Thursday, August 21, 2008

Vendor managed inventory features

A Vendor Managed Inventory program implementation should include:

1. A way for the supplier to monitor the status of inventory at the customer site. This is often accomplished by sending electronic data interchange (EDI) transactions between the supplier's and customer's computer systems. Automated dispensers (similar to vending machines) are also utilized to record material consumption.
In order to determine when products should be replenished as well as the quantity that is needed, the supplier must have current information as to how much of each product is being consumed at the customer site, when stock receipts arrive, and other transactions that affect on-hand quantities.
The recalculation of replenishment parameters for each item at least once a month. These replenishment parameters include:
* For items with recurring usage: These are products that are sold or used on a regular basis. For each of these products, the supplier must calculate the anticipated demand of each product between deliveries along with a safety-stock quantity. The safety stock is reserve inventory maintained in case actual usage exceeds anticipated demand. Larger safety-stock quantities require a greater investment by the customer, but will help avoid stockouts of products whose actual usage is hard to predict. Good replenishment software can show the customer different inventory investments and the resulting service level – that is, a realistic estimate of the percentages of requests that can be completely filled from stock inventory.
The average inventory investment is the sum of the safety-stock investment along with the average value of inventory that will be on hand between deliveries from the vendor. Notice that a much greater investment is needed to increase the service level by a small percentage.
For items with sporadic usage: These products are used infrequently, and are typically maintained based on a multiple of the number of normal order quantities that should be able to be filled from stock inventory. The normal order quantity is the number of pieces typically sold or used at one time. For example, if the item is sold by the dozen, the normal order quantity would be 12 pieces, Typically, one normal order quantity will be maintained for each of these items, but two normal order quantities may be maintained for very critical parts. Again, this depends on the amount of money the customer is willing to invest in this type of inventory.
2.The normal time period between deliveries to the customer.
3. A method of transmitting collaborative forecast information to the supplier. Collaborative information is normally gathered from customers, salespeople, and other sources and reflects anticipated changes in future usage of products. Note that it is common practice for the customer to assume full responsibility for additional inventory delivered due to collaborative forecasts – that is, there is a handling charge if this speculative inventory must be returned.
The automatic return of material that has not been used for "x" number of months. Remember that under a VMI agreement a customer has purchased stock on the advice of the supplier. If that inventory is not used within six to nine months after delivery (and is not designated to be a critical repair part), the supplier should automatically issue a return-goods authorization and give the customer full credit for the return.

Guarantees of performance. When it enters a VMI agreement, a customer invests in a specific amount of inventory anticipating a forecasted service level for the products supplied under the agreement. But what happens if this service level is not achieved? For example:
* The supplier may not retain enough inventory to adequately replenish the customer's stock.
* The supplier may not replenish inventory as promised.
* The supplier's forecasting and replenishment system may not result in the agreed-upon service level.
If each partner concentrates on its core competences, both firms can increase their productivity and profitability.

Vendor-Managed Inventory

Many firms are trying to concentrate on the "core competences." They want to outsource minor tasks and activities when it is cost effective to do so. For a distributor, an example of one of these tasks is the replenishment of less-expensive products. For a manufacturer, it may be the procurement of MRO (maintenance, repairs, and operations) inventory. A popular way to outsource these procurement activities is a vendor-managed inventory (VMI) agreement. Under a VMI agreement, a supplier takes full responsibility for maintaining stock of its products at a customer's facility. VMI agreements differ from traditional consignment agreements in that the customer is billed for material when it is delivered, not when it is consumed or issued. When establishing a VMI agreement, the supplier and customer must agree on:
* The specific products that will be covered under the VMI agreement.* "Acceptable availability" of these products at the customer's site and the corresponding investment required by the customer. Usually the supplier and customer will agree on a "service level," which is the percentage of orders for a product that can be completely filled out of the VMI stock inventory. The higher the agreed-upon service level, the more the customer will have to invest in the supplier's products.
* How often the stock of these products will be replenished.
* The automatic return of material that is no longer needed by the customer.
Potential advantages for a customer participating in a VMI program include:
* Eliminating the cost of managing replenishment parameters and issuing purchase orders.
* Establishing an extremely reliable source of supply for products that are very important to its operations but represent a relatively small investment.
Advantages to the supplier include:
* Securing all of a customer's business for the types of products it supplies.
* The ability to better plan its own inventory replenishment needs because the supplier's buyers can monitor the actual sales or use of its products at the customer's site.

Goal of Effective Inventory Management

The goal of effective inventory management – that is, to meet or exceed customers' expectations of product availability while maximizing the organization's net profits or minimizing its inventory related costs.One of our primary areas of concentration has been the improvement of future predictions of product sales or usage, otherwise known as "demand forecasts." the accuracy of any demand forecast is dependent on the "goodness" of your sales or usage history. Does this data truly reflect what would have been sold or used under "normal" circumstances?
Many software packages identify possible unusual usage at the end of each week, month, or other inventory period. The simplest of these systems compare usage in the month just completed to the total usage recorded over the previous "x" months, or inform you if you were out of stock for more than "y" days. More advanced systems bring to the attention of a buyer significant differences between the demand forecast and actual sales or usage recorded during the inventory period just completed. A common feature of both methods is a belief that usage history has been recorded correctly.

Safety Stock and Inventory Management

Computer systems maintain the stock of inventory items with parameters such as minimum and maximum quantities. Some of these parameters are objective – that is, there is one right or optimum answer. For example, an economic order quantity balances the actual cost of a product, inventory carrying costs, and costs of purchasing to determine the specific replenishment amount that results in the lowest total cost of each piece of the product.

Other inventory parameters are subjective in nature. There is no one best answer. Safety stock (also known as safety allowance) is one of these. Safety stock provides protection against stock-outs due to unexpected demand for a product or delays in receiving a replenishment shipment from a supplier. It is insurance. Like many other types of insurance there is no "right" or optimum amount. If you talk to three different life insurance agents, they will probably suggest you buy three different amounts of insurance. When you are determining safety stock quantities you have to ask yourself, "how much do I want to invest in preventing stock-outs?"
The answer will probably be different for various products you stock. In determining the safety stock amount, you have to ask:

* What is the likelihood that this product will experience a stock-out?
* How disappointed will customers be if this product is not stock?

