Inventory is required simply because you need to have an item on hand for a customer to examine and be able to purchase immediately. Otherwise, you can have a catalog and make to order.
It is very common for a business without good inventory management to have an average immediate availability rate of only 65%. Conversely, 35% of your range is not available to your customers at any one time. With some basic changes, you can adjust that so your top sellers are achieving around 98% availability. This is a 50% improvement in your sales capability.
There are also countless examples of small and large business going bankrupt because of runaway inventory – too much of the wrong stuff.
Inventory management is considered as science but you don’t need a degree, only a few quick and dirty smarts to gain some major improvements to your bottom line.
Inventory adds costs:
In accounting terms inventory is treated as an asset, because (theoretically) you can turn it into cash. In business practice it attracts costs. Here’s why.
- Working capital. Inventory ties up your money. Not all of your purchase decisions for resale are successful and you can end up with a very large amount of unsaleable stock – non-working capital.
- Storage costs. if you can reduce inventory you reduce these three storage costs:
- The costs of space and associated utilities.
- The cost of storage systems to optimize that space – bins, and racking, checking tables.
- The cost of systems to control your inventory.
- Shrinkage is caused by customers or staff stealing from you, poor control practices in receipts and sales (stealing from yourself) or from damage in storage. You need better controls.
- Labour. With put-away and order picking functions in a low-tech Gudang some 70% of the time is spent walking between locations. When you reduce your inventory you can dramatically reduce the amount of time required and save at least a portion of a person’s time so they can be multi-tasked.
- Counting stock. Most businesses now perform cyclic stocktakes – counting a few hundred items at a time with more frequent counts of attractive/expensive items. If your item labels have barcodes, you can cut counting time from days to hours. Your barcode in transaction recording is also much more accurate than with writing or keyboard.
- The cost to resupply. You need staff and systems to replenish display inventory from a cupboard or your gudang. You need systems and people to order it and receive it from your supplier, and pay for it. Don’t neglect replenishment as you can lose up to 17% of sales if your systems are inadequate.
Step 1 – Use the Pareto Principle
Not all inventory is equal, and you can get the most out of your inventory by making use of the 80/20 rule. We can generally say that:
- 5% of your items generate 40-50% of your profits.
- 20% of items generate 70-80% of profits.
- 50% of items generate 95% of profits.
- Conversely, the bottom 50% of your items generates only 5% of your profits!
So your first step is to rank your items by what value they give you. I prefer using the annual gross profit for each item, not sales. Then classify items into these categories:
- the top sellers that produce 50% of your profits.
- items that produce the next 30% of profits.
- items that produce the next 15% of profits.
- the balance of 5% of profit and non-movers – usually 50% of your range is not really productive. Never order these again.
Step 2 – Start Generating Cash
Sell off your Cat D items on sales. Do it regularly and do it often. See my previous article for loss leaders. With one large wholesaler, we liberated over $2 million. With a fashion retailer, $50,000.
Step 3 – Optimize Inventory Elements
Demand or Sales. Nobody really knows exactly what quantity you will sell today or tomorrow, so we forecast. Forecasts are generally a combination of what you have sold before adjusted by what you think will happen tomorrow. You don’t have to be precise to start; just buying the same quantity you sold last week or month is better than no system at all.
Time. if you, my supplier, are next door to my shop with a hole in the wall between us, I have no need for inventory. When a customer comes in and asks for an item, I call out to you and you pass me the item. Then the further away you move the more need I have for the stock to keep my customer. So time affects stock levels – reduce the time and you reduce stock.
The Time factor has three elements.
- Review Period. This is the period between placing orders. If you order every day you need to order less than every month. The actual period will be a balance between the costs to place the order in your own business and with your supplier versus the cost of freight and savings in inventory. Weekly and monthly review periods are most common.
- Lead Time. This is the most critical time factor, the amount of time it takes to place an order and get inventory from your supplier. There are three elements involved:
- the time it takes your business to realize a need, approve and place the order,
- the time it takes for the supplier to deliver, and
- the time it takes you to check the delivery, place the item in inventory and add it to your stock record so people know it available for sale.
The first and the last are totally under your control and most easily reduced. Work with your supplier to cooperatively reduce their lead times.
- Safety Stock. Safety stock is used to cover variations in demand during your lead time. For quick and dirty safety stock, I use one month for A Category, 2 weeks for B Category and no safety stock for C Category.
Step 4 – Set Your Inventory Levels
Inventory Levels Max/Min. This is how you set your inventory and reorder point levels.
- Your Min (minimum level) is the time combination of (Lead Time + Safety Stock) x Demand. When your inventory drops to this level it is time to order so you don’t run out of stock.
- Your Max (maximum level) is your Min + (Review Period x Demand).
- When you reorder, the reorder quantity takes you back up to the Max. Very simple, but very effective.
Step 5 – Measure Inventory Performance
We measure Inventory as stock turns.
- First, take your cost of sales for the year.
- Then divide this by your average inventory for the year – (Starting Inventory + Finishing Inventory) / 2
- The more stock turns, the better your inventory management.
In a cash flow crisis, don’t slash inventory orders across the board. In sequence:
- Stop ordering C Cat items.
- Reduce your B Cat safety stock.
- Reduce your A Cat safety stock.
These priorities will have the least impact on sales and cash generation.