Inventory management may not be as sexy as creating social media strategies or viral marketing campaigns, but it is a key component in your marketing strategy. How you manage your relationships with your vendors and stock levels has a direct affect on customer loyalty and profitability.

Finding the balance between overstocks and backorders has always been a challenge. The Internet has made it harder. Customers and prospects expect a larger product selection and you have to deliver. If not, established big box companies or startup entrepreneurs will be happy to oblige.

Fortunately, increasing item selection online is more economical than in a store or catalog. Unfortunately, it generates higher operational costs.

If you haven't reviewed your inventory management strategy in a while – say, six months or more -- this is a great opportunity to reduce costs, increase service, and improve cash flow.

The high cost of backorders

Customer acquisition and retention is the driving force for growth. Backorders reduce both. It doesn't really matter what your overall backorder rate is when you look at it from your customers' perspective. If customers have a backorder experience with several orders, they will shop somewhere else first. And, if they discuss your company with their friends, it won't include a recommendation!

While it seems counter-intuitive, a customer is more likely to purchase again within 30 days of an order. If that order is backordered, any marketing attempts receive resistance.

Costs that are more tangible exist, too. They include additional shipping and order processing expenses.

How much is the overstock in your warehouse?

The one with the dust and dents? I guarantee that it is too much. While your backorders are robbing you of future sales, overstocks are stealing your cash flow.

Finding the balance between the two is the key to consistent and profitable growth. In addition to the standard carrying costs, too much inventory increases your shrinkage from damage, reduces productivity, and can adversely affect your branding.

Yes, I said branding. When companies get in an overstock position, the effort to liquidate can create an atmosphere of desperation. Customers notice when the same items are continuously on sale with greater reductions. After a time, they start waiting for the sale before they buy. It is a slippery slope that ends with a massive, permanent liquidation.

Improving your inventory management is the fastest way to reduce costs and improve services.

Start the process by reviewing your analytics. If you have established benchmarks, begin with them. If not, do it now. The top four benchmarks are:

--Annual turns: Annual sales divided by average inventory level. Use cost of goods numbers instead of selling price. Example: A company with annual sales of $24 million has an average inventory level of $5 million. The annual turns are $24 million/$5 million or 4.8.

In most cases the higher the turns, the better. The exception is when a company has a high backorder rate. It is sacrificing service and long-term gains for short-term inventory turns.

--Backorder rate: Percentage of units backordered in relation to units ordered.  This is best calculated on a daily basis and averaged over the month.

For example, if your units sold for the day is 300 and 60 units were out of stock, your backorder rate is 20%. If a top selling item is out of stock, it will drive your backorder rate up and customer value down quickly.

--Overstock rate: The dollar amount of overstocked (more than maximum required) in relation to total inventory. Example: A company with an inventory level of $5,000,000 and $1,000,000 of overstocks has an overstock rate of 20%. When you factor in carrying costs, the best approach to an overstock situation is quick liquidation. Keep in mind when you are discounting the items, that a dog is a dog regardless of where you are trying to sell it.

--Initial fill ratio: The ratio between the total number of orders and the ones filled the first shipment. Example: If there are 1,000 orders in a given time period and 900 were filled on the first shipment, the initial fill ratio is 90%.

(FYI: Don't play with your initial fill ratio by holding orders until backordered items arrive. The negative effect on service more than offsets the shipping cost savings. Depending on your customer expectations, you may be able to hold the order 24 hours before shipping the in-stock items, but never longer.)

Please note that there are many ways to calculate the previous benchmarks. The methods presented are ideal for small to mid-size companies. Large businesses that can take advantage of the economies of scale may benefit from analytics that are more sophisticated.

The key to successfully using analytics is consistency. Once you have established a protocol for measuring your benchmarks, keep it.

Next week we’ll look at ways to reduce your costs without sacrificing service, including some tips to get you started.

Debra Ellis is the founder of Wilson & Ellis Consulting (www.wilsonellisconsulting.com). She specializes in improving customer acquisition and retention using marketing, analytics, service, and strategic planning.