How to Calculate Unplanned Inventory Investments

By Fool.com

Inventory management is a critical skill for business managers and a major consideration for investors and economists. To understand the subtlety of this art, we can use a quantitative metric -- unplanned inventory investments -- to understand the implications of inventory management for an individual business, as well as the broader economy.

Understanding "unplanned inventory investments" Businesses invest in inventory today to sell in the future. The amount they invest is based on assumptions about the costs, sales, and growth that a business projects. If any of those assumptions change, or if the business reality fails to match those expectations, then the business must change its investment in inventory.

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This change results in an unplanned inventory investment. Businesses can invest more than they initially planned if growth is stronger than anticipated, or if costs are lower than anticipated. Likewise, businesses can invest less than planned if sales are low, or costs are high. These assumptions and plans change month to month, week to week, and sometimes even day to day.

For example, a gift shop will need more inventory around the Christmas holidays because of the increased sales during that season. Or a bar may need more inventory on Fridays and Saturdays because people are more likely to imbibe on the weekends instead of work nights.

How to calculate unplanned inventory investments To calculate a business' unplanned inventory investment, subtract the inventory you need from the inventory you have. If the resulting unplanned inventory investment is greater than zero, then the business has more inventory than it needs.

When this happens, the business has invested cash into its inventory that could have been used elsewhere -- marketing, advertising, or hiring new employees. However, now that this cash is tied up in those extra inventory purchases, it can't be converted back to cash until either sales increase or until the business owner stops purchasing the same level of new inventory. Depending on the business and level of unplanned inventory investment, this can take anywhere from days to months to correct.

Negative unplanned inventory is when the business doesn't have sufficient inventory to meet customer needs. When this happens, the business would have empty shelves during its busiest hours. This can happen due to higher-than-anticipated sales, like when a certain toy goes viral at Christmas time leading to shortages nationwide. An inventory shortage can also occur due to poor management decisions, where not enough capital is allocated to inventory even when sales projections are accurate. In either case, negative unplanned inventory causes lower sales that would have otherwise occurred.

Macroeconomic implications When businesses across the whole economy all begin to have negative unplanned inventory investments, that can indicate that the economy is picking up steam. In practical terms, it means that businesses across the country have collectively underestimated sales. That implies that consumer demand is growing, which leads to higher economic growth.

On the other hand, consistent positive unplanned inventory in the economy can indicate that growth is slowing, or may even be negative. This is because businesses have collectively overestimated sales, meaning that the consumer is pulling back.

In a stable economy, some businesses will have negative unplanned inventory investments, while others will have positive. It could be random, or it could reflect the difference between strong management and weak management.

The best managers will balance inventory levels efficiently and consistently. When macroeconomic forces push their inventory out of balance, these managers will be the first to react and correct the problem quickly. For investors, these are the managers that will lead high-performing companies through the good times and the bad.

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