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.

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.

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.

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.

Inventory management- evaluation ratios

The periodic use of ratio analysis to monitor the performance of your inventory is a highly recommended practice. The two main ratios for evaluating how well you manage your inventory are the Inventory Turnover Ratio and the Average Number of Days of Inventory:

• Inventory Turnover Ratio (ITR): The ITA measures the number of times your business "turns over" its inventory in a year. It is a measure of the operating efficiency of your business. The more frequent the inventory turnover, the greater the ratio. A higher ratio is preferable. To calculate inventory turnover, divide Cost of Goods Sold (COGS) by Average Inventory. Use only finished inventory to simplify the calculation. A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances, a low rate may be appropriate; that is, when higher inventory levels have occurred in anticipation of rapidly rising prices or shortages. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business.
• Average Number of Days of Inventory (ANDI): ANDI measures the number of days it takes, on average, to sell your finished goods inventory. This ratio is simply the inverse of the Inventory Turnover Ratio. To calculate the ANDI, divide the number of days in a year (365) by the ITR. The fewer the number of days that finished goods sit on the shelves, the better.
  

Monitoring your Inventory Turnover Ratio and Average Number of Days of Inventory helps you to improve inventory management and to avert write-offs associated with stale inventory.