Inventory Management- Why and How?
Inventory Management- Why and How?
It is said that “Inventory is MONEY sitting around in another form”. Therefore, it becomes essential to take decisions around inventory management at a very early stage of your business to maximize profit by saving various Inventory Mismanagement costs.
Let’s look at the scenario where we don’t care about managing inventory at all, we place the order when the demand arises or we keep excess stock. What will happen?
The result will be either –
- Excessive Carrying cost
- Liquidity Risk
- Physical Deterioration
- Opportunity cost on invested fund
- Failure to meet customer demand
- Customer shift to the competitor
- Effect on Goodwill
The results are not so luring to ignore inventory management. Thus, it becomes necessary to implement one or more of the following Techniques to ensure Effective Management of Inventory.
- Economic Order Quantity(EOQ):
EOQ gives an answer to the question “How much to order”. Being an important cash flow tool, EOQ assists in deciding what would be the best optimal order quantity at the company’s lowest price which will avoid unnecessary ordering and carrying costs. It refers to that number ordered in a single purchase so that the total cost of ordering and carrying costs are at a minimum level as well as interest on capital invested can be minimized. Your ordering cost includes the delivery cost, invoice verification cost, payment processing cost etc. and carrying cost includes space rent, insurance cost, deterioration, etc. The formula for EOQ can be better understood by looking at the example.
Let’s take an example of a retail clothing shop(ABC Ltd) that carries a line of men’s shirts which sells 500 shirts per month. ABC Ltd incurs a fixed order placement, transportation, and receiving cost of Rs 3000 each time an order is placed. Each shirt costs 500 and the retailer has a holding cost of 20% of the unit cost. Here EOQ will be calculated using the below-mentioned formula.
EOQ = the square root of (2*A*CO)/CI
A = Annual demand,
CO = Ordering cost per order
CL = Carrying cost per unit.
Using the above formula, EOQ for ABC Ltd will be 600 shirts per order and at this level of order quantity, inventory cost will be Rs. 60,000/-. Any order-level below or above 600 will result in a higher cost than EOQ.
- Minimum Safety Stock:
Apart from implementing an EOQ system, it is also important to work out a minimum safety stock level. It is the stock level that exists at the time of placing the next order. This technique is to help you avoid the stock out situation due to the supply lead time.MSS can be calculated by using the below formula.
Safety Stock = (Maximum Daily Usage x Maximum Lead Time Days) – (Average Daily Usage x Average Lead Time Days).
Continuing the above example let’s say the maximum daily usage is 40 shirts, the maximum lead time is 5 days and average daily usage is 18 shirts followed by an average lead time of 3 days.
So, our minimum safety stock would be = (40 shirts x 5 days ) – (18 shirts x 3 days) = 146 shirts.
- Prioritize with ABC:
Certain products need more attention than others. ABC analysis helps you focus on your inventory management by separating out products that require a lot of attention from those that don’t. This technique can be implemented by going through your product list and adding each product to one of three categories:
- Products having high value with a low frequency of sales
- Products having moderate value and a moderate frequency of sales
- Products having low value with a high frequency of sales
Category A items require frequent attention because their financial impact is significant but sales are unpredictable. Category C items require less supervision because they have a smaller financial impact and they’re constantly turning over. Items in category B fall somewhere in-between hence mixed approach can be taken for this.
Example: Let’s consider a furniture showroom that sells all types of furniture from the household to corporate furniture. Here prioritizing furniture into ABC based on its value will make it easy to keep track of inventory as periodicity can be set based on category.
Category A – The furniture that falls under this category are the ones that are most important to the company. They can either be the ones that are highly in demand, the ones that are generating the most revenue, or the ones falling under the hottest trend for the season.
Category B – This furniture is essential to the company, but not as much as the ones in category A. A smaller market or lesser comparative demand are some of the reasons.
