Smarter Inventory, Better Cash Flow.

Inventory is one of the most misunderstood and cash-intensive assets in a small business, and managing it strategically can dramatically improve cash flow, reduce risk, and support sustainable growth.

Inventory is often treated as an operational detail, but for many small businesses it is one of the biggest drivers of cash flow strain and hidden risk. In this episode, Henry Lopez reframes inventory for what it really is – cash tied up on your shelves – and explains why poor inventory decisions can quietly suffocate profitability.

Henry walks through the most common inventory challenges small business owners face, including trapped working capital, spoilage and obsolescence, shrinkage, unpredictable demand, and the temptation of bulk-purchase discounts that often do more harm than good. He explains why inventory typically lives on the balance sheet rather than the P&L (Profit & Loss Statement), and how that accounting reality can mask its true impact on business performance.

The episode introduces Economic Order Quantity (EOQ) as a practical framework for deciding how much to order and when, using a simple widget example to show how EOQ balances ordering costs against holding costs.

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Economic Order Quantity (EOQ) – A Simple Walkthrough

EOQ (Economic Order Quantity) is a simple method for determining how much inventory you should order at one time. Its purpose is to minimize your total inventory cost by balancing the cost of placing orders with the cost of holding inventory.

Rather than guessing—or buying in bulk just to get a discount—EOQ helps you make data-driven purchasing decisions that protect your cash flow.

What EOQ Is Solving

Every business faces two competing inventory costs:

1. Ordering too frequently
If you place many small orders, you increase:

• Administrative time
• Shipping costs
• Receiving and processing work

2. Ordering too much at once
If you buy in large quantities, you:

• Tie up cash
• Increase storage and handling costs
• Increase the risk of damage, shrinkage, and obsolescence

EOQ finds the point where these two costs are balanced.

The Three Numbers You Need

To calculate EOQ, you only need three inputs:

D = Annual demand
How many units you use or sell in a year.

S = Cost per order
What it costs you each time you place an order, including purchasing time, shipping, receiving, and processing.

H = Annual holding cost per unit
What it costs to hold one unit in inventory for a year, including storage, insurance, damage risk, shrinkage, and the cost of cash tied up.

These do not have to be perfect estimates—EOQ is still far better than guessing.

Example:

Let’s assume your business sells widgets (a fictitious product).

• Annual demand (D): 2,400 widgets (about 200 per month)
• Cost per order (S): $50
• Annual holding cost per widget (H): $4

The EOQ formula is:

EOQ = √( (2 × D × S) ÷ H )

Where:
D = Annual demand (units per year)
S = Cost per order
H = Annual holding cost per unit

Widget Example:

D = 2,400 widgets per year
S = $50 per order
H = $4 per widget per year

EOQ = √( (2 × 2,400 × 50) ÷ 4 )
EOQ = √( 240,000 ÷ 4 )
EOQ = √( 60,000 )
EOQ ≈ 245 widgets

This means the most cost-effective order size is about 245 widgets, which you would normally round to 250 widgets per order.

How EOQ Helps with Bulk Discounts

If a supplier offers:

“Buy 1,000 widgets and get a lower unit price.”

EOQ helps you ask the right question:

Does the discount save more than the extra cost of holding and tying up cash in 750 extra widgets?

Bulk buying only makes sense when:

Discount savings exceed extra storage, risk, and cash tied up.

How to Use EOQ in Your Business

You can implement EOQ with a simple spreadsheet:

• Enter D, S, and H
• Let the formula calculate your EOQ
• Use it to set your standard order size and purchasing cadence

Revisit EOQ when:

• Demand changes
• Lead times change
• Costs change
• Tariffs or suppliers change

Even with estimated inputs, EOQ brings discipline, clarity, and better cash management to your inventory decisions.

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On this episode of The How of Business podcast Henry also explores the origins of Just-In-Time inventory, its roots in Toyota’s post-war production system, and how small businesses can responsibly apply lean inventory principles today, especially now that most supply chains have stabilized after COVID disruptions.

Finally, Henry outlines the core components of an effective inventory operating system, from software and supplier management to a short list of essential KPIs that help business owners stay in control.

The key takeaway: inventory decisions are cash decisions, and managing them well is critical to long-term business health and growth.

“Inventory management is not just about what you sell or use, it’s how you invest your cash, manage risk, and determine whether your business can grow and survive.”

Inventory Management FAQ:

Question: Why is inventory such a major cash flow issue for small businesses?
Answer: Inventory ties up working capital in physical form, making cash unavailable for payroll, marketing, or growth while also introducing risks like obsolescence, spoilage, and shrinkage.

Question: What is Economic Order Quantity (EOQ)?
Answer: EOQ is a formula that helps determine the most cost-effective order size by balancing ordering costs with the cost of holding inventory.