Products are more likely to be out of stock if they experience:
* Inconsistent supplier lead times. If vendor shipments are often several weeks late, you may want to keep some extra stock to "cover" customer demand during these unexpected delays in receiving a replenishment shipment.
* Large fluctuations in sales or usage. You might sell 10 pieces or 1,000 pieces of a product in a month without much advance notice of when usage will significantly increase.
In deciding how much safety stock you want to maintain, perform this analysis for all of the items in your inventory to see how many total potential stock-outs you will experience with the various levels of safety stock. Also note when all of the resulting ending balances for a product represent a very high level of inventory. These products probably have fairly predictable usage and consistent lead times.
With this information the customer began to fine-tune their investment in inventory. They examined the stock-outs of painful backorder items and selectively increased the safety stock until there were no out-of-stock situations.
Your investment in safety stock is subjective. There is no "right" answer. But with some simple tools and analysis you can make an informed decision that will ensure that the funds you make available for safety stock are invested as wisely as possible

Inventory ranking

Distributors, manufacturers, and retailers often stock thousands of products. Properly managing the physical inventory and replenishment of these items is a challenging task. While most buyers and salespeople realize that not all items are equally important to customers or their company, it often difficult to identify those products that demand the most attention.
* 80% of your sales are generated by 20% of your salespeople.
* 80% of your sales come from 20% of your customers.
* 80% of your stock sales involve 20% of your inventory items.
But this rule is not always true. In fact for many companies, 80% of sales are generated by only 10% to 13% of stocked inventory items!
Rank or classify your products based on their contribution to total sales. The products that account for 80% of your sales are typically referred to as "A" ranked items. This may be 5%, 10%, or 20% of your products.
While this type of ranking is important to identify those products that have the most potential for inventory turnover (i.e., opportunities to earn a profit), it is not as valuable in answering other inventory-related questions, such as:

* What products should be maintained in stock?
* Where should a specific inventory item be located in your warehouse?
A special-order item is not maintained in stock inventory, but is ordered and received to fulfill a specific customer requirement.
Reorder quantities of a product with a high cost of goods sold ranking should be carefully determined to achieve a high level of inventory turnover. At the same time you might consider maintaining additional safety stock for products with a high hit rank to minimize the chance of stock-outs. You also might want to include a third type of ranking in your classification analysis, one based on profitability.Ranking products based only on annual cost of goods sold provides an incomplete picture of inventory performance. Three-way ranking provides valuable information concerning each stocked product's contribution to the overall profitability of your organization, information that is vital in your quest to achieve Effective Inventory Management.

Inventory problems solving

Many companies suffer from several, apparently conflicting, inventory problems:

* Frequent stockouts of critical products.
* Large quantities (and value) of excess inventory and dead stock.
* Inaccurate product availability information in the computer system.
The underlying cause of these problems are the strategy companies hope would enhance their ability to effectively serve customers. Let's look at some of the reasons why their branch replenishment policies were doing more harm than good:
1. Any available stock could be transferred out of any other branch at any time if it was needed to fulfill an immediate customer need. On the surface this policy may make sense. Why keep four units of a product on the shelf in one location if it can be sold by another branch? Isn't that what inventory turnover and customer service is all about?
2. Salespeople buy because they know what customers really need.
3. Branches may overbuy in order to place vendor "target" purchase orders on a regular basis. A target order meets a vendor's requirements that enable a company to receive the discounts or terms that allow them to competitively sell the vendor's products. If each branch has to meet the vendor's target requirement when placing a replenishment order, they may have to purchase more of a popular item than they would if they could split shipments with other branches. They also might have to buy full package quantities of slow-moving products as opposed to "sharing" a package with other company locations.
At these companies, these problems and others could be solved by putting specific buyers in charge of replenishing inventory of specific product lines in all customer locations. These individuals had both customer service and inventory turnover goals they were expected to meet or exceed. This could be done through:
* Ensured that replenishment orders were issued as soon as the replenishment position of a product fell below its order point (lead time usage + safety stock or reserve inventory)
* Split replenishment orders between branches and centrally-warehoused slower-moving items.
* Possible unusual usage is identified and analyzed.
* Buyers approve all inter-branch transfers. After all, they are responsible for maximizing both customer service (i.e., minimizing stockouts) and inventory turnover.

All buyers were not necessarily physically located in the same office, but each was responsible for specific product lines throughout their company. As a result we achieved the results that every company desires: a maximization of both customer service and corporate profitability through effective inventory management.

Effective inventory management again

Lean manufacturing is helping producers throughout the world reduce inventories, lower labor costs, and increase their overall efficiencies. The same concepts embraced by lean manufacturing practitioners can help distributors achieve the goal of effective inventory management:
"Effective inventory management allows an organization to meet or exceed customers' expectations of product availability with the amount of each item that will maximize net profits or minimize costs."
There is a common philosophy that states, "The definition of insanity is repeatedly doing the same procedure, the same way, expecting different results." Are there re-occurring problems in your warehouse? Is there an easy to record damaged or stock inventory that for some reason cannot be used? This material includes:

* Damaged material found in the warehouse.
* Unintentional scrap created when a mistake was made in filling an order.
* "Drops" or quantities of a product that are too small to be sold or used.

In many organizations, damaged or unusable inventory is hidden. Maybe it is thrown in a scrap pile or discarded. But the best-run organizations encourage or (better yet) insist that employees record these "unquality events." Recorded events are analyzed to determine if polices or procedures can be changed to prevent the same mistakes from occurring again in the future.

Out-of-stock reports

Most computer systems provide buyers with out-of-stock reports. These are listings of stocked products with no available inventory. Because the stock-out sales orders cannot be filled, salespeople cannot provide the service their customers expect. Buyers scramble to obtain inventory to prevent the "crisis" of the out-of-stock situation from becoming the "catastrophe" of losing those valuable customers.

Out-of-stock reports are, in fact, "gotcha" reports: They inform a buyer of a problem that already exists. Wouldn't it be better if a computer system warned a buyer of an impending crisis? That is the goal of an "early warning system."

It is unbelievable that the report writers available in almost every system have the ability to create "early warning" stock-out reports, but few organizations utilize them. Check with your IT department or software company to see if the following reports or inquiries can be created for your top-selling "A"-ranked items as well as for other products that are crucial to maintaining a high level of customer service:

The available quantity (on-hand – current committed) is below the safety stock level. Safety stock is "insurance" inventory designed to fill unusual customer demand during the lead time or to compensate for delays in receiving replenishment shipments. Buyers should be informed if reserve inventory is being used to fill orders so they can expedite existing incoming shipments or obtain the product from an alternate source. At the very least, if a stock-out does occur, the buyers will not be caught off guard; they will have information in hand as to when the out-of-stock product will be available.

The actual usage by the 7th day of the current month is greater than 50% of the forecast demand for the month. Often, a buyer will be unaware of a surge in sales of a particular product until it is out of stock. If buyers know that sales of a product have suddenly "taken off," they can bring more of the product into inventory before a stock-out occurs.

The actual usage by the 14th day of the current month is greater than 75% of the forecast demand for the month. This is another check to identify products that suddenly have an unexpected dramatic increase in sales or usage activity.

The actual lead time for the just-received stock receipt is more than 50% over the anticipated lead time. The buyers can contact the vendors to determine if the delivery of the latest stock receipt is reflective of future lead times for the item. If so, the buyers can issue replenishment orders for the item earlier than they have done in the past to avoid a future stock-out.

The available quantity of the item at the time of stock receipt is less than an "x"-day supply. You didn't quite run out of the product during this replenishment cycle, but what is the possibility of a future stock-out? Does the forecast, lead time, safety stock quantity, or some other replenishment parameter for the item need to be adjusted?

Restricting the early warning system to fast-moving items and products that are critical to your corporate image will ensure that your buyers aren't buried in data. They won't receive a multitude of alerts, but every one they do get will require their attention. When we propose early warning reporting to our customers, their buyers, inventory planners, and purchasing agents often ask, "Why haven't we had this type of notification all along?" Some buyers prefer alerts in a daily end-of-day report, others as an inquiry, and still others as an email as soon as the situation is identified. The format doesn't matter as much as getting the information. Tell your software people that you want to immediately implement this critical reporting. Countries need an early warning system to prevent attack from foreign powers; you need one to protect something that is crucial to the survival and success of your firm: your customer service!!!

How much to stock?

