This week we asked our interns the following questions about inventory:
Elaborate on the role of purchasing inventory? What is the risk of not purchasing enough inventory or over purchasing and sitting on too much inventory? How do the lead times affect a small business? What type of detailed planning and/or forecasting would go into purchasing the right mix of goods? Take me through an ideal situation from the time you order the goods to the time it arrives and you’ve received it in full.
What is inventory?
Inventory are essentially the goods and materials that a business holds for the purpose of reselling it.
There are three basic reasons for keeping an inventory:
- Time – The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amounts of inventory to use in this lead time. However, in practice, inventory is to be maintained for consumption during ‘variations in lead time’. Lead time itself can be addressed by ordering that many days in advance. In skateboarding, the lead times for building new skateboards can range from 4-8 weeks or wheels from 4-6 weeks, and are a function of the production times to build the goods and the time to ship the goods.
- Uncertainty – Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods. In skateboarding, January and February are typically very low sales months whereas May, June and July are very strong months.
- Economies of scale – Ideal condition of “one unit at a time at a place where a user needs it, when he needs it” principle tends to incur lots of costs in terms of logistics. So bulk buying, movement and storing brings in economies of scale, thus inventory. As volume goes up, shipping costs go down overall per unit. This same rule applies to you as a customer when you order goods and pay UPS or FedX or USPS shipping. For example, if you are in England and want to order a bamboo skateboard, UPS shipping will cost around $40 for 1 deck. But if you order 2 decks, cost will be around $50, which reduces the per deck shipping cost to $25 = $50/2. By the time you reach 100 decks, you can get it down to around $10/deck, but you will need to use a LTL shipper.
- Appreciation in Value – In some situations, some stock gains the required value when it is kept for some time to allow it reach the desired standard for consumption, or for production.
All these stock reasons can apply to any owner or product.
Special terms used in dealing with inventory
- (SKU) or stock keeping unit is a unique combination of all the components that are assembled into the purchasable item. Therefore, any change in the packaging or product is a new SKU. This level of detailed specification assists in managing inventory. It’s always good to use a consistent numbering and alphabetical system for goods.
- Stockout means running out of the inventory of an SKU. This is never good for business because your customer will be very upset! Think about when you want to order that brand new hot skateboard graphic and it isn’t available because too many people purchased it (demand=high) before you.
- “New old stock” (sometimes abbreviated NOS) is a term used in business to refer to merchandise being offered for sale that was manufactured long ago but that has never been used. Such merchandise may not be produced anymore, and the new old stock may represent the only market source of a particular item at the present time. Typically these type of goods are liquidated resulting in the price going down significantly. Many companies exist by just reselling this old stock – companies such as overstock.com and even Groupon.com.
Typology of Inventory
- Buffer/safety stock
- Cycle stock (Used in batch processes, it is the available inventory, excluding buffer stock)
- De-coupling (Buffer stock held between the machines in a single process which serves as a buffer for the next one allowing smooth flow of work instead of waiting the previous or next machine in the same process)
- Anticipation stock (Building up extra stock for periods of increased demand – e.g. ice cream for summer)
- Pipeline stock (Goods still in transit or in the process of distribution – have left the factory but not arrived at the customer yet)
While accountants often discuss inventory in terms of goods for sale, organizations – manufacturers, service providers and not for profits - also have inventories (fixtures, furniture, supplies, etc.) that they do not intend to sell. Manufacturers’, distributors’, and wholesalers’ inventory tends to cluster in warehouses. Retailers’ inventory may exist in a warehouse or in a shop or store accessible to customers. Inventories not intended for sale to customers or to clients may be held in any premises an organization uses. Stock ties up cash and, if uncontrolled, it will be impossible to know the actual level of stocks and therefore impossible to control them.
A great accounting/financial system for managing inventory is using a program called Quickbooks. At any point, you can run a physical inventory worksheet and go out and count the physical goods versus what is in the system. Let’s say your system shows 100 skateboards but you only have 99. In this case, you will want to look at all sales and ensure that the inventory was accounted for. In this case, a logical example might be that someone came in off the street to the office and asked for a 8″ skateboard. An employee went to the warehouse and grabbed one, but didn’t complete the paperwork yet, which once done, would remove that from the system. Since nventory is an asset, just like cash, accounts receivables, etc., it is very important you manage it properly. Many companies do what is called “cycle counts” to ensure that the inventory is being managed properly. There is nothing worse than waiting until the end of the year, only to find out you’ve lost a few hundred items, resulting in tens of thousands of dollars of lost goods.