Question: Why buying in bulk is not always a smart decision?
Answer: Bulk discounts often increase holding costs and cash tied up in inventory, which can outweigh the per-unit savings and reduce overall profitability.

Question: What is Just-In-Time inventory and does it work for small businesses?
Answer: Just-In-Time inventory focuses on ordering smaller amounts only when needed to reduce excess inventory; while not risk-free, it can significantly improve cash efficiency when supply chains are reliable.

Question: What inventory KPIs should small business owners track?
Answer: Key metrics include inventory turnover, days of inventory on hand, inventory as a percentage of revenue, stockouts, and obsolete or lost inventory.

Henry Lopez (00:12):

Welcome to the Howe Business Podcast. This is Henry Lopez. This episode is about inventory management for small business owners. You can think of inventory as like cash that you can’t use for anything else and it’s probably sitting on your shelf. And for many small businesses, it can quickly become one of the biggest strains on your overall cashflow and your profitability. Whether you stock materials, parts or finished goods, managing inventory by gut feel or a simple spreadsheet perhaps, instead of having a strategy and a system, well, that can slowly suffocate your cashflow. And so on this episode, I’ll share some ideas, some best practices and break down how to manage inventory smarter so it protects your cash better, reduces your risk and exposure, and supports the growth of your small business. You can find all of the Howa Business Resources, including the show notes page for this episode, and learn more about my one-on-one and group coaching programs at thehowabbusiness.com.

Henry Lopez (01:06):

I also invite you to join the How A Business Community on Patreon, and please subscribe wherever you might be listening so you don’t miss any new episodes. So inventory can be a silent profit killer, but before we get into the tactics and some of the best practices I’d like to share, let’s reframe what inventory really is inside your business. Inventory, as I said at the outset, is stuff. It’s your raw materials, your goods, your parts, your inventory for resale. It’s cash in physical form that’s sitting on the shelves. And for many small businesses, if you have inventory, it might be the biggest use of cash or certainly the biggest spike uses of cash when we have to make those purchases. It’s a hidden risk a lot of times because we have to plan for that or we may not have the working capital to make the purchases that we need to have enough inventory to either make or deliver on our product or service.

Henry Lopez (01:59):

And it’s often one of the least understood assets because that’s really what it is technically in our business is an asset that we hold in the form of inventory. So whether you’re a sign company, for example, you’re making signs, commercial signs, and you need all of the materials, the vinyl, the letters, all of the stuff that goes into making a sign, those materials that you’re managing. Or maybe you’re an elevator service company and you have motors and parts and other electrical components or a doctor’s office and you have to manage and keep track of your medical supplies, which can really add up really fast. Or of course, a retailer where you have stuff up on the shelves that people come in to buy. Or maybe a food distributor that has inventory that’s extremely perishable or a restaurant where you’ve got inventory and you have to have enough inventory to hopefully satisfy the demand, but you’re projecting, how much do I need?

Henry Lopez (02:48):

How much do I need to have for the week if that’s how often you get deliveries? So those are some of the examples that maybe you or the business you’re thinking about starting are dealing with when it comes to inventory. The other thing technically about inventory that can be challenging is really the amount of inventory that we have on hand belongs on the balance sheet. It usually should not or does not appear on the P&L. Now, you might just recognize it all the month that you buy it, and that’s fine as you’re managing your accounting on a cash basis. But the point is that the value of that inventory really belongs on the balance sheet. It’s an asset until we use it either in parts or in making something or in selling a product off the shelf. So you can look at it as affecting profitability because it’s cash that’s tied up that doesn’t otherwise get sold and we can’t make a profit on it until we sell it.

Henry Lopez (03:40):

It’s sitting on the shelves. And of course that’s costing us money because we have to have that space. We have to keep the lights on. It’s taking up valuable space perhaps. And of course, then we have the issue which I’ll dive into more in a moment of that inventory becoming obsolete. Now let’s look at why inventory can be such a challenge for a small business owner. First is, again, this concept of cash being trapped in inventory, and that’s really the most critical. Inventory ties up our working capital. It’s cash that we can’t use for anything else. So we have to be very careful with managing and planning our working capital for these inventory purchases, in particular if you make large purchases of inventory periodically. Now for something like a restaurant, not as big of a deal necessarily on a weekly basis because you’re buying it more frequently.

Henry Lopez (04:28):

But if you make a large inventory purchase in a retail environment, for example, every three months and it’s a large amount of money, you got to plan for that. That’s where cash forecasting comes into play. And we’ll touch more about the systems that you need in place to make sure that you can manage your inventory, not only that you have on hand, but that you’re going to need in predicting that. But cash gets trapped in inventory. The other challenge with inventory is obsolescence and spoilage, which is that things happen to this inventory. It could be things that aren’t necessarily directly related, like a technology change that makes a part obsolete as a result or a new model or type that’s available. Therefore, people may not want now what we have in inventory or expiration dates, of course, if it’s something that’s perishable or has some sort of a shelf life.