How do you know if you have too much, too little, or just the right amount of stock inventory? One way is to compare the value of your current inventory to an "ideal inventory investment." In this article we will discuss how to calculate the value of this "right" amount of inventory. As with many of our other inventory analysis tools, calculating the ideal inventory investment requires that we first separate those inventory items with recurring demand from those items with sporadic usage.

Recurring Usage Items
Recurring usage products are sold or used on a regular basis. Typically these items:
* Have had usage in at least eight of the last twelve months.
* Have had usage in at least four continuous months in the last twelve months (this second condition identifies seasonal items that are only sold during certain times of the year).

Replenishment of these items is normally based on safety stock quantities, order points, line points, and standard order quantities:
* Safety Stock Quantity: The "insurance" inventory maintained in stock to protect you from stock outs resulting from unexpected customer demand or vendor shipment delays.
* Order Point: The Safety Stock Quantity plus predicted demand during the anticipated lead time.
* Line Point: The Order Point plus predicted demand during the supplier review or order cycle; the normal length of time between typical replenishment orders with the supplier.

Sporadic Usage Items

In many organizations more than 50% of stocked products have sporadic usage – that is, they are not sold or used on a regular, predictable basis. In other words you have no idea when they will be sold or used. In previous articles we have suggested that you base the inventory of sporadic usage products on a multiple of the normal or typical order quantity. For example, if you normally sell or use two of the items in a transaction, you would set the "target" stock level equal to two pieces (if you wanted to maintain one transaction in stock) or four pieces (if you wanted to maintain two transactions in stock).

You might think that like recurring items, the average or ideal value of sporadic inventory items should be some average of the normal quantity on hand, perhaps the target stock level divided by two. But because sporadic usage items are not consumed or sold on a predictable basis, it is very difficult to calculate an "average" investment for these items. After all, you might have the two or four pieces of a sporadic usage item in stock for a week, a month, or for more than a year! Therefore we have to consider the "ideal" value of sporadic inventory items to be equal to the target stock level quantity times the average cost. It's true that because we will occasionally use some of the stock of some sporadic items, the value of the target inventory will overstate the average value of some items. But this is the most accurate method we know of determining the ideal value of sporadic inventory items.
Unfortunately the value of the inventory of a sporadic inventory item will often exceed the value of the target stock level. Why? Because you may have to order a vendor package quantity of a product when replenishing stock. And the vendor package quantity may not have any relationship to the normal customer order quantity. For example, say that the normal customer order quantity of a product is three pieces and we want to maintain two normal order quantities in stock. The target stock level is six pieces (2 orders x 3 pieces per order). Whenever the replenishment position of the item falls below six pieces, a replenishment order is issued. If we must order a vendor package of 10 pieces, the product's stock level after we receive the replenishment shipment will probably be greater than the target stock level of six pieces.Because sporadic inventory is not sold on a recurring basis, we must carefully monitor the value of any amount of sporadic inventory in excess of the target stock level, particularly for those items with a high unit cost. We can define "planned excess" of sporadic inventory items as a quantity equal to:

(Target Stock Level - Normal Order Quantity) + Vendor Package Quantity

One of our goals should be to minimize the value of this planned excess. If a sporadic inventory item has a high planned excess value consider:
* Ordering an amount of the product close to the normal order quantity, even if you have to pay a higher price per unit.
* Discontinuing the product from stock inventory and ordering it only as necessary to fill specific requirements.
* Sharing one vendor package quantity among several stocking locations.
* Substituting a slightly more expensive item without passing the additional cost to the customer. Saving the carrying cost of excess inventory of one sporadic inventory item may more than compensate from the reduced profit on the resulting sale.

One of the best inventory metrics involves comparing the value of your current inventory to the sum of the values of the ideal stock level for each product. If the values are not close to one another, your buyers or inventory planners are probably not following the replenishment recommendations generated by your computer system. Are the system recommendations inadequate to provide your desired level of customer service and inventory turnover? Or do your buyers need more training in using your system to help your company maximize the return you receive from your investment in inventory? Either way, comparing your actual inventory to the "ideal" will lead you to action that can lead to improved profitability.

In our next article we will explore what you can do if your calculated ideal stock level is too high and needs to be reduced in order to achieve your organization's inventory turnover and profitability goals.

Cycle counting

Cycle counting is the process of verifying the on-hand quantity of a specific number of stock products every day. In previous articles, I have described how to set up and maintain an effective cycle counting program and why this process is usually better than a full physical inventory for maintaining an accurate perpetual inventory in your computer system. But verifying on-hand quantities is only one of the advantages of cycle counting. The other benefit of a cycle counting program is to improve your business processes, including:
* Making sure that all material movement is properly recorded.
* Ensuring that stock receipts are put away in the proper location.
* Verifying that the right quantity of the right item is shipped on outgoing orders or is pulled from stock for an assembly.
* Preventing shrinkage from theft and the mishandling of stocked items.
Absolute Value of (Quantity Counted – Current Stock Level)] ÷ Current Stock Level
Process improvement results from carefully analyzing significant stock discrepancies.
Including the "absolute value" of "Quantity Counted – Current Stock Level" in this equation signifies that a discrepancy should be analyzed if significantly more or less inventory is found during the cycle counting process.
It is impossible to achieve effective inventory management without accurate stock levels in your computer system. A comprehensive cycle counting program is a valuable tool for ensuring that the quantities in your computer system agree with what is physically in the warehouse. But to be certain that stock levels remain accurate over time, you must investigate significant stock discrepancies and take corrective action to prevent similar problems from reoccurring in the future – that is, you must utilize cycle counting to improve the way you run your business!

New Stock Items

It is common for new stock items to have a spike in sales or usage volume soon after they are introduced. This temporary high volume may be due to:
* Promotions for the new item or salespeople featuring the new item in sales calls.
* Customers wanting to try the new product.
* Customers establishing a normal stock quantity of the product in their inventory.
As in our other examples, if we were to stock based on monthly usage (i.e., four or five pieces per day), we would not be adequately stocked for the scheduled plant shutdown weeks. Accurate forecasting for these seasonal events again requires examining weekly usage – that is, the quantity sold or used in the same week last year, adjusted for increasing or decreasing trends in business.

An accurate demand forecast allows use to meet or exceed customer expectations of product availability with the least amount of inventory. While few demand forecasts are 100% accurate, we must continue to strive to reduce the forecast error (i.e., the difference between the forecast and actual usage) to better predict future demand of products. After all, no major league baseball player has ever achieved a batting average of 1,000 – but this fact does not stop them from trying to improve and play better baseball. Shouldn't you also continually do your utmost to improve the profitability and productivity of your investment in inventory? One of the ways to do this is to apply forecasts based on weekly usage whenever it is appropriate.

Weekly forecasting

The order point is a "minimum" quantity for the product, and is equal to anticipated demand during the lead time plus a safety stock quantity. Safety stock is insurance inventory to protect customer service from unusually large usage or shipment delays during the time it takes to replenish inventory. When the stock level falls below the order point of 150 pieces, a replenishment shipment would be issued to the vendor.

Each new order point becomes effective at a date equal to the first business day of the week minus the lead time.
So, four business days before the start of week one, if the stock level of the product was less than 497 pieces, a replenishment order would be issued. If the stock level was equal to or greater than 497 pieces, the buyer would leave the item alone because he has plenty of stock available to see him through the first week of the month. The result: The distributor will have this critical item available when their customers want it. Also notice that the order point drops during the period of the month with less usage activity. We are not ordering the material far in advance of when it will be needed. This will help improve the inventory turnover and overall profitability of the distributor.