From accounting, the balance sheet states that assets = liabilities + stockholders equity. What this means essentially is that when you put cash into your company, you have a balance equal in value called equity. Now, if you had borrowed that money from a bank, that would be a liability, not equity. When you convert that cash to inventory, you are only changing the assets side. As you sell your inventory, the inventory is deducted.
On the income statement, if you sell 1 item, you recognize the sale of that one item and the cost of that item. For example, if you sell a skateboard for $30 that costs you $12 to make: $30-12 = $18. $18 is the gross profit. If you take $18/$30 = gross profit margin %. If you had $30 and $15 cost, you would get $15 gross profit and a $15/$30 = 50% gross profit margin.
While the reasons for holding stock were covered earlier, most manufacturing organizations usually divide their “goods for sale” inventory into:
- Raw materials- materials and components scheduled for use in making a product. For skateboards, this might be the veneers, glue, grip tape, bolts, bearings, wheels, etc.
- Work in process, WIP – materials and components that have begun their transformation to finished goods.
- Finished goods – goods ready for sale to customers. Completed skateboards with wheels, trucks, bearings, grip tape, deck, bolts that are shrink wrapped and ready to go.
- Goods for resale – returned goods that are salable. An example might be a longboard with a small scratch on the graphic. In this case, the item would be sold for a little less than a regular one. There are many customers who prefer to buy goods that are discounted as it saves them money. Plus the skateboards are going to get scratched eventually anyways.
Principle of inventory proportionality
Inventory proportionality is the goal of demand-driven inventory management. The primary optimal outcome is to have the same number of days’ (or hours’, etc.) worth of inventory on hand across all products so that the time of runout of all products would be simultaneous. In such a case, there is no “excess inventory,” that is, inventory that would be left over of another product when the first product runs out. Excess inventory is sub-optimal because the money spent to obtain it could have been utilized better elsewhere, i.e. to the product that just ran out.
The secondary goal of inventory proportionality is inventory minimization. By integrating accurate demand forecasting with inventory management, rather than to past averages, a much more accurate and optimal outcome.
Integrating demand forecasting into inventory management in this way also allows for the prediction of the “can fit” point when inventory storage is limited on a per-product basis.
The technique of inventory proportionality is most appropriate for inventories that remain unseen by the consumer, as opposed to “keep full” systems where a retail consumer would like to see full shelves of the product they are buying so as not to think they are buying something old, unwanted or stale; and differentiated from the “trigger point” systems where product is reordered when it hits a certain level; inventory proportionality is used effectively by just-in-time manufacturing processes and retail applications where the product is hidden from view.
The use of inventory proportionality in the United States is thought to have been inspired by Japanese just-in-time parts inventory management made famous by Toyota Motors in the 1980s.
Here’s what the interns wrote this week:
The ability to control inventory and make appropriate and intelligent purchasing decisions is the key to keeping customer relationships intact and increasing profitability. If you do not purchase enough products and have to wait on product you may be losing out on a lot of money. This money can be lost by missing an opportunity for a sale, operating costs for running a business that may have little to no commodity, and potential future sales by making customers shop elsewhere. Having too much inventory is essentially money with a a shelf life. With too much stock, money is potentially wasted as well. The money caught up in having an excess of inventory is money that could have been spent on other avenues of running the business. Lead times can make or break a small business. If the company cannot afford to carry an abundant amount of overstock, then they plan on a more conservative model that often times allows just enough product to be left to get the next shipment. When the lead times on some products take longer than originally expected, it causes ripples in the fluidity of the rest of the business. If there is an expected delivery date, but the product does not show for days or weeks following, then money is lost. A small business typically has a large amount of its cash tied up in inventory. With such a large financial investment in his business, the small businessperson must make every effort to reduce the risks associated with carrying inventory. One way to protect from inventory shortfalls is by building a safety margin into basic inventory figures. To figure out the right safety margin for your business, try to think of all the outside factors that could contribute to delays, such as suppliers who tend to be late or goods being shipped from overseas. Once you’ve been in business a while, you’ll have a better feel for delivery times and will find it fairly easy to calculate your safety margin. The ideal situation would involve a very simple process free of changes, delays and returns. Initially, the customer has a Product Inquiry which will turn into a sales quote. Then the sales quote will turn in to a formal order placement. After the order has been placed, there is an order confirmation that is sent and soon thereafter the customer will be sent a bill. Then the company sources where it will pull the product from. The distribution center fills the order and sends the shipment. Finally, the delivery of the product finds its way to the customer. -JD
