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The Top 10 Inventory Management Mistake

All materials within are a copyright of the author and The Rand Group, LLC

The Top 10 Inventory ManagementMistakes

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The Top 10 Inventory Management Mistakes


Disclaimer

The information contained within this whitepaper is the opinion of the author and in no way represents the opinion of The Rand Group, LLC. The information contained within should not be taken as legal or binding, and should be referred to as an opinion piece by a subject-matter expert. All materials within are a copyright of the author and The Rand Group, LLC, 2014 respectively.

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Distributors strive to achieve the goal of effective inventory management:

“Effective inventory management allows a distributor to meet or exceed customers’ expectations of product availability with the amount of each item that will maximize their profitability or minimize their total inventory investment.” But often distributors fail to achieve this goal (or even come close to achieving it). Inventory turns out to be not only their largest asset, but also their biggest source of frustration.

Effective inventory management is not impossible to achieve. It does not take a lot of specialized knowledge or talent. What it does require is commitment; a commitment to develop, implement and execute a step-by-step plan that will overcome the inventory-related obstacles faced by your company. This whitepaper is designed to help you understand what is preventing you from achieving effective inventory management and what you can do to maximize the profitability and productivity of your investment in stock inventory. Let’s look at the 10 most common inventory-related mistakes made by distributors.

Not Stocking What Your Customers Want to Buy

When you stock a product you are making a commitment. This commitment is to have that product available in reasonable quantities for immediate delivery to the customer. The more frequently customers request a product, the more reason you have to stock it. A 'hit' represents an appearance of a product as a line item on a customer order, regardless of the actual quantity ordered. Whether the customer orders one piece or 1,000 pieces it still represents one hit. If your computer system records the hits for each product, sort your inventory based on the number of hits recorded in the past 12 months. Does each of the items that have sold fewer than four times in the past year have to be retained as a stock item in that branch location? If your computer system does not accurately records hits examine products with sales of three of fewer of the past 12 months. Getting rid of this 'stuff' will free up money and space for more of the products that your customers want to buy.

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Unintentionally Losing Money

Most distributors’ warehouses are filled with two things: stock and 'stuff'. Stock is the material that you intend to be in the warehouse; 'stuff' is everything else. Stuff includes dead stock, left over quantities of special order items, unwanted returns, etc. It also may include some slow moving products. Our first task in our quest to achieve effective inventory management is to separate the good stock material from the stuff. This is the process of developing and maintaining an approved stock list for each branch or warehouse.

The Good: The inventory that you stock that provides a positive return on your investment. That is, you make money when you sell the product.

The Bad: Inventory that doesn’t provide a return on your investment, but contributes to other profitable sales. For example, you might have to stock a line of slow moving repair parts to support the sales of other, hopefully very profitable products. Bad inventory is often a necessary evil. It is not an investment but an expense. That is, it is an expense of doing business.

The Ugly: Inventory that doesn’t provide a return on your investment, and doesn’t contribute to profitable sales. If you’re in business to make money, there is no reason for this stuff to be in your warehouse.

Sort your slow moving products in descending order based on the value of current inventory. Identify those items that don’t meet your corporate profitability goals. Ask salespeople why each of these slow moving, low profit items should remain on your approved stock list. Each of these products must be 'tied' to another profitable item or customer. That is, an item or customer must be profitable enough to justify carrying this 'dog' product.

Basing Replenishment on Inaccurate Demand Forecasts

A forecast is a prediction of what you will sell or use in the future. Distributors use a variety of methods for calculating demand forecasts but few examine the accuracy of these predictions. We suggest you calculate the forecast error (especially for your critical or 'A' ranked products) with the following formula:

[Absolute Value of (Forecast – Usage)] ÷ [The Smaller of Forecast or Usage]

Usage is the actual quantity sold, transferred or otherwise used in a specific month. To illustrate the calculation of the forecast error, consider the following items:

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Notice that the first two items have the same forecast error. We believe it is equally bad to underestimate or overestimate demand. If your average forecast error exceeds 50%, evaluate alternative methods for calculating future demand of stocked items.

Running Out of Critical Items

You want to meet or exceed your customer’s expectations of product availability. Many distributors do not realize that when you reorder a product, not how much you actually order, is what allows you to avoid stockouts and provide outstanding customer service. For example, if you sell two pieces of a product per day, and the item has a lead time of seven days, you need to reorder the product when you have 14 pieces remaining on the shelf (2 pieces per day * 7 days = 14 pieces). But there is a chance that you might sell more than your forecast per day. Or there may be a delay in receiving the replenishment shipment from the supplier.