Effective MRO inventory management

Managing products that are going to be consumed internally by an organization is normally referred to as maintenance, repairs, and operations (MRO) inventory. Typical questions are:
* How do we decide what products we should stock to maintain our operations?
* What quantities of these products should be kept on hand?

Action plan for achieving effective MRO inventory management.
What Products Should be Stocked?
Many organizations have too much inventory in their maintenance and repairs inventory. Unlike inventory for resale, MRO inventory is not an investment; it is an expense of doing business. Make sure that you are not adding to this expense with unneeded items. Be sure that there is a valid need or justification for stocking every one of the products in your current MRO inventory:
* The product cannot be obtained in the time period necessary to fill a need once the need has been determined.
* The product must be purchased in a quantity greater than what is needed to fill a particular need.
* The cost of carrying a product in inventory is less than the procurement cost.

Often companies will have spare parts in stock for machinery that is no longer in service. When they retired a piece of equipment, no one bothered to check to be sure that all of the spares for the machine were removed from the parts room. That is why we recommend that once a year you examine each of the products currently in your MRO inventory that have not been used in the past 12 months. Question whether it is absolutely necessary to continue to maintain a quantity of each one of them. It is also a good idea to develop a spreadsheet listing each MRO product, the machine(s) or operation(s) it supports, and the quantity of the product normally needed for a repair or maintenance activity. That way, when you discontinue a process in the future, you can easily identify the replacement parts that can be removed from your MRO inventory.

How Much of Each Item Should be Maintained in Inventory

You can separate your MRO inventory into three categories:
* Continual-Use Items – These are maintenance items and other products that are continually used.
* Specific-Need Inventory – Though not continually used, these items are used on a regularly scheduled basis.
* Emergency-Repair Parts – These are parts whose use sporadic usage cannot be predicted.

Every one of your MRO stocked products should be assigned to one of these categories. Continual-use items are just like the recurring stock products we address in other articles and our books. Please refer to these resources to determine how to calculate a forecast of future demand and other purchasing parameters for these items. Most organizations have too much money invested in the other two types of MRO inventory. Specific-need inventory products are required for scheduled maintenance operations. Unless these are very inexpensive items (i.e., they don't cost much to carry in stock), most companies are best off acquiring just what they need before each scheduled task. Emergency-repair parts are a different story. Since you don't know when each of them will be required, how can you determine how many of each one to stock?
For very critical parts that can completely shut down operations, we will keep one normal-use quantity of each item in inventory even though we can get a replacement part in less than a day. And if the lead time of a very critical part is greater than a week, we will probably want to keep three normal-use quantities on the shelf in our parts room. The cost of this "insurance" is the annual cost of carrying inventory (normally 20% to 25% of the inventory value of the target stock level). You must weigh this expense against the cost of shutting down operations. Notice that we are not even considering maintaining an inventory of a non-critical part unless it has an extended lead time.

The average-use quantity suggestions in this table are not "cast in stone" and should be adjusted for your organization's specific needs. However, if you must reduce the value of your spare-parts inventory, we strongly suggest you discontinue or reduce your stock of non-critical and somewhat critical parts before reducing the target stock level of any of the very critical items. After all, these products support the lifeblood of your vital operations.
With proper management of MRO inventory, an organization can maintain an outstanding level of productivity at the lowest possible overall cost. But like any other process, it cannot be accomplished without a logical, methodical action plan

Effective inventory management and inventory investment

Many companies try to capture all unfulfilled customer requests and add them to the actual usage recorded for a specific inventory period. They believe that by including these lost sales in usage history, future demand forecasts will be adequate to cover the unfulfilled sales or usage experienced during the current inventory period.As part of a comprehensive customer relationship management (CRM) program, it is important to capture lost sales in order to see what customers are not being adequately served. Indeed, your sales manager probably wants to know if your most important customer requested an out-of-stock product five days in a row. But as we've seen, adding lost sale quantities to actual usage may not truly reflect the quantities of a product actually needed. The adjusted figures may distort future demand forecasts and result in either additional lost sales or excess inventory.

We've found that there is a better way to adjust actual usage for lost sales. This method does not require sales people to accurately record customer requests and protects you from capturing phantom demand. As with other aspects of our inventory management philosophy, we have different recommendations for items with recurring activity (i.e. those that are sold or used on a regular basis) and those with sporadic usage.

Recurring Items
are sold on a regular basis. As these are the products customers request most often, it is important to correct for out-of-stock situations in order to ensure a high level of customer service.
1. Specify whether each of these inventory items will or will not accumulate backorders. If an item will accumulate backorders, customers will wait for you to receive the product. As a result, these items tend not to experience lost sales. If the product will not accumulate backorders, customers will go elsewhere to obtain the item. These are the items that will probably experience lost sales.
2. At the end of each inventory period (i.e. week, month, four-week period, etc.), record the number of days each product was out of stock.
3. For items that will not accumulate backorders, multiply the days out-of-stock by the forecast demand/day and adjust monthly usage by this quantity.

Sporadic Items
are not sold on a regular basis and whose replenishment parameters are based on the normal quantity sold or used in one transaction as opposed to the forecast demand for an upcoming inventory period.
1. Record the number of times a product is out of stock (or its available quantity drops below the normal or average sales quantity).
2. If the product is out of stock more than one or two times in a six month period, automatically increase the minimum quantity for the product by the normal quantity sold or used in one transaction.
Note that to avoid an unrealistically large inventory investment, most organizations will tolerate a certain number of stock-outs of non-critical sporadic-usage items. That is why we normally will wait for several stock-outs to occur over a certain period before making the adjustment. However, this rule is not "cast in stone," and should be adapted to each company's specific situation and needs.A good forecast is the foundation of an effective inventory management program. The better the prediction of future demand of a product, the easier it will be to provide a superior level of customer service while minimizing your overall inventory investment. Correcting actual usage for lost sales opportunities is an essential part of the forecasting process. But to be effective, these corrections must predict, as accurately as possible, what would have been sold or used had the item continuously been in stock.
When the stock level of an item falls below the minimum quantity, it is time to reorder the product, right? But there are instances where it is difficult to maintain accurate stock levels because it is impractical to record each individual material disbursement. These are usually very inexpensive products that are taken from stock as needed by the user. But most of these items do have significant usage. And in many cases, a company would suffer a hardship in the event of a stock-out. After all, a product does not have to be expensive in order to shut down production or to be deemed important by customers.
How do you maintain effective inventory management of these items without accurately recording every material disbursement?We change our focus and don't concentrate on what people are using or buying. We track the rate at which we have to replenish the "open stock" available to consumers or other users of the product. The on-hand quantity in the computer system reflects the total quantity in unopened containers (boxes, cartons, gallon bottles, etc.) in "bulk storage" that have not yet been released for sale or use. Note that bulk storage could be a locked cabinet, a high shelf, or a bin location in the back room or warehouse. It just has to be a location that is not accessible by end users of the product. This bulk storage inventory is used to replenish the "open stock" of the item (i.e., the stock available to consumers). As a container is taken from bulk storage and made available to workers or customers, the on-hand quantity is reduced by the container quantity. Therefore the on-hand quantity in the computer reflects an accurate count of the quantity in bulk storage. When the on-hand quantity drops below the minimum stock level or order point, the product should be reordered. Usage history of the product reflects the number of containers of the product that were released from bulk storage in a day, week, month, or other significant inventory period. This usage history can be utilized to forecast future demand for each bulk-storage item. Unexpected increases in replenishment from bulk storage should be reported to management as it might reflect pilferage or some other problem that should be investigated.

