New targets to improve margins. You want to reduce your inventory costs. How can you achieve that without compromising the level of service? How do you strike the right balance between purchasing, inventory costs and having to turn customers away because you are out of stock? What is the optimum level?
How much inventory should I keep?
Determining the correct amount of inventory is a constant balancing act between supply and demand. Previously you could sit down once a year and determine your inventory and supply strategy, and the appropriate strategy to replenish your inventory (ordering or manufacturing). Since the life cycle of items is becoming increasingly shorter, this approach no longer works.
To calculate the optimal inventory level, we consider the following, among other things:
- the demand patterns of the item: the average demand, the distribution in the demand and the pattern. A regular demand pattern is easier to predict than a pattern that is irregular. The latter means it is almost impossible to build up an inventory. After all, the more irregular the demand for the product, the more (reserve) stock you have to build up. If the product is only purchased occasionally, then it is often no longer realistic to keep an inventory of it. Products that are essential and where a fast delivery is critical are the exception here.
- the delivery time to replenish the inventory; The quicker the inventory can be replenished, the less reserve stock is required. Automation helps with this. By monitoring the inventory levels in real time you can replenish these by the minute and additional buffer time (and therefore extra reserve stock) is no longer required.
- Cost factors; The costs of holding stock can be divided into three main categories:
- Space: consider here the lease or financing of the premises, but also cooling or heating, security, rent. Other costs are also included, such as employee costs and the cost of purchasing forklift trucks. The costs for space are expressed in m2 storage and you should reckon with 100-200 euros per square meter storage for this.
- Risk: this includes the costs for insurance, theft, but also the risk of obsolescent stock. Certainly in the case of fashion-sensitive products, or food, where products lose their value relatively quickly. The costs for risk vary per sector or product type, but you should reckon with an average of 10% of the value of the inventory.
- Interest: This is perhaps the most difficult cost aspect to determine. Maintaining an inventory requires an investment. This money has to be borrowed, or it concerns money that cannot be invested elsewhere in the company. Companies charge bank interest or use an internal ‘opportunity’ percentage for this. These percentages vary but are between 10-15% of the value of the inventory.
If you add up all of the above costs, you will arrive at a total of around 25% of the value of the product. If you maintain an inventory of 1 million euros, these costs can therefore total 250,000 euros annually!
The costs of ordering also come into it: the Wilson EOQ (Economic Order Quantity) Model is still a good and simple method to determine the 'optimal' order size. It quickly gives a thorough estimate, where the optimum is calculated between the costs of ordering and the costs for maintaining the inventory.
Costs of having to turn customers away because you are out of stock
In addition to the ‘visible’ costs, you also have to deal with the consequences of having to turn customers away. The customer asks for a product which is not available at that time.
The impact of this is huge:
- Not being able to (fully) deliver an order, resulting in additional handling and transport costs, because goods are sent out in multiple shipments. This also causes additional internal costs, such as processing and administration.
- You could, of course, opt to delay the entire shipment. The upshot: later delivery and invoicing. This can create cash flow problems, since you receive your money later while your investments are in your inventory.
- Or even worse: the customer decides to purchase the product elsewhere and does not return. The loss of a customer has major consequences: wooing and winning a new customer is expensive, existing customers are relatively loyal and therefore less price sensitive. In addition, loyal customers are often also the source of effective word of mouth advertising.
How can it be done?
Here are several other tips, which can assist in determining the best balance in stock management:
- Time to dust off the Wilson EOQ (Economic Order Quantity) Model! Apply it. This is still a sound and powerful tool to calculate a good and reliable order size.
- However, look at the phase in the life cycle that a product is in and at the length of that cycle. Is the latter shorter than 6 months? Then purchase the item once, and not again. Is a product in the last phase of the life cycle? (“decline”), then do not build up a new stock of it.
- Use forecasting methods. This increases the reliability of the expected demand and leads to less reserve stock. Please note: You can only say something about the expected demand when there are more than 4 months of history.
- With items that are occasionally requested (extremely irregular demand), it is impossible to apply a (standard) forecasting method.
- Use the most recent periods of history to test the forecast you made (on the previous periods).
- Keep product spare parts out of the analyses of normal commodities. These almost always have very irregular demand. Please note that even if these spare parts are rarely requested, if they do get ordered then they will determine the level of service that your customer experiences!