Safety stock (also known as safety allowance) is additional inventory that you maintain to protect against stockouts due to unusually high demand during the lead time or delays in receiving a replenishment shipment. Often distributors take a 'paint roller' approach and use one rule for determining the safety stock quantity for all stock items. But some items require more safety stock. These include 'critical image' items that you must always have in stock to retain your reputation as a reliable supplier. But be careful in identifying these critical items. Keeping large amounts of safety stock for too many items will 'balloon' your inventory and have a detrimental effect on your company’s profitability.

Not Minimizing the “Total Cost of Inventory”

Many distributors feel that if they buy a product at the lowest possible unit cost (i.e., the lowest price the supplier offers) they will maximize their profitability. However they do not consider two other costs incurred in buying and maintaining inventory:

The Cost of Replenishing Inventory. This cost includes:

• Deciding what products need to be replenished• Issuing the purchase order• Expediting the purchase order (if necessary)• Processing the receiving paperwork for the shipment• Approving the vendor’s invoice for payment• Processing the vendor payment

The cost of ordering is expressed as the amount (in dollars) necessary to process a line item on a purchase order. This is based on the idea that you spend about the same amount of time reordering a product regardless of the quantity ordered. But processing a purchase order with 100 line items will usually take more time than processing a five line purchase order. The current typical cost of replenishing inventory is ranges from $5 to $6 per purchase order line item.

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The Inventory Carrying Cost. This is your cost of maintaining a dollar’s worth of inventory in your ware house for an entire year and includes:

• Moving material to the proper bin location and shifting it to other warehouse locations as necessary

• Insurance, taxes, and other assessed charges on the inventory• Rent and utilities for the portion of your warehouse used to store material• Physical inventory and cycle counting• Inventory shrinkage and obsolescence• 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.

The total cost of carrying inventory, in dollars, grows as the investment in inventory grows. Typical annual carrying costs currently range from 16% to 24%. This means that it costs you anywhere from 16 cents to 23 cents in order to maintain a dollar’s worth of inventory in your warehouse for an entire year.

The economic order quantity (EOQ) formula is designed to balance what you actually pay the vendor (including freight and other charges), the cost of replenishing inventory, and the cost of carrying inventory during the time it takes to sell the entire shipment:

Applying the EOQ correctly will cause you to buy smaller quantities of items with a large number of dollars moving through inventory more often, and larger quantities of products with few dollars moving through inventory less often. Using the EOQ will lead you to maximize your inventory turnover and your corporate profitability.

Bringing in Inventory Too Soon or Too Late

As we said before, issuing replenishment orders at the right time helps to ensure that you have the inventory your customers’ want, when they want it. The anticipated lead time is the length of time you estimate is necessary to order and receive a replenishment shipment of an item. Anticipated lead times should be separately maintained for each product, in each warehouse, from each source of supply.

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Many systems calculate an anticipated lead time by averaging the actual lead times associated with the last several stock receipts. If your system utilizes this method be sure it takes into account all four elements of an accurate anticipated lead time:

• The time it takes you to place a replenishment order once you know that more stock is needed• The time it takes your supplier to fill your order and ship it to you• Transit time to your warehouse• The time it takes you to unpack and prepare the stock received for sale or use

Many distributors have found that replenishment is better managed by setting anticipated lead times equal to the longest typical lead time for each item. For example, if actual lead times for an item range from two to four weeks, they will maintain a four week (i.e., 28 day) anticipated lead time for the product. This will help ensure that adequate inventory is available to cover customer demand during the time it takes to replenish stock.

Tolerating Arguments Between Departments Concerning Inventory

Stockouts and excess inventory often create friction between sales, purchasing, and the warehouse. Everyone seems to blame someone else for their company’s failure to achieve the goal of effective inventory management. But in order to achieve success, each department must realize their vital role in making sure that you have the inventory your customers’ expect to be available while maximizing your organization’s profits:

Salespeople should:

• Determine what products should be stocked in each branch or warehouse. Salespeople should be in almost constant communication with customers. They are likely in the best position to determine what you must have in inventory to meet your customer’s expectations. That doesn’t mean that you must carry anything and everything that a customer might ask for someday. It does mean that your customers’ impression should be that your inventory better meets their needs than the stock of your competitors

• Help develop the forecast of future sales of each product. Your salespeople are also in the best position to observe your customers’ changing needs over time. They should help determine why there was a large discrepancy between a forecast and what was actually sold in a specific week or month. For example, why did a customer buy an unusually large quantity of an item? Will this be a new ongoing requirement or was it a one time only sale? Studying unusual sales activity can provide salespeople with valuable information that can be used to increase future sales!

