By Benjamin Ellerd
Inventory – A Bad or Good Word?
The word “Inventory”, according to Merriam-Webster, is simply defined as a list of goods that are in a place, such as a business location or warehouse. But many business owners know that inventory can be a vastly more complex resource to manage and control successfully. Companies often over-invest in inventory for the sole purpose of ensuring that they are not “out of stock” when a customer wants to buy, or a manufacturing operation needs to build, products offered for sale.
Cash – The Finite Resource
Over time, in addition to tying up valuable cash resources, poor inventory management often results in companies having too much of inventory they do not need, and not enough of that which they do need. This often results in purchasing more inventory in response to immediate requirements, without considering the wisdom or necessity of purchasing inventory on an emergency basis. For instance, it is not uncommon for purchases of materials to be made, when the company already has the materials in stock. In environments with challenging inventory management problems, the company often does not know exactly what inventory is in the building, or the warehouse people can’t find the inventory they are trying to pick. This is a common problem with many variations, all of which are usually a waste of time and resources.
Persistent overbuying is often followed by under-utilization, devaluation and eventual obsolescence of inventory the company probably should not have purchased in the first place. Eventually, many companies find they have so much cash tied up in useless inventory providing no “return on investment”, that other parts of the business begin to suffer cash resource shortages. While this pattern does not apply to every business with inventory, it is certainly a familiar story to many small and medium businesses, especially those that are struggling, or go out of business due to cash flow issues.
The Quick Fix
Many business owners, faced with greater awareness of inventory management problems, immediately begin searching for, and acquiring, quick-fix solutions. They often hire more people; purchase limited-function inventory control or bar coding software; fire suppliers and hire new ones; and issue edicts about maximum inventory spending levels, all with the laudable goal of quickly fixing inventory management issues. But acquiring a solution before understanding the problem is a bit like buying shoes before knowing the required shoe size. Likewise, the probability of actually solving inventory control problems successfully with this approach are about the same as getting the right shoe size in such a scenario… about 1 in 10.
Cause & Effect
Before diving into inventory management solutions, it is important to have a thorough understanding of the causes and effects of inventory control issues within the business. Here is a step-by-step approach toward framing inventory problems in relatively simple, manageable increments. The results of these information gathering steps (which should be formally documented) can later be used as input when evaluating and prioritizing potential remedies to inventory management and control issues.
There will be a temptation to try and solve problems as they are encountered and discussed in these steps. But the key objective in this phase is to gather and quantify information, not to deliver solutions. That will come later, once a full understanding of inventory-related issues and requirements have been thoroughly discovered and vetted.
The 4 Steps
Here are 4 steps that can be undertaken immediately by companies ready to improve their inventory management and control practices:
1. Defining the Problems
The first step involves creating a list of inventory problems by department. This is a bold step, because it involves asking employees and managers the question: “what’s wrong with this picture?”. But even though they might not talk about it openly (without a little coaxing), employees are often the best source of information regarding what works and what doesn’t within small companies. There may be a temptation for managers to “fill in the blanks” on behalf of their employees, or marginalize their input altogether. While it is certainly the owner’s prerogative to decide how to proceed in this area, the best information comes from the people who actually execute the work on a daily basis in each department.
So, the best approach is to call a meeting (or meetings), bring a yellow pad, ask employees how inventory control problems affect day-to-day operations, and write down everything they say. Depending on the industry served by the company, feedback such as the following will not be uncommon:
Sales – “We’re losing deals because we can’t deliver what the customer is buying”.
Marketing – “Our promotions are ineffective because customers get excited about, and take action on specials, only to find the products we’re promoting aren’t available.”
Purchasing – “We’re spending a fortune on freight because we buy so much inventory on an emergency basis. We also routinely have suppliers drop-ship parts we actually have in stock, because the service techs can’t find the parts they need before they leave for the customer site.”
Warehouse – “We never know what we have and what we don’t have, so we often think we can fill an order completely, only to find out at the last minute that we can’t, because of unanticipated inventory shortages. That requires us to start the pick/pack/ship process over again so the shipping paperwork is correct.”
Manufacturing – “Our production plans are always a mess, because we’ll plan and begin a production run, only to have to take the run offline because we’re missing a critical raw material. This stopping and starting of production jobs is killing us in unproductive labor cost and diminished productivity”.
Accounting – “Our invoices a getting paid more slowly because we partial-ship most of our orders, and our customers have to take extra steps to reconcile multiple shipments against their purchase orders. Too often, our invoices wind up in the customer’s research pile, instead of being processed smoothly and quickly”.