Purchasing inventory is extremely vital to any organization. Companies need to factor in many components when deciding quantities to purchase. This aspect is extremely important so inventory is not too short or overstocked. If a company doesn’t have enough inventory, a company can suffer substantially in customer service, higher payments on rushed shipping, unreliability, decrease in client relationship and revenue. On the opposite hand, if a company has over bought, it has a sunk cost from the payment of the unsold goods, but can be seen as an opportunity for PR and discounts for customers. Lead times can be helpful to have with third parties. For each shipment, the company would know the status of their goods with the third parties and if they meet benchmarks to be on track for deliveries. Coming from another point of view, lead times can help when looking for third parties to work with. For example, how quickly you could get inventory and how much, could be some determining factors. In addition, small companies could gain traction if they have the fastest lead time compared to competitors while still having quality products. When looking for the “right mix” of goods, one must create an effective plan and forecast in advance of the market they anticipate to work with. Companies must plan which products and quantity they need to meet the requirement to fulfill their order and uphold their quality and brand. Companies must also create a timeline of their best and worst case timeline scenarios to know how much room they have to shop around and negotiate with buyers, if necessary. When looking at third parties, one must factor in lead times, prices, long term benefits, quality, etc. Once these plans have been made, the company must next consider countries and companies they would like to work with. In the case of working with foreign companies, one has to forecast the market and understand the politics, exchange rates, laws, and similar prices in relation to the location. There are many factors that would create an ideal situation for working with a third party. Once I ordered my products I would want a timeline of what to expect in terms of timeline of product production and final delivery time and quantity. I would like to be updated weekly, of the progress of the goods and have the company be on time for delivery or ahead of schedule. Ideally this would happen with no setbacks or errors. – NB
Inventory is an essential part of business that can either make a company thrive or go up in flames. The importance of inventory also varies from business to business. For example, in the meat and produce industry inventory control is extremely important. If at the end of the day if a company is left with an overstock of goods then the meat or produce is most likely to go bad. If a company doesn’t order enough produce then the business will lose out on potential revenue. In other markets it can be less costly to overstock something like skateboards because there is no expiration date. However when a small company struggles to break even each month then inventory then becomes very important. For example if Bamboo orders too many decks then styles may change or tastes in the consumer market and they might get stuck with inventory that won’t sell. However if the order to few then they run the risk of losing potential customers. In order to purchase the right mix of goods for one it takes experience. It takes knowing the market and what will sell and what still needs to be tested. The steps you should consider however is how many boards did I sell last month? Was there a shortage or a surplus at the months end? Did a certain model appeal to more customers? What are other companies doing, is another skate company about to launch something big that might take away from my market power? An ideal situation when ordering goods would go something like this. Order the goods FOB destination therefore the seller will pay for the shipping. When good arrive unload truck and stock warehouse shelves neatly and efficiently in order to speed up the process once a transaction is made. A buyer orders a product online or by phone or any other means. Then the order is processed and package for shipment FOB shipping point. That would be the ideal scenario for shipping and receiving inventory. -BB
Proper inventory control is the key to running a successful business. There are many factors to take into account when thinking about your inventory. Insufficient inventory, lead time and excess inventory are the top three things to look out for. I have worked a lot in the service industry and have been constantly dealing with inventory and the problems that come with it. Understanding everything there is to know about inventory control can make a huge difference in any business whether it is a small privately owned business or a giant chain. The first step to creating inventory control is setting up a business plan. Your business plan will help you find out how much inventory your business is going to need and when you need it by. Your inventory should have a variety of your business’s products and you should have enough to cover normal business. The biggest and most common mistake is having insufficient inventory. This can cause huge and unneeded problems. For example if a major skateboard distributor were to run out of inventory, it will not only affect the customers and the reviews they put online but will affect the workers at the warehouse. The workers will have nothing to do in the warehouse so you will be paying them to do nothing. When the stock finally does arrive you will end up paying over time