• Help keep inventory records accurate. Salespeople are usually very empathetic with their customers. They often will go to great lengths to meet a customer’s needs. However they must follow your established rules for properly recording all material disbursements. For example, salespeople should not take material out of a warehouse without properly recording it in your computer system.

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Purchasing or Replenishment People should:

Make sure that inventory is available to meet the sales or usage forecast. While accomplishing this primary and most important goal, buyers must replenish stock in such a way as to minimize the 'total cost' of each piece or meet your company’s inventory investment goals. Decisions buyers must make include:

• Deciding the best source of supply for each product in each stocking location. Do you buy it, and if so, from what vendor? Are replenishment quantities transferred from a central warehouse or distribution center? Do you assemble a product from component parts in this warehouse?

• Determining the 'best' replenishment quantity for each product. As we previously discussed the economic order quantity (i.e., EOQ) balances the cost of the material with the carrying cost of inventory and the cost of issuing and receiving replenishment orders. However if your organization must minimize its total inventory investment, buyers may decide not to buy the EOQ, but only enough of each product to satisfy customer demand until the next replenishment shipment can be received

Warehouse Personnel should:

• Organize stock in the warehouse to minimize the cost of filling orders. After all you ship material far more frequently than you receive it. It makes sense to store material to maximize the efficiency of the order fulfillment process

• Keep inventory records accurate. If the quantity in the computer system does not agree with what is in the warehouse, salespeople won’t know what is available for sale and buyers will not replenish inventory at the right time. This task probably will involve conducting full physical inventories or cycle counting certain products each day

When every department understands its unique responsibilities in achieving the goal of effective inventory management, your chances of success dramatically increase!

Not Having Goals to Measure Performance

It is common knowledge that people tend to do what you inspect, not what you expect. It is critical that at the end of every month you measure the improvement in the performance of your stock inventory. We have found that with three simple metrics you can measure your progress in achieving the goal of effective inventory management:

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Customer Service Level:

The customer service level measures how often you have the products you’ve committed to stock when your customers want them. It is calculated with the equation:

Number of line items for stocked products shipped complete by the promise dateTotal number of line items for stocked products ordered

Notice that we measure line items shipped complete. That is, when the entire quantity ordered is delivered, in one shipment, on or before the 'promise' date listed on the order. If the customer orders ten, and we ship ten, we get credit towards the customer service level. But, if the customer orders 25 and we only ship 24 before the promise date, we get no credit. This is truly a pass-fail test. Why no partial credit for shipping 24 out of 25? Well, if the customer wanted 24, he or she would have ordered 24. They wanted 25! The customer has to find that last one somewhere else; probably at your competitor’s warehouse down the street. Why no credit if we deliver the quantity in more than one shipment? Your customer has to process multiple stock receipts and your firm has to process multiple shipments. Both parties incur additional costs.

Though service level goals vary by distributor, most of our clients aim for an overall 95% customer service level but a 98% - 99% service level for their designated 'critical' items.

Inventory Turnover

Every time we sell an amount of a product, product line, or other group of items equal to the average amount of money we have invested in those items, we have 'turned' our inventory and generated another opportunity to earn a profit from our investment in stock inventory. The inventory turnover rate measures the number of times we have turned our inventory during the past 12 months and is calculated with the equation:

Cost of Goods Sold from Stock Sales During the Past 12 MonthsAverage Inventory Investment During the Past 12 Months

How do you determine your turnover goals? Well, most distributors who have 20 - 30% gross margins should strive to achieve an overall turnover rate of six to eight turns per year. Companies with lower margins require higher stock turnover. If your company enjoys high gross margins, you can afford to turn your inventory less often.

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The Turn-Earn Index

The inventory turn objectives described above are for companies that have overall gross margins between 20 - 30%. But if a company enjoys higher margins, it can be successful with lower inventory turns. Many surplus houses justify keeping items in their warehouse for years because they bought the material for pennies on the dollar and will eventually sell some of it for a premium. The Turn/Earn Index will help you balance turnover and profits. It is calculated by multiplying inventory turns by the gross margin percentage. It highlights situations where high margins can compensate for low inventory turns.