2. Quantifying Inventory Management Problems
This step involves quantifying and applying a dollar value to the inventory management problems outlined in Step 1. It’s a more challenging step, but it has to be done, and the results will help prioritize issues and (down the road) measure the value of potential solutions against the cost of the problems. It will also provide a reality-check against management’s perception of how inventory issues are really affecting the company. Relevant questions to employees might include the following:
Sales – “How many deals have we lost in the last 90 days due to stock-outs, and what is the dollar value of those losses?”.
Marketing – “How many promotions have missed their targets because of delivery problems, and what is the value of those promotions?”.
Purchasing – “How much have we spent on emergency freight shipments due to raw material or finished goods shortages?”.
Warehouse – “How many orders are we unable to ship on time, and complete because of finished goods or packaging material shortages?”
Manufacturing – “How many production runs have been pulled offline because of unexpected raw material shortages? What is the value of labor and equipment downtime due to production interruptions relating to inventory shortages? How is our production capacity being impacted by inventory-related issues, and what is the value of that impact?”.
Accounting – “How are payment delays relating to inventory shortages affecting aged receivables, and what is the value of those payment delays?”.
3. Calculating Inventory Turnover Ratio
Although there are variations for different industries, the inventory turnover (or “turn”) ratio provides a key indicator as to how quickly inventory is being utilized or sold over time. Inventory turnover is the number of times inventory is sold or otherwise consumed (i.e. used in manufacturing) relative to cost of goods sold for a particular accounting period.
Optimal Inventory Turn Ratios are usually unique to specific industries and the nature of products being sold. For instance, high value inventory such as real estate properties or expensive medical equipment may not move (or turn) as quickly as products characterized by lower dollar values and higher demand per capita. Still, Inventory Turn Ratio is an important metric for any company investing in inventory.
The most common calculation for Inventory Turn Ratio involves two variables: Cost of Goods Sold, and Average Inventory Carrying Cost, both measured during a common reporting period. For instance, in order to calculate the Inventory Turn Ratio for an annual period, the total Cost of Goods Sold (from the Profit and Loss Statement) for that annual period should be determined first. Then, a calculation of the Average Inventory Carrying Cost per month should be made. This can be accomplished by averaging the Inventory Asset value on the balance sheet for each month in the same reporting period as the Cost of Goods Sold value from above.
The actual Inventory Turn Ratio calculation is then: Cost of Goods Sold ÷ Average (monthly) Inventory Carrying Cost for the same reporting period. For example, if a company wants to calculate the Inventory Turn Ratio for the year, the numbers might look like this:
Cost of Goods Sold $2,156,000
Avg Monthly Inventory Carrying Cost 310,000
Inventory Turnover Ratio 6.96
Low Ratio – A low inventory turn ratio (say, under 5) may indicate inventory overinvestment, reduced demand for certain raw materials in manufacturing (perhaps due to redesigned products), or not enough sales relative to the average inventory carrying cost.
High Ratio – An excessively high ratio (over 17) may indicate that the company is not keeping enough stock on hand to meet demand, possibly spending excessively on emergency shipping costs or drop-ship fees, or simply failing to meet its delivery obligations due to inadequate raw material, finished goods or packaging inventory levels.
4. Valuating Devalued Inventory
As a final step in the initial investigation and quantification of inventory management problems, it’s time to take a realistic look at the lost value associated with obsolete, slow moving and scrap inventory. This involves calculating (or estimating, if necessary) the difference between the amounts originally paid for the devalued inventory still on-hand, versus the present value of the same inventory.
For a business owner, this can be a painful assessment to make, because it essentially measures dollars “flushed down the drain” as a result of poor inventory management and control practices. But it should also serve as a catalyst for making changes that will be positive for the company, now and in the future. As with most other aspects of managing a small business, owners must be willing to face reality in order to solve the company’s management and control problems.
As a word of caution, it is very important that the company’s CPA or tax advisor be consulted before making adjustments to the inventory carrying cost reflected on the company’s balance sheet. There may be a tax implication (positive or negative) that will need to be handled properly. But there’s no harm in determining the value lost from obsolete, slow moving and scrap inventory. In fact, it’s a key indicator that owners committed to change will want to measure and understand the nature of.
Understanding and quantifying inventory management issues thoroughly is an important first step toward positive change and improved use of the company’s capital resources (specifically, cash and inventory), and most importantly, people. It helps owners, managers and employees become more knowledgeable about inventory control challenges, and prioritize which inventory management issues need to be addressed first. It also sets the stage for better inventory management and control practices that will benefit the entire company in many ways, both tangible and intangible.
Article source: http://ezinearticles.com/?expert=Benjamin_Ellerd
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