Overstock Vs Understock – Causes, Risks and How to avoid both

Inventory Management is a delicate balancing act between overstocking and understocking.

So if you had to choose – Overstock Vs Understock? Which one is worse?

While understocking might seem worse than overstocking, they can both be harmful to your business.

If you understock and have insufficient inventory, you risk not being able to meet sales demand and could lose out on business. Or you may be forced into accepting backorders which you will then scramble to fulfill.

On the other hand, if you overstock and end up with excess inventory, you’ll have money locked into raw materials which you cannot convert quickly enough into sales. Even though from an accounting perspective inventory is an asset, it’s not a liquid asset. Inventory still is “money stuck” in the business which you want to convert into customer cash as quickly as possible.

So, one of the key objectives of inventory management is to ensure that you have the optimal amount of inventory to meet customer demand.

Topics

In this article we’ll cover the following topics about overstocking and understocking:

1. Definitions
2. Causes
3. Risks
4. How to avoid
5. Key Takeaways

What is Overstocking?

Overstocking refers to a company ordering more inventory than what it needs to meet projected customer demand.

This excess inventory could be in the form of finished products, or the raw materials, parts and components needed to manufacture finished products.

Overstocking or having a stock surplus can be dangerous and can create a false sense of security because, in the long run, it can end up costing a business a lot more than just the COGS.

At the minimum, you may need to find ways to get rid of excess inventory, which will be a cost in itself.

What is Understocking?

Understocking refers to a company ordering less inventory than what it needs to meet projected customer demand.

While Understocking can be a part of a deliberate strategy, more often than not, it is a reflection of poor inventory management.

Why do we overstock or understock?

Poor demand forecasting

If you cannot accurately predict which products you will sell in which quantities next month or the next quarter, how can you know how much inventory to purchase from your suppliers?

Poor demand forecasting is a common cause of understocking.

Unexpected growth or slump in sales

While an unexpected growth in sales is not a cause of understocking, it can certainly result in a product being understocked for future sales.

Surprise sales growth is not uncommon during the holiday season.

Similarly, a slump in sales can cause overstock as you are unable to move inventory out of your stores and to customers.

Production difficulties

If either you or your suppliers are facing production difficulties, you may not be able to sufficiently stock up with products to meet projected customer demand.

Logistical difficulties

Logistical difficulties like poor weather, border controls, customs problems, and strikes can prevent products and raw material that you ordered from reaching your stores and warehouses. This is a possible cause of understocking.

Poor inventory management

All of the above points can be encapsulated into a single point: Poor inventory management. Inventory management is a science. And there are techniques available to ensure that you always have an optimal amount of inventory add are neither overstocked nor understocked.

Setting proper reorder points is one such technique to ensure that you place orders with your suppliers the moment your inventory drops to a certain level.

Fear of running out-of-stock

We all dread the scenario where a customer walks into a store, asks for a product and we have to say that we don’t have it in stock. This is classic FOMO – Fear Of Missing Out.

And so, most of us prefer to have a bit of overstock so that we never have to say no to any customer or be forced to take a backorder.

So, the fear of running out of stock is a reason for overstocking.

Financing difficulties

A final reason for ending up in an understock situation is plain and simple: you just don’t have the funds to order enough stock in advance.

Financing difficulties are more common than you might imagine, and they force businesses to make tough decisions about how best to deploy their free cash flow.

Risks of Overstocking

1. Cash flow constraints
   Money that is stuck in excess stock can be more productively used in other parts of your business. Overstocking can create cash flow constraints which will increase your operating costs.
   
   Just calculate your excess inventory at the end of each fiscal period and you’ll see just how much money is stuck.
   
   
2. Extra warehouse costs
   All stock requires space. And if you are overstocked, you’re going to need even more space. And so additional warehousing costs is a common downside of overstocking.
   
   
3. Increased product shelf time
   The longer your product stays on your shelf the more it’s costing you. In this case, time literally is money. Because inventory is money tied up.
   
   
4. Risk of Wastage
   If you sell perishable products with an expiration date, you’ll have no choice but to throw them away once the expiration date has passed.
   
   Similarly, if you sell products that deteriorate overtime or if they lose value overtime, then the longer you keep them in your inventory the less likely you are to sell them and may need to throw them away.
   

Risks of Understocking

1. Missed sales opportunities
   If you do not have enough stock to meet customer demand, you are going to miss out on sales opportunities.
   
   A customer who requests a product which you do not have in your store or in your warehouse may not be willing to wait till you place an urgent order with your supplier or manufacture the product. The customer may just go to your competitor instead.
   
   
2. Customer dissatisfaction
   When a customer tries to buy a product from you and is unable to do so, this experience will inevitably lead to dissatisfaction.
   