From an accounting point of view, we are "consuming" the entire quantity when it is released to consumers. That is, the total inventory value is being reduced by the value of the container, though the product is still in your facility in an "open" bin. Is this a "perfect" solution to maintaining an accurate inventory? Even though the on-hand quantity of open-stock items is not reduced when an individual piece is sold or consumed, customers or projects often must still be charged for the items. This can be accomplished in several ways including:

Issuing a special charge based on the average amount of open-stock material consumed on each order or in the course of a month. Most consumers are now used to their automobile dealers adding a line item on repair or maintenance invoices for "fluids and other consumable maintenance items." And many companies charge each department for a share of the total office supplies consumed in a month based on the number of people in that department.

Utilize a special type of inventory item in the computer system for open-stock products. These items can be billed out to a customer on an invoice (i.e., nails being purchased in bulk at a hardware store), but an individual sale does not reduce the on-hand quantity of the item.

Because they are usually small, inexpensive, and/or hard to count, open-stock items have proved to be a nightmare for many manufacturers, distributors, and retailers. Unfortunately they are often necessary elements in a manufacturing process or crucial in maintaining a high level of customer service. Our goal should be to maintain an adequate inventory of each of these products with the least amount of effort.

Effective Inventory Management and Demand Forecasting

It is no secret that an accurate forecast of the future demand of a product is crucial in achieving the four "rights" of effective inventory management: that is, getting the right quantity of the right item to the right location at the right time. As we've discussed in previous articles, products with different patterns of usage require different forecasting methods. The forecast for items with recurring usage is usually based on four elements:
* Some sort of average of past usage.
* A trend derived from past usage.
* Future anticipated usage that is not revealed in past usage or trends.
* A forecast horizon reflecting when material ordered today can be received and the length of time for which inventory must be purchased.

If an item has recurring usage (that is, it is sold or used on a regular basis) we can test various formulas that apply different factors to each of the four elements to determine the best method of forecasting future demand of each item. But applying these elements to an item with sporadic activity (i.e. one that is not sold on a regular basis) produces strange results
It's easy to see that forecasting future usage of an item using an incorrect formula will result in stocking the wrong quantity of the wrong item in the wrong location at the wrong time. To achieve effective inventory management, it is essential to be able to differentiate between items with sporadic sales and those with recurring usage activity.

Stock counting, cycle counting

Cycle counting and the process of counting some stock items or warehouse locations every day are a valuable tools in ensuring the accuracy of your perpetual inventory. We've seen numerous cases in which organizations, after implementing a comprehensive cycle counting program, have had a much more accurate perpetual inventory than they had when they performed full physical inventories. Because accurate on-hand quantities are vital to both providing outstanding customer service and maximizing inventory turnover, it is not surprising that more and more distributors and manufacturers are implementing cycle counting programs.

But cycle counting programs can be difficult to maintain over a long period of time. Many firms become frustrated with the "coordination" problems inherent in cycle counting that are usually not found in a full physical inventory. When companies conduct a full physical inventory, they temporarily halt all normal material movement – that is, they stop filling orders, putting away stock receipts, shipping material, etc. Before this is done, a special effort is made to ship as many orders as possible and put away all stock receipts. During the actual counting process the business is virtually closed down. Counters do not have to worry about someone doing something that will affect the quantity in stock during the full physical inventory process.

Extensive preparation is necessary for a full physical inventory. It is not practical to complete this preparation before each daily cycle count. It is equally difficult to conduct cycle counts only when a business is closed and there is no material movement. After all, cycle counting should be performed every day. Even if a company counts before or after normal working hours when there is little or no material movement, paperwork involving items being counted can be "floating" somewhere in the warehouse or office. For example, a quantity of an item may have been pulled from the shelf but not yet shipped. Or a stock receipt for a product may have been put away but not yet entered into the computer system.
This simple process has the potential to dramatically cut the time necessary to perform daily cycle counting. No longer will people roam around your facility trying to determine if a particular order was picked or put away before or after a product was cycle counted. The result: More accurate inventories with less effort and frustration, a winning combination for any organization. This method could turn out to be a very valuable tool in your quest to achieve effective inventory management!

Inventory carrying costs .more

Some items take up more space, and are harder to handle, than other products. Many companies feel that items that take up more space should absorb more of the total cost of carrying inventory. In order to apportion the cost of space and material movement to individual products or product groups, we must determine how much of the total space used to store products is being used by an individual item.
1. Calculate the total cost of rent and utilities for the portion of your facility used to store inventoried products as well as moving material in that area.
2. Determine the total cubic volume of space currently used to store stock material. This may not be the total cubic warehouse space. For example, if you just moved into a new warehouse and are using just 25% of the available space, the inventory stored in that area would still need to absorb 100% of the cost of rent, utilities, and moving material, not just 25% of the total cost.
3. Divide the total cost by the total cubes used to store material in order to determine the storage cost per cube.
4. Determine the total cubic volume assigned to a particular product

inventory carrying costs calculation

The specific cost of carrying a specific product or group of products in inventory is calculating by totaling the five components:
* Insurance, Taxes, and Opportunity Cost: Multiply the ITO factor (calculated above) by the average inventory investment of the item or group of items.
* Shrinkage Cost: Multiply the calculated shrinkage factor by the average inventory investment. If history is any indication, this portion of the average inventory value will eventually be lost, stolen, misplaced, or broken.
* Obsolescence Cost: Multiply the calculated obsolescence factor by the average inventory investment. Again, if history is any indication, this portion of the average inventory value will eventually be classified as obsolete inventory.
* Cost of Counting: Add the annual cost of counting the item.
* Cost of Rent, Utilities, and Moving Material: Add the calculated annual cost that was based on the cubic volume of space required to store the item.

Divide the sum by the average inventory investment for the item to determine the product's specific carrying cost percentage.

Is this a lot of work? Of course. But if significantly different amounts of effort are necessary to maintain individual inventory items in your facility, the exercise may be worthwhile. Remember that the cost of carrying inventory is one of the keys to effective inventory management, and that accurate information usually leads to outstanding results!

Inventory shrinkage and obsolence

Shrinkage and obsolescence includes any stock material that is purchased but not sold, used to provide a service, or is part of an assembly or finished good. This includes material that is lost, stolen, broken, scrap, or becomes obsolete in our warehouse. Some products are more susceptible to shrinkage and obsolescence than other items. We need to determine factors for these two important components of the carrying cost.

To calculate a shrinkage factor for a specific item, divide the total amount of adjustments due to shrinkage (material lost, stolen, broken, or considered scrap) recorded in the past 12 months by the total stock receipts for the product during the same time period. Why don't we use the average inventory value in this calculation? Because all inventory adjustments are already reflected in the average inventory value. We want to determine how much of the total quantity of the inventory that was received could not be sold, used in production, or used to service a customer. Many companies calculate a shrinkage factor for an entire product line, rather than for individual items. This allows a shrinkage factor to be applied to products that have not yet been inventoried for a full 12 months.

