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___________________________________________ By Michael F. Hornung Inventory is a major investment for many companies. Therefore, effective inventory management is critical to their financial success. The first step to improving a company’s inventory position is to determine its current status. This can be done by using long-established methods that evaluate how effective a company is controlling its inventory. There are two primary measurements used to achieve this, the ‘Inventory Turnover Rate’ and ‘Days Inventory’. There are two different ways of calculating these ratios. The method used will depend on whether it is going to be compared to industry standards or for internal evaluations. The difference is due to the factors used in calculating the values. Let’s look at the Inventory Turnover Rate External Inventory Turnover Rate = Total Cost of Sales / Inventory For external assessments, divide your ‘Total Cost of Sales’ by your ‘Inventory’. Compare this value to industry standards for your business such as those contained in: the “Annual Statement Studies” by the Risk Management Association; “Industry Norms and Key Business Ratios” by Dun & Bradstreet; or those published by your trade association. This will help you identify where you stand relative to your industry and help you determine if you need to take any actions. Internal Inventory Turnover Rate = Cost of Sales, material / Inventory For internal evaluations, divide your ‘Cost of Sales, material’ by your ‘Inventory’. This will be your actual inventory turns and the most accurate. Compare this value to your budget, if you have one, and historical past. This value is used in deriving other operational ratios such as the time it takes you to convert inventory to cash and how long you will need to finance your inventory. The formula for your Days Inventory is Days Inventory = 365 / Inventory Turnover Rate The goal, in most cases, is to have a high turnover rate and therefore a low days inventory. However, realize that a ratio can be unfavorable if either too high or too low. A company must balance the cost of carrying inventory with its unit and acquisition costs. Most people do not realize that the cost of carrying inventory is 25% to 35%. These costs include warehousing, material handling, taxes, insurance, depreciation, interest and obsolescence. Here are some actions a company can take to improve its inventory position. Compare your values to industry standards; a budget (if you have one); and your historical past. Watch for variance and undesirable trends. A company’s average inventory is defined by the following equation: Average Inventory = 1/2 Order Quantity + Safety Stock This formula dictates what direct actions can be taken to change the inventory value. So, to reduce it, there are two areas that can be acted on, either the order quantity or safety stock. First examine how order quantities are being calculated. Try reducing them across the board. Realize that doing this will increase the number of times purchase orders are issued and therefore may increase acquisition costs. Unit costs may also increase because of smaller order quantities. The smaller order quantities will also affect product availability because the balance-on-hand will approach zero more frequently. These increase costs and the product availability issue can be offset by negotiating blanket orders with vendors. The second part that makes up the inventory is safety stock. Review the safety stocks levels and lower them where possible. Many levels are set arbitrarily even in automated systems. Safety stock requirements can also be reduced by improving the inventory accuracy. Installing an inventory control system can help achieve this. Control your inventory by limiting access to it. Without good physical control the best inventory control system is of no use. Here are some other actions that can be taken to reduce your inventory. Place an emphasis on reducing purchasing errors. This can reduce overstocking and, more important, minimize stock outs that result in expensive expedited purchases. Sell excess and obsolete inventory or return it to your vendor. Do not allow vendors to deliver early or late. Also the delivered quantity should not vary from the order quantity. Provide your purchasing and material management personnel with formal training. This will arm them with better negotiating skills that will result in better prices and terms. Finally, adopt the purchasing policy of Vendor Partnering. Provide your primary vendors with a detail forecast of your future needs. Give them as much information as possible. You want them to have a warm fuzzy feeling when doing business with you. This is what the big companies are doing. This will result in better prices, improved terms, better delivery and enhanced customer service. Let’s see how else these measurements can be used. You can determine what your inventory level should be. Recommended Inventory Level = Total Cost of Sales / External Published Turnover Rate Compare this value to your inventory level to determine if you need to take any actions to improve your position. You can also determine the amount of money you will need to invest in inventory to support a specific level of sales. Inventory Investment = (Desired Sales * % Cost of Sales, material) / Internal Turnover Rate This is extremely helpful in identifying inventory investment requirements in a growth environment. These tools and techniques will allow you to maintain your optimum inventory level and minimize your total costs. |
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