Henry Lopez (05:14):

And then there’s shrinkage, and that’s where we lose the inventory before we even have a chance to sell it and make a profit so it’s a total loss. And that can be as a result of theft, whether it’s internal or from shoplifting or damage. It gets damaged when it’s in our control, on our shelves, in our warehouse. It can spoil, of course, as we just talked about, because it goes out of date in case of something that’s perishable like food items. The other challenge is unpredictable demand. It’s hard for us to forecast accurately, especially with newer businesses or businesses where we might have fluctuations, or if it’s seasonal, that forecasting is hard to do, especially if you don’t have a system to help you with forecasting. Or one large job might really throw things off in the way of inventory usage and in your forecasting.

Henry Lopez (06:06):

The next challenge is what I call the bulk discount trap. And this is where we get offered that if you buy 600 instead of 500, you get that price break. And so we get tempted to buy that 600 because we’re going to make money on it or save money. And that might be true if you’re actually going to realize and use that inventory, but more likely than not, what you’re doing is hurting yourself and tying up even more cash in inventory. So vendors often want to push us to buy more and pay less per unit, but we got to be very careful with this. And then you might have what we call the COVID hangover. Certainly during COVID, we had significant impact on supply chains. And so a lot of businesses had to really shift from what was previously just in time inventory strategies to getting as much as we could when you were able to get it because you didn’t know how long it was going to take.

Henry Lopez (06:58):

What I hear from most of my clients and in most industries, supply chains are back to normal, but we may not have adjusted. Maybe we got so averse to not having inventory on hand that we’re still keeping too much inventory. That might just be a practice that we think, well, better to have more and not run out, but that’s not necessarily to our advantage. So be careful that you’re not stockpiling because of fears of the supply chain that really are no longer realistic. Now that we’ve talked about how inventory ties up cash and creates risk, let’s look at one way to decide how much you should actually order. And one of the ways to do that is what’s called EOQ or economic order quantity. This is a commonly used in larger organizations and small businesses. It’s a common formula that’s used to help you determine how much inventory you need.

Henry Lopez (07:50):

You can think of it as a simple framework for figuring out the most cost-effective amount of inventory to buy at any one point in time. It balances two competing forces. The cost of placing orders like shipping and admin time and receiving expenses and the cost of holding inventory, which includes storage, insurance, damage, obsolescence, and of course the cash tied up on your shelves. So even if a supplier offers you a lower unit price for buying in bulk or for buying more, this economic order quantity formula is one way to help you see whether that discount that’s being offered really outweighs the extra cost and risk of holding all of that additional inventory. The goal isn’t necessarily the cheapest unit price. It should be the lowest overall total cost and the best use of your cash. So let’s walk through an example using just the fictional widgets.

Henry Lopez (08:48):

Let’s say your business sells about 2,400 widgets each year or about 200 a month, 200 widgets a month. And every time you place an order between admin time, shipping and receiving, it costs you about $50. And once those widgets arrive at your location, it costs you about $4 per widget per year to store them, to insure them and to carry the risk of damage and obsolescence, as we’ve talked about. And so the economic order quantity formula takes those three numbers, annual demand, cost per order, and holding cost or carrying cost, and calculates the order size that minimizes your total costs. So when you plug those numbers in, an economic order quantity formula tells you that ordering about 250 widgets at a time is more efficient than ordering a thousand just to get a discount. I’m also going to give you more details on this that you can walk through to understand this better on the show notes page for this episode at thehowbusiness.com.

Henry Lopez (09:49):

The key is to be careful not to get enticed with these discounts that vendors entice us with to buy more now when it might be counterproductive. In fact, it might cost you more in the long run, even though you got that “discount” upfront. So that’s called economic order quantity. If you’re not using that to help you make these inventory purchase decisions, I encourage you to learn how to use that, use a tool, an inventory management system that’ll help you calculate that or a spreadsheet for that matter to help you calculate that number.

Henry Lopez (11:46):

So once you understand how to use economic order quantity, then I think it’s important to talk about just in time inventory and how that fits into this whole thing of managing your inventory in a small business. Just in time inventory comes from post World War II Japan, specifically Toyota Motor Company in the late 1940s and ’50s. This is back when Japan was rebuilding after World War II, and they faced three severe constraints, which was very limited capital, very limited factory space, and very limited access to raw materials, not unlike what we face as small business owners, right? So Toyota couldn’t afford to operate like their counterparts in America at the time, American manufacturers who had large warehouses and massive stockpiles of parts. So instead, an engineer at Toyota developed what became the Toyota production system, and one of its core principles was producing and delivering parts only when needed in the amount needed at the time needed.