To get an accurate obsolescence factor, we usually have to use a longer time period. For example, if you normally consider inventory obsolete after it has been in your warehouse for 12 months, you might want to divide the amount of write-off adjustments made this year by the total amount of stock receipts for the item last year. Why? Because any material written off due to obsolescence this year was probably received last year. Again, it might be more meaningful if you calculate an obsolescence factor for an entire product line rather than an individual product.If you don't liquidate obsolete inventory on an ongoing basis, you may also want to vary the time periods you consider in this analysis. For example, one of our customers had a large obsolescence write-off last year that covered material that had been received anywhere from two to five years ago. To calculate their write-off factor, we divided the amount of adjustments due to obsolescence over the past two years by the total amount of stock receipts recorded in that two- to five-year period.

Physical Inventory and Cycle Counting

Most companies count their fast-moving items more often than their slow-moving products. And some products are easier to count than others. As a result, the "cost of counting" can vary from one item to another.

In calculating the counting element of the carrying cost, we usually start by grouping similar stocked items that are stored in similar storage units. We then determine the average number of products in each group that can be counted in one hour as well as the labor cost of performing the count. This cost includes the time spent:

* Performing the actual count
* Entering the count information into the computer system
* Reconciling any discrepancies in the count

The total cost per hour is divided by the number of products that can be counted in that hour. The result is then multiplied by the number of times each product is scheduled to be counted in a year to arrive at the total cost of counting a specific product.

Costs

To determine the specific carrying cost for a product, we first have to determine what factors of the carrying cost will not vary by item. These are the factors that are solely dependent on cost or value of the average on-hand quantity:

* Insurance and taxes
* Opportunity cost of the money invested in inventory

If you take the total amount of these two elements and divide it by the average inventory value, the result is the cost of these elements per dollar of your average inventory investment. We will call it the ITO (Insurance, Taxes, and Opportunity Cost) factor.

Inventory Carrying cost

It is important to know your cost of carrying inventory. It is a critical factor in deciding what products to stock and when to reorder them, as well as the best quantity to order. Too often companies and organizations use an imprecise "rule of thumb" to estimate their cost of carrying inventory. The result: Bad inventory management decisions.

In a previous article, "The Mysterious Cost of Carrying Inventory," we gave you some direction for calculating an overall cost of carrying inventory for your entire company or an individual warehouse. The calculation considers these expenses and alternative opportunities for revenue:

* Moving material from the receiving dock to the proper bin location and shifting it to other warehouse locations as necessary.
* Rent and utilities for the portion of your warehouse used to store material.
* Inventory shrinkage and obsolescence.
* Physical inventory and cycle counting.
* Insurance and taxes on the inventory.
* Opportunity cost of the money invested in inventory – that is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment. Or, if you finance your inventory purchases, the amount of interest that you pay the bank.

The sum of these factors is divided by the average inventory value to determine an overall carrying cost percentage – that is, what it costs to maintain a dollar's worth of inventory in your warehouse for an entire year.

But some companies find that it costs more to stock some items. Maybe they take up more space or are more susceptible to shrinkage and obsolescence. If the carrying cost percentage is used in so many critical inventory-related decisions, doesn't it make sense to calculate as accurate a carrying cost as possible for each product? If you believe that your cost of carrying inventory may vary for different segments of your inventory, consider calculating a cost of carrying inventory for each item.

Slow-moving inventory

You want to stock the products that your customers request most often in your warehouse(s). But what about products with sporadic sales, or no sales at all?
Even though a product is infrequently taken from stock (or may have never been taken off the shelf), the item must be available for immediate delivery if it is ever needed.

Every business needs to create its list of critical repair products. But as you add each item to this list, consider:
Is the item "critical" or merely "important"? A critical part not only shuts down a machine, it shuts down an entire process or vital service. For example, one of our customers is a food processor. They have one large mixer that is used to combine the ingredients necessary to make any of 25 different products. If the mixer is out of service, none of the 25 products can be produced. The company keeps on-hand in their inventory a spare piece of every component of the mixer. On the other hand, the company has 10 identical wrapping machines. If one wrapping machine breaks down, its workload can be reassigned to the other machines. Production might be delayed for a couple of hours, but the process would not be shut down. The spare parts for the mixer are critical inventory. Those for the wrapping machine are merely important and can be ordered as needed for next-day delivery. Keep in mind that a critical item has the potential, on its own, to shut down a process. When creating your critical item list be sure to note the process that is dependent on each product.
Maintaining critical item in inventory is considerably less expensive than buying one or two pieces whenever they are needed from an alternate source of supply. Keeping several years' supply of selected inexpensive products on the shelf will not have a great effect on your company's overall profitability. And by putting a significant amount of these items in inventory, you won't waste your buyers' time forcing them to continually deal with these "nuisance" items. Concentrate on ensuring you have the optimal quantities of those items that have the most dollars flowing through your warehouse.High-profit, slow-moving items may also represent a good inventory investment. The gross profit that results from each sale may be so large that it offsets the cost of carrying the inventory for a prolonged period of time.
Most companies have to maintain slow-moving products in inventory. However, you must be sure that each of these items improves your overall customer service and/or your company's net profitability.

Inventory mangement and Sporadic Sales

A lot of firms stocked big amounts of unique products in each of several warehouses. Their buyers seemed overwhelmed with the task of maintaining an adequate inventory of each of these items, most of which were not sold on a regular basis. At each company we worked to "tame the replenishment beast".
The replenishment of these popular products should be micro-managed to maximize inventory turnover (i.e., the number of opportunities to earn a profit) while retaining a high level of customer service. Indeed most books and articles on inventory management (including ours) focus on maximizing the profitability of these items that customers request most often. Most if not all of the methods described in these publications involve a prediction of future demand based, at least in part, on a calculated average of past usage. Although the specific calculation may differ from method to method, most rely on the average or weighted average of the quantity sold or used over a specific period of time.
We could apply other forecast demand formulas, but the results will probably be the same. The demand forecast will be less than the normal sales quantity of 10 pieces, and as a result there will not be enough inventory on-hand to meet the customer's needs.An item experiences sporadic sales if its normal sales quantity is greater than the average quantity sold or used per month.
The average sale quantity often reflects the normal sale quantity. However its accuracy may be influenced by one or two unusual sales. A more accurate method of determining the normal sales quantity is to search transaction history for the mode in the transaction history of the product – that is, the quantity that is most often sold or used.
Although items with sporadic sales or usage do not (or should not) usually represent a large portion of your total inventory investment, stocking these items correctly is crucial to providing a high level of customer service. It does not make sense to stock these products unless you maintain the most commonly requested quantity in your warehouse.

Inventory management and vendors

How well your vendors are helping you achieve the goal of effective inventory management and which of these methods produces the best results.
Qualifying each vendor's inconsistency in lead times is very important. In order to maintain superior customer service, you must maintain more safety stock (i.e. reserve inventory) to compensate for greater inconsistencies in vendor lead times. This additional safety stock raises the average value of stock inventory and results in decreased corporate profitability.
Determine if the problems:
* Had a negative effect on the service you provided to your customers.
* Caused you to maintain additional inventory to maintain a satisfactory customer service level.
* Increased your operating costs.
The best way to improve your operations, reduce your operating costs, and improve customer service is to closely monitor the problems produced by your current operations. Applying the vendor satisfaction analysis to supplier shipments is a good way to identify ways to improve your replenishment process.

