Inventory Management is a science with a bit of art. If you’re using more art than science, it’s a near certainty that your business is not running as well as it could. Today we’re going to focus on the science side of inventory management. We will introduce a few terms, including some metrics or “key performance indicators” that sophisticated companies use to make sure their inventory is working for them. Let’s begin with just a few basic terms.
Min / Max
As you’ve probably guessed, “min” is short for “minimum” and “max” is short for “maximum”. When we’re talking about inventory, min is the minimum quantity of any one item that you’d like to keep in stock.
In a more sophisticated inventory management system, you would have two levels of minimums: order level, and minimum level. Order level is the trigger point to place an order with your vendors so that the materials arrive before you fall below the minimum level. To calculate this number, you need to take into account the lead time, the optimal or minimal order quantity and the rate at which the material is being depleted in order to determine the order level. Again, the objective here is to ensure that inventory of a particular item never falls below than minimum level.
Most smaller businesses simply treat the min quantity as the order level. In other words, the moment the inventory of an item falls below the min, you place an order to replenish the stock. It’s ok that the inventory level fell below the min and will likely fall even further. Essentially, you’re just making sure that you don’t run out of stock. For the remainder of this discussion, order level and min will be treated as being the same.
The max is determined by historical sales volumes of a particular item. It helps you decide how many of any particular item you need to order (order quantity):
Order quantity = max – current inventory level
This is simplistic, but its infinitely better than waiting until you run out, or just playing it by ear.
NOTE: Sometimes you can’t order exactly what you need (the order quantity calculated above). For example, sometimes you need to order full truckloads in order to get the price you want. Often that involves mixing and matching quantities of various items from one particular vendor. It’s really difficult to get a full truckload simply by calculating the order quantity using the max and current inventory level. However, the max that’s specified for each item – used in conjunction with sales history – can provide an excellent guideline to help determine order quantities in this “fill the truck” scenario.
Minimum Order Quantity (MOQ)
This is a simple idea. It is exactly as it sounds: many vendors won’t sell to you unless you buy a minimum quantity of that item. This is usually driven by shipping costs or minimum economical production quantities.
Often the MOQ is greater than the order quantity we calculated above which means you would be bringing in more inventory than you need. If you are confident that you won’t run out of stock, you can lower the min (the order point) so that bringing in the MOQ doesn’t cause you to exceed your max for that item. If you can’t lower the min (say because of lead times – to be discussed below), you may be stuck with a higher than desired inventory level of that item for a period of time during every re-stocking cycle.
The lead time is the amount of time it takes between placing a purchase order and receiving your items into stock. Why does it matter? It matters because it is necessary to help you calculate your min. I’ll use a simple example to explain:
Let’s say that historically you sell 10 Widgets per week. Your lead time is 3 weeks. If you place a PO with your Widget vendor, it takes three weeks to arrive. If you want to avoid stockouts, then your min can be calculated as:
Min = lead time (in weeks) X consumption rate (units / week)
In this example, min = 3 weeks X 10 units / week = 30 units.
Economic Order Quantity (EOQ)
The EOQ is a more sophisticated way of calculating your ideal order quantity. It factors in price, fixed costs per order (labor to unload, etc.) and holding costs as well as consumption rate and lead times. It’s pretty unusual for small or even medium sized businesses to be placing orders based on EOQ. This is one for the big players so I won’t go too deep into the calculation in this particular blog post.
Metrics / Key Performance Indicators
There are a number of metrics related to inventory management that can help you to run your business better. These metrics are also used by those who may want to invest, loan money, or acquire your company to determine your company’s worth and your company’s ability to pay its bills and survive. For the sake of this post, let’s focus on three of these metrics. We’ll learn what they mean and how they can help you do a better job managing your company.
Please note: all of these metrics can be applied to your overall inventory level, to an individual item, to a class or category of items, to a particular inventory location, etc.
Average Days to Sell Inventory
You’ll also hear this called “Days Sales of Inventory”. This tells you how many days it takes to turn over your inventory. This can be calculated as follows:
Average Days to Sell Inventory = Average Inventory Level / Cost of Goods Sold * 365
In this calculation, Cost of Goods Sold is the total COGS for the entire year. In other words, it’s the total amount spent on inventory during that year.
The Average Inventory Level is calculated as: (beginning inventory + ending inventory) / 2.
The Average Days to Sell inventory doesn’t mean much on its own, but it can be very valuable in two ways:
- You can compare it to industry standards to see how well you’re doing.
- You can monitor it over time to see if your performance is improving or deteriorating.
If the number is increasing, then either your sales of that item are dropping, or your inventory levels are climbing, or both. Regardless of the reason, an increase in Average Days to Sell Inventory is a call to action.
Inventory turnover is a lot like Average Days to Sell Inventory. Essentially, it’s the number of times that your average inventory level gets sold in a year. Here’s how it’s calculated:
Inventory Turnover = Cost of Goods Sold / Average Inventory
For example, if you spent a total of $1,000,000 buying Widgets this year, and the average inventory for Widgets is $100,000, then you’re turning your inventory 10 times in one year. Just like Average Days to Sell, you can use this number to see how well you’re doing relative to similar sized companies in your industry.
You can also monitor your company’s Inventory Turnover trends. If turnover is decreasing, then either sales have decreased (you’re buying less since there is less demand) or average inventory is increasing, or both. Either way, this is not a good situation.
I should also note that if inventory turnovers get too high as the result of a decrease in inventory levels, you may be increasing the danger of stockouts. Typically, a higher inventory turnover is what we’re aiming for – but not if it leads to lost sales.
Inventory Holding Costs
Also known as carrying costs, this is a true measure of the cost of holding inventory. Holding costs are calculated as follows:
Holding Costs = Warehousing Costs (rent, labor, utilities) + Opportunity Cost (cost of capital) + Cost of Lost Inventory (losses from theft, damage, and obsolescence)
Obviously, you want to keep your holding costs to a minimum. Again, you should benchmark your holding costs against inventory standards and you should also be monitoring your own holding costs. If holding costs are climbing, you’re heading in the wrong direction.
In the next blog we’re going to change gears a little bit and talk about the typical differences between POS requirements for retailers of high-volume, low-value products and retailers of low-volume, high-value products.