Category C – This category includes the products that are neither in category A nor category B. Company doesn’t wish to put in more effort to sell off this furniture as they are not of high value to the company. Odd sizing, colour combinations, patterns can be the possible reasons for the company to put this furniture in category C.
- Accurate Demand forecasting:
A huge part of good inventory management depends upon an accurate prediction of demand. The demand forecast takes Historical sales data to formulate an estimate of the expected projection of customer demand. Essentially, it’s an estimate of the goods and services a company expects customers to purchase in the future. So don’t forget to consider the following aspects along with historical data while forecasting the demand.
- Trends in the market.
- This year’s growth rate.
- Guaranteed sales from contracts and subscriptions.
- Seasonality and the overall economy.
- Planned ad spends which could increase the demand.
A leading bike maker refers to the last 6 months of actual sales of its bike of the particular model, engine type and color level; and based on the expected growth, forecasts the short-term demand for the next 6 months for purchase, production and inventory planning purposes.
- Improve relationships with suppliers:
Improving relationships with suppliers benefits indirectly in inventory management. When you need to return a slow-selling item to make room for a new product, restock a fast-selling product very quickly, mitigate manufacturing issues, or temporarily expand your storage space, it’s important to have a strong relationship with your suppliers. Suppliers will be willing to give you priority only when they get priority.
In general, having a good relationship with your product suppliers goes a long way. Minimum order quantities are often negotiable. Suppliers more often follow a minimum order level technique below which they will turn your order down. To avoid carrying excess inventory by procuring it at the MOQ level, your relationship with suppliers will play an important role to negotiate the MOQ level.
A good relationship isn’t just about being friendly. It’s about clear and proactive communication. Communicate at regular intervals with your key suppliers and let them know when you’re expecting an increase in sales so they can adjust production. Also, get an understanding of the situation from the supplier when a product is running behind schedule so you can suspend promotions or look for a temporary substitute.
- Batch Tracking:
Batch tracking is a quality control inventory management technique wherein users can group and monitor a set of stock with similar qualities. This method helps to track the expiration of inventory or locate defective items back to their original batch.
For example, In case you are running a milk factory, you can track the different variants of milk in batches. A batch of milk is a set of individual containers of milk that use the same ingredients and has the same expiration date because they were produced together, at the same time. In case a defect is found in the milk packet of a specific batch, the entire batch can be called back by tracing the batch number.
- Physical Inventory count:
Beyond getting ready for tax season, taking physical inventory count helps you to find out if any goods are lost or stolen. In most cases, you will be trusting your software and reports from your warehouse to know how much product you have in stock. However, it’s important to make sure the facts in the report match with the actual stock lying in the warehouse/storage room. Usually, companies do the stock counting at the year-end because it ties in with accounting and filing income tax. Although physical inventory checks are typically done once a year, it can be incredibly disruptive to the business, and believe me, it’s tedious. In case you find any discrepancy, it can be difficult to pinpoint the issue when you’re looking back at an entire year. Hence, physical inventory audit at an interval of say, every quarter, should become part of business policy.
With an effective inventory management system in place, business owners can improve their supply chain and reduce various costs such as stock insurance cost, carrying cost, ordering cost etc. significantly which in turn would result in healthy business profit and advantage over competitors.
Try this one metric to see how effectively you as a business owner are managing your inventory. Simply compare your inventory turnover days with benchmarks given in the table below if you belong to any of these industries. Inventory Turnover Ratio can be calculated by using the formula
= 365* Average Inventory/Cost of goods sold
Benchmark Inventory Days
Food and Kindred Products
General Merchandise Stores
What does the result indicate:
The calculated Inventory days should be at or below the benchmark days given in the table. A high ratio means that the firm is holding a low level of average inventory in relation to sales. Holding inventory means money tied up in stock. Your Inventory Turnover Ratio is directly correlated with the cash conversion ratio. The higher or quicker the Inventory Turnover, the lower will be the cash conversion cycle which means your investment in inventory will turn in cash faster.
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