Collaborative forecasting

There is another form of electronic commerce that promises to greatly increase the efficiency of the supply chain. It is called Collaborative Planning Forecasting & Replenishment (CPFR). CPFR involves a customer regularly notifying a supplier of his/her expected future needs of certain products.
Collaborative forecasting works to solve two of the greatest challenges faced by buyers and inventory managers:

* Stock outs of critical products
* Unneeded safety stock sitting on the shelf gathering dust

Of course there are many instances in which customers cannot predict their future product needs – but whenever they can, collaborative forecasting promises to increase productivity and profitability throughout the supply chain. Let's work to replace inventory with information.

Wednesday, August 20, 2008

Inventory carrying cost

Company's inventory carrying cost percentage – that is, what it costs to maintain a dollar's worth of stocked inventory in your warehouse for an entire year. The carrying cost is used in many inventory analysis and planning formulas including the economic order quantity formula, the calculation that is designed to determine your "best buy" replenishment quantity.
* It is fairly easy to calculate a distributor's or manufacturer's inventory carrying cost.
* There is no single accurate default value for the inventory carrying cost.
Replenishing inventory with quantities other than this "best buy" quantity will cause your company to experience higher costs and/or excess inventory.
There is no way to determine which order quantity represents the "best buy" without accurately calculating your company's specific carrying cost percentage and cost of ordering stock. The cost of ordering stock is the cost of issuing and processing a line item on replenishment order. I have read many articles stating that, as with the inventory carrying cost, this number is also too hard to calculate. Many analysts suggest that you should just pick a value between $5.00 and $6.00. As with using rules of thumb for the inventory carrying cost, if you just guess at your company's cost of ordering stock, the resulting economic order quantity will not represent your company's best buy quantity.

manage dead inventory

Dead and excess inventory – that is, your stocked products that haven't sold for a certain length of time (usually a year).
turning excess inventory into cash is good. But before you put considerable effort into a dead stock liquidation program, be sure that you are currently "buying right" – that is, be sure you are ordering the right quantities, of the right items, at the right time.To show you how "buying right" does more for your profitability than liquidating dead stock, we'll look at an example. We ranked the items for one of our distributors. The ranking process identifies those products that provide the most opportunity for your company to earn a profit. We begin the process by sorting all stocked products in a warehouse in descending order, based on cost of goods sold (COGS) during the past 12 months.
Sure, liquidating dead stock is important. But it probably won't contribute as much to your overall profitability as the process of ensuring that you are buying the right quantities of fast-moving products at the right time. This distributor has a long way to go to achieve his inventory-related goals, but he's off to a good start.

Sunday, August 17, 2008

"Free" inventory

The same as there is no such thing as a free lunch, there is no such thing as free inventory. Just because the vendor issues a credit for any unsold material at the end of a season doesn't mean that the distributor doesn't incur costs in carrying the stock in their warehouse for the remainder of the year. These are the costs the distributor will experience in carrying this stock:
* Moving material from the receiving dock to the proper bin location and shifting it to other warehouse locations as necessary (such as to bulk storage at the end of the season and back to the picking area at the start of the next season).
* Insurance on the inventory. If it is in your warehouse, you are probably responsible for it.
* Rent and utilities for the portion of your warehouse used to store material. The material takes up space that could be used to store other products, sublet to another business, or not rented in the first place.
* The cost of physical inventory and cycle counting. If you don't buy it, you don't have to count it.
* The cost of inventory shrinkage. If it is in your warehouse, someone may steal it or it may be broken.
* Opportunity cost of the money invested in inventory – that is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment. Or, if you finance your inventory purchases, the amount of interest that you pay the bank. Note that the distributor will only experience the opportunity cost during the popular season, as they will get their money back for any unsold material when the season ends.

The one typical cost of carrying inventory that this firm won't experience is product obsolescence. They won't have to sell some of the material below cost, or throw it out, because it has exceeded its expiration date or fallen out of fashion.
Yes, because of the vendor's special credit policies, the distributor should purchase more inventory. But, they should be careful not to get carried away and fill up their warehouse with material that won't contribute to the company's bottom line. There is, after all, no such thing as free inventory. Remember this to make you inventory management effective!

How to avoid inventory shrinkage

Here are several policies that will help to solve the inventory shrinkage problems faced by many distributors.
  1. Limit access to the warehouse
  2. Pay your employees well. We've seen great results when the accuracy of on-hand quantities affects the compensation of all employees that have access to warehouse inventory. These employees are motivated to treat your inventory as if it was their own. It's like having management constantly watching over your warehouse operations.
  3. If someone is caught stealing, get rid of him.
Inventory accuracy is a necessary element in any effective replenishment system. If your buyers don't know how much of a product is in your warehouse and available for sale, there is no way they can accurately determine when to replenish stock and how much to order. You'll end up with a "lose-lose" inventory: shortages of products your customers expect you to have in stock, and excess quantities of slow-moving items/ Thia is a key to effective inventory management!

Inventory shrinkage

by by Jon Schreibfeder
Many employees don't realize the value of your stock inventory and may "borrow" products or take samples
for their personal use. Unfortunately, there is another reason why material disappears: theft. Many distributors find it hard to believe that their employees or customers would steal. But unfortunately stealing, especially petty theft, is a very common reason for "inventory shrinkage." And a distributor who doesn't admit that theft is a problem, or a potential problem, is just burying his or her head in the sand.

Employee theft is not a new phenomenon. Nearly a hundred years ago, my great-grandfather owned a clothing store in Weston, West Virginia. He occasionally commented that he'd been in business for 30 years and had never sold a single handkerchief to an employee (these were the days before Kleenex).

Did the employees think they were stealing? Probably not. These were good people who never would have thought of taking money out of the cash register. But they didn't appreciate the true value of inventory. They didn't see the direct relationship between the inventory in the store, turning that inventory into cash by selling it to customers, and using that cash to pay employees and other expenses. As we stressed in the article mentioned above, employees must see all inventory shrinkage as an expense that reduces the amount of money available to pay wages and benefits. It takes money out of their pockets.

There are, of course, some people who are truly thieves. And sometimes a distributor inadvertently hires one. Thieves usually don't see their long-term security tied to the success of the firm that employs them. Most often these individuals have a short-term goal: that is, getting as much material as possible out of the warehouse (without being caught).

Some distributors install security cameras and other theft-deterrent devices. While they are important tools in a retail environment, the effectiveness of these "hi-tech" solutions in a distribution warehouse is questionable. True, they may be a deterrent to some theft, but employees who are also thieves usually put considerable thought and effort into getting around these systems and continue to steal. At the same time, honest employees often feel intimidated and resentful as "big brother" continually watches their every move. These feelings often discourage good and loyal employees from giving their all for the company.

A better way to discourage theft is for management to create an atmosphere that encourages effective inventory management.

