces operational flexibility. For example, a business with cash-flow problems might not be able to make the inventory and other investments necessary to respond to changing customer preferences and thus lose market share to its competitors. Companies also might incur additional expenses for disposing of the excess inventory.
Higher costs and lost sales opportunities usually mean lower profitability. For a public company, it could mean a loss of investor confidence and lower share prices. Research by Waterloo, Ontario-based Wilfrid Laurier University professor Kevin B. Hendricks and Georgia Institute of Technology professor Vinod R. Singhal found that excess inventory announcements are associated with negative stock market reactions, especially for public companies with high growth prospects or companies with high debt levels.
Better inventory planning, just-in-time manufacturing and more accurate forecasting of consumer demand are some of the ways to avoid excess inventory. According to The Retail Owners Institute, companies should aim for a turnover rate that matches the industry average and produces the right flow of merchandise to drive sales growth and optimize profits. The turnover rate is equal to the cost of goods sold divided by the average inventory at cost.
Companies should also look for cost-effective ways to dispose of inventory. According to Wall Street Journal writer Willa Plank, some businesses sell their excess inventory to liquidators. They are able to receive some cash upfront and close the transaction quickly.