Say, for example, you turn over inventory of an item four times a year and earn an average 30% gross margin on each sale of the product. That’s a T/E Index of 120. We get the same return on investment value if we turn the inventory of an item only twice, but make an average margin of 60% on every sale:

2 turns * 60% average margin = 120

On the other hand, the stock of a product with an average margin of 20% has to turnover six times in order to achieve the same 120 T/E Index. Your T/E target should normally be at least 120 (e.g. a vendor line turning six times annually and earning an average 20% margin).

Arranging Your Products in a Logical Order

Most distributors stock similar items next to each other in the warehouse. For example, a distributor may stock all of his brushes together, all of his paper products together, and all of his plastics together. But, in all probability, a few items are responsible for the majority of his sales volume. These fast moving products may include some brushes, some paper products, some plastic products, and some items in other product categories. In order to maximize the productivity of warehouse employees, it makes sense to group these fast moving products together.

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Notice that the fastest moving products, regardless of product category, are closest to the shipping staging and receiving area. The slowest moving products are furthest away from this area. After re-arranging the items in her warehouse based on product movement, one distributor in Baltimore doubled the number of orders she could process in a day without adding any more warehouse space or people! But arranging your warehouse based on product movement requires accurate bin location assignments! That is your computer system knows where each and every product is stocked.

Note that if you stock products with different storage requirements you probably have different types of shelves or racks in your warehouse. Treat each type of storage unit as a 'mini-warehouse'. Store the most often picked items in the most accessible locations in their appropriate shelving unit or rack.

Not Insisting That All Material Movement is Properly Recorded

Do you have salespeople who take, without paperwork, a sample of a product to a customer? Or do technicians grab material to solve a customer’s problem with the promise to 'do the paperwork later'? These employees probably don’t think they are doing anything wrong. After all they are servicing the customer. But they are also creating discrepancies in your inventory management system. Your computer does not know that the item was removed, so the on-hand and available quantities of the product are not properly adjusted. As a result one of the following situations may occur:

• The item is not reordered at the proper time because the system thinks there is more inventory in the warehouse than is actually there

• Another customer may be promised the item because the computer shows the item in stock. But after the customer has driven 20 miles to pick up the product, you discover that the 'cupboard is bare'

If you don’t have accurate on-hand quantities in your computer system you are forced to overstock to ensure that you have enough inventory to meet your customers’ needs. Just like if your spouse doesn’t consistently balance your checking account you are probably forced to maintain an unusually high balance to avoid bouncing checks.

Organizations that have achieved effective inventory management have established policies and procedures for processing the following types of transactions:

• Normal stock receipts – From previously issued purchase orders and transfers• Unexpected stock receipts – The stuff that just shows up on your receiving dock• Requisitions – A request for material to be consumed within your company• Emergency requisitions – Products that are needed after hours of before normal paperwork can be

processed• Sales – Phone orders, will call orders, internet based orders, etc.• Direct shipments – Shipments that go from your supplier directly to your customer• Orders for non-stock or special order products• Transfers to other warehouses or facilities• Assembly orders• Bin-to-bin transfers within your warehouse

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• Returns of regular stock • Returns of non-stock material• Returns of damaged material• Returns to your supplier• Adjustments due to mishandling inventory, theft or other reasons

Encourage employees to add other transactions to this list. Have everyone agree on the right way to process each transaction. Publish and distribute the policies and procedures guide. Everyone in your organizations should agree that there are two ways to handle inventory: your approved way and the wrong way.

By properly recording all material movement you will ensure that the on-hand quantities in your computer system are accurate. You will minimize your inventory and material handling costs while meeting or exceeding your customer service level goals.

Summary

In this whitepaper we’ve briefly discussed the 10 critical mistakes distributors often make in managing their inventory. If your company is experiencing some of these issues, start to address them today. As soon as you get started you will be on your way to achieving effective inventory management!

Speak to a supply chain expert today

http://www.randgroup.com/industry/distribution-software/#sup-chain-ex

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About Rand Group

Rand Group is a professional services firm that serves the oil and gas, manufacturing, distribution, and construction segments within the state of Texas. Rand Group combines the business acumen of CPAs and industry specialists with the technology expertise of software developers and process improvement specialists to drive real business results utilizing technology. Consistently the fastest growing application partner in the US domestic market, Rand Group has built a reputation of making systems work for business.

Rand Group. Software Delivered as Promised. No Surprises.

For more information please visit www.randgroup.com.

http://www.randgroup.com.

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