Inventory Turnover

inventory turnover." Turnover is the number of times you sell your average investment in inventory each year. Turnover is calculated with the following formula:

Cost of Goods Sold from Stock Sales during the Past 12 Months divided by Average Inventory Investment during the Past 12 Months.
If the results of the inventory turnover equation are to accurately reflect the performance of a firm's investment in stock inventory, we must take great care in determining the values for both cost of goods sold and the average inventory value. Let's look at these two components.
Cost of Goods Sold

The value appearing in the numerator of the equation should reflect the cost of goods sold from stock over the previous 12 months. For example, if we are calculating turnover at the end of August, 1999, turnover should be based on the total cost of goods sold from September, 1998 through August, 1999. Direct and drop shipments (i.e. sales of material sent directly from a vendor to a customer) are not included because the material never passes through your warehouse, and as a result is not reflected in the average inventory value appearing in the denominator of the equation – that is, we have not made an investment in inventory in order to generate these sales.

Special order items (i.e. products ordered for a specific customer order that are not normal inventory items) are also not included in turnover calculations because they do not remain in inventory for a significant period of time. They normally are shipped to customers within several days of their receipt from the supplier. Including the cost of special order items in the cost of goods sold used in the equation tends to exaggerate turnover.

The cost of goods sold figure is not always accurately calculated. For example, some companies compute turnover by considering year-to-date cost of goods sold, and compute an annual figure based on this amount. For example, August is the eighth month of the year. At the end of this month, we're two-thirds the way through the year. If a company's cost of goods sold through the end of August is $8,000,000, that company may feel that this will be two-thirds of the annual cost of goods sold ($12,000,000). But this method assumes that sales are consistent throughout the year. If a company experiences any seasonal fluctuations (e.g. a slowdown during the Christmas season) this method will not result in an accurate cost of goods sold amount. As a result, the calculated turnover will not reflect actual inventory performance.

If you are considering turnover for the company, you should only include the cost of goods sold of items delivered to customers. This would include amounts sold to customers as well as quantities used for repairs and in assemblies. Including transfers in the calculation of overall corporate inventory turnover produces exaggerated results. After all, a company could continually transfer material from one location to another without ever selling it to a customer. If we were to include transfers in turnover, the company would have incredibly high inventory turnover, but no sales!

However, if you are calculating the inventory turnover for a central warehouse, you should include transfers in the calculation of inventory turnover. Central warehouses are facilities that serve as the normal source of supply for other company locations. These branches are customers of the central warehouse. If we don't consider transfers in the inventory turnover of a central warehouse, the results of the calculation will fall short of actual turnover for that facility.

Most companies use average cost in the calculation of the cost of goods sold. You may use another cost basis (e.g. last cost, FIFO, LIFO, etc.) as long as you are consistent from month to month. Also, be sure that the cost basis used for the cost of goods sold in the numerator is the same cost basis used for the average inventory value in the denominator of the equation.

Conventional Ways of Calculating Safety Stock

There are two common conventional methods for calculating the safety stock quantity for a product:

* Percentage of Lead Time Demand
* Days Supply

As we discuss the various methods for calculating safety stock quantities, we'll refer to two variables, "forecast demand" and "usage." Forecast demand is a prediction of how much of a product will be sold or otherwise used in a particular month, and usage is the quantity that was actually sold or used.
Percentage of Lead Time Demand
One of the inventory consultants advocated that, for most items, 50% of lead time demand provides an adequate safety stock quantity.
Demand per day is multiplied by the projected lead time resulting in a lead time demand. Safety stock is half this amount. This quantity represents a X day reserve.
This method is easy to understand but it tends to maintain too much or too little safety stock for many items. For example:

Products with long but very reliable lead times and with fairly consistent demand. If we use this method for an imported product with a 12-week lead time, we'll keep six weeks stock in reserve as safety stock. If we usually receive the shipment on time and demand doesn't vary substantially from month to month, we'll have too much safety stock – in other words, too much money tied up in non-productive inventory.

Products with very short lead times and significant variations in demand from month to month. If a product had a one-week lead time, this method will keep a three or day supply of the item in reserve as safety stock. If usage tends to vary significantly from month to month, there probably won't be enough safety stock available to consistently fill customer demand and the company will experience stock outs.

Days Supply
The days supply method allows a buyer to manually specify a number of days supply of a product to hold in reserve as safety stock. Because a buyer usually does not have the time to review the safety stock parameters for every item each month, he or she will probably set the days supply to provide more than enough safety stock. After all, in the eyes of most buyers, excess inventory is usually preferable to stock outs. As a result, the days supply method often results in the accumulation of non-producing inventory.

Remember that the purpose of safety stock is to protect customer service from unusual customer demand during the lead time or delays in receiving a replenishment shipment. Why not base the amount of safety stock maintained for each item on the variations in demand and lead time? The greater the variation in demand and/or lead time, the more safety stock will be maintained for the item. This is referred to as the "average deviation method."
First we need to calculate average deviation. Next we have to calculate the average deviation of the product's lead time.As a final step in determining the safety stock quantity, we'll multiply the average deviation by a deviation multiple. The deviation multiple used is dependent on the customer service level we want to provide to our customers. Customer service level is defined as the percentage of line items for stocked products shipped complete by the promise date. The higher the multiple, the more safety stock we'll maintain, and the higher the customer service level. Please refer to our other articles for a complete discussion of the customer service level.Be careful! Using a higher deviation increases the amount of non-moving inventory on your shelf!

Safety stock and effective inventory management

Theoretically, it should be easy to determine when to reorder a stocked item from a supplier. If you know that customers will order ten pieces of the product each day, and you know that it will take seven days to get the shipment from the vendor, you should reorder the product when there are seventy pieces on the shelf.
This quantity is appropriately called the "order point." But the order point formula contains one more element: safety stock. Safety stock provides protection against running out of stock during the time it takes to replenish inventory. Why is this protection necessary?
* Demand is a prediction based on past history, trend factor(s), and/or known future usage of a product. The item's actual usage will probably be more or less than this quantity. Safety stock is needed for those occasions when actual usage exceeds forecasted demand. It is "insurance" to help ensure that you can fulfill customer requests for a product during the time necessary to replenish inventory.
* The anticipated lead time is also a prediction, usually based on the lead times from the last several stock receipts. Sometimes the actual lead time will be greater than what was projected. Safety stock provides protection from stock outs when the time it takes to receive a replenishment shipment exceeds the projected lead time.
The safety stock quantity allows you to satisfy customer demand for the product until the replenishment shipment arrives from the supplier
How Much Safety Stock Do You Need?
When a replenishment shipment arrives, the available quantity is usually somewhere in the shaded area of the graph. Notice that the safety stock quantity is in the middle of the shaded area. Half the time you will use some or all of the safety stock before the replenishment shipment arrives. The other 50% of stock receipts will arrive before you use any of the safety stock. On average, the full safety stock quantity is always on the shelf when the replenishment shipment arrives. It is, on average, "non-moving" inventory.

A distributor puts inventory in her warehouse to sell it to customers. Profits from these sales are necessary to pay the distributor's expenses and provide a return on her investment. With this thought in mind, it seems as though it would not be a good idea for a distributor to intentionally have non-moving inventory in stock.

On the other hand, keep in mind the goal of effective inventory management:"Effective inventory management allows a distributor to meet or exceed his (or her) customers' expectations of product availability with the amount of each item that will maximize the distributor's net profits."
Safety stock is, in reality, an expense of doing business. But it is necessary to ensure good customer service. To maximize profits, we must carefully control all expenses, including safety stock. Therefore, we want to achieve our customer service goals with the least possible amount of safety stock.