Henry Lopez (12:45):

And that’s the idea that then became what we now call just in time inventory. And the philosophy again is that we eliminate excess inventory and we hide production inefficiencies and we are able to put it back on the supplier to manage its essence and incur the cost of carrying that inventory for us. But then again, along comes COVID and it disrupts that supply chain and a lot of businesses, including small business owners, paid the price of not having enough inventory on hand. Now, having said that, a little bit of the history there, it is important for us to leverage these concepts as much as possible, the concept of just in time inventory. It doesn’t mean no inventory on hand for us as small businesses. It means those smaller orders, especially when you use the economic order quantity formula so that we’re ordering the right amounts at the right time instead of larger amounts because we’re getting a supposed discount.

Henry Lopez (13:44):

Now that supply chains, again, have come back to normal for most of us, we need to go back to, if you haven’t already, these smaller orders, and also looking to buy from vendors that can support us in that way again. No business can run completely lean, and we have to be careful with imported items, of course, now, especially in the world of tariffs and what are those lead times and parts. So all of that still has to come in. It’s not just economic order quantity, of course. That applies to some things, but you have to understand lead times, especially on critical components if that’s what you’re keeping in inventory. Where your inventory comes from dramatically changes how much risk you carry. So overseas inventory, if you’re sourcing from China or India or somewhere else, then you’ve got to look at the advantages, of course, of lower unit costs, but higher lead times and higher risk and higher exposure to things like tariffs or other disruptions to the supply line.

Henry Lopez (14:44):

So that means that you’re probably going to have to hedge on having more inventory. For domestically sourced items, raw materials, inventories, perishables, you can potentially pay a higher unit cost, but you’re going to have faster replenishment. And so you have less cash tied up. So there are trade-offs. And so those are things you have to consider as well and manage as part of your overall strategy of managing your inventory in your small business. We need to think about inventory management as an operating system, and there are several components to that at a high level. First is managing the physical inventory and knowing what you have, what do you have on hand. And so an inventory system, inventory software is key to this. Having a live real system that tracks quantities and locations and usage and reorder points, all of those things are key features in a software system, more than just a spreadsheet.

Henry Lopez (15:42):

If you have nothing and you go to a spreadsheet, that’s great. But I encourage you if you do have significant inventory that you implement an inventory management system. And finally, your inventory strategy is only good as your suppliers, of course. So you’re working with your suppliers, especially for key items in the way of lead times and other contractual obligations, minimums, reliability, your terms on paying for this inventory. All of those kinds of things are important for you to manage as you manage that relationship with those critical vendors. Now let’s talk about some KPIs, some key metrics that you should have at a minimum to manage your inventory. As with any KPIs, you want to keep them limited. You don’t want to overdo KPIs, and some of these may not apply to you, but certainly inventory turnover. In other words, how long does that inventory live on your shelf before you move it?

Henry Lopez (16:39):

Days of inventory on hand. In other words, based on how much you sell on a daily basis, how much do you have on hand? Inventory on hand is a percentage of revenue. Stockouts, tracking when do you have stockouts? What items? Why? And then tracking obsolete inventory.That’s the inventory that gets lost. We’re using that term obsolete broadly. It could be because of theft, it could be obsolescence, it could be because it went bad. Whatever the case might be, you must track that number. So those are some high level KPIs that might be a good place to start if you’re not tracking those already as it relates to your inventory. So if we bring this all together, your inventory decisions really are cash decisions. They’re decisions about risk. So that is what makes up this strategy. So I encourage you to make sure you know what you have on your shelves.

Henry Lopez (17:35):

First of all, track things, what you use, what becomes obsolete, what isn’t moving, rethink your buying habits. If any of what we’ve talked about applies, or whether you’re buying too much or maybe not enough, that’s usually not the case, or being kind of enticed to take a discount to buy more, but that may not really make sense. All of those things, I want you to really rethink how you make those decisions and make sure that you manage your inventory and your forecast for your inventory so that it doesn’t kill you from a working capital perspective. Inventory management is not just about what you sell or use. It’s how you invest your cash, manage risk, and ultimately it can determine whether your business can grow, stay healthy, and survive. This is Henry Lopez, and thanks for joining me on this episode of The How of Business.

Henry Lopez (18:24):

I wish you the best as you start and grow your successful and profitable small business. I release new episodes on Monday mornings, and you can find the show anywhere you listen to podcasts, including the Howe Business YouTube channel and my website, the howwoodbusiness.com. Thanks again for listening.