   It doesn’t mean that the customer is dissatisfied with the product or your store. It simply means that the customer now has a negative association with your business because he or she was forced to go somewhere else to look for the same product because you didn’t have it in stock.
   
   
3. Damage to the brand
   If your brand is built on providing high customer satisfaction then having a customer who is dissatisfied, for any reason, is going to hurt your brand.
   
   If you are chronically understocked and have to regularly turn away customers eventually that’s what your brand will mean to your customers.
   
   
4. Higher cost of inventory
   By being understocked, if you always acquire products or raw materials at the last minute, you might end up paying more for them.
   
   And now you will end up with inventory that costs more.
   
   Now this might be worth it if the cost of storage is very high or if the products lose value over time. So, whether purchasing inventory at the last minute is cost effective or not is something you will need to calculate.
   
   
5. Higher shipping costs
   If you purchase your inventory well in advance, you might be in a position to negotiate shipping costs with your shipping partners. You might even be able to ship the inventory when it is cheapest to do so.
   
   On the other hand, if you are understocked and you order inventory at the last minute you will be forced to pay whatever shipping costs might be prevalent at that time.

How to avoid Overstocking and Understocking

As you now know, Overstock Vs Understock is a moot comparison because both can be harmful to your business.

So the question is, how can we avoid both and have an optimal amount of inventory. Here are some inventory management techniques that can help.

Here are the 5 techniques to avoid Overstock and Understock situations:

1. Always accurately know your inventory levels
2. Define clear reorder points
3. Understand sales patterns and improve demand forecasting
4. Improved communication (and relationships) with suppliers
5. Assign an Inventory Controller as the point-person to manage inventory

Let’s take a closer look at each of these.

1. Track inventory levels

Always accurately know your inventory levels
The first step in knowing if you have sufficient inventory is to know how much inventory you actually have.

If you do not carry large quantities of inventory, you might be able to manually count each item in your store or warehouse.

Alternatively, you could deploy a mobile inventory solution and use mobile phones to track inventory levels.

If you carry large quantities of inventory you might need to invest in an automated process to track items using RFID tags, barcodes or QR codes.

Regardless of the technique that you deploy, always make sure that you’re aware of your inventory levels. A primary cause of being overstocked or understocked is simply not knowing how much stock you have.

2. Define Reorder Points

Define clear reorder points and follow them.
Once you have a system in place for measuring inventory levels, define reorder points at which you will place orders with your suppliers for more products or raw material.

Make sure you have a separate reorder point for each product, and you base it on the sales patterns and delivery or production times for that product.

Ideally, you should link your CRM, your Inventory Management System and your Purchasing Management System to each other.

This way sales information about a product can be correlated to inventory levels and when reorder points are reached, the Inventory Management System can trigger the Purchase Management System to place an order with a supplier.

3. Track Sales Patterns to improve forecasting

Understand sales patterns and improve demand forecasting
By analyzing and understanding sales patterns, you will be in a better position to know at what inventory levels to set reorder points for different products.

Studying sales patterns will also help improve demand forecasting and lower the risk of running out of stock because of poor forecasting or ending up with overstock because of the fear of losing sales

4. Communicate with your suppliers

Improved communication (and relationships) with suppliers
If understocking is part of your strategy, make sure that your suppliers are aware of this.

If you surprise them with last-minute orders, they may not be able to fulfill them.

Negotiate contracts with shorter lead times.
Another tactic could be to take inventory from your suppliers on consignment. You could then overstock without hurting your cash flow. You will, however, incur additional storage costs.

5. Assign an Inventory Controller

Assign an Inventory Controller as the point-person to manage inventory

Make sure that you have a point person responsible for all aspects of managing inventory. Typically, this will be your Inventory Controller.

The Inventory Controller will monitor inventory levels, ensure that inventory is being restocked once reorder levels are reached, be responsible for inventory forecasting based on sales demand analysis, and liaise with suppliers to ensure that you always have the optimal inventory on-hand.

Key Takeaways

1. With overstocking you have more inventory than what you need to meet customer demand while with understocking you don’t have enough.
   
   
2. Overstocking and Understocking can both be harmful to your business.
   
   
3. We end up overstocking or understocking because of:
   • poor demand forecasting,
   • sales surprises (upside and downside)
   • manufacturing and/or logistical problems
   • poor inventory management techniques
   • fear of missing out on sales opportunities
   • or simply not having funds to buy enough stock
     
     
4. Overstocking can result in less free cash flow, additional warehouse costs, increased product shelf time add possible wastage.
   
   
5. Understocking can result in missed sales opportunities, unhappy customers, damage to your brand and higher costs to acquire and transport inventory at the last minute.
   
   
6. Overstocking and under stalking are avoidable be using proper inventory management techniques and a professional inventory management software to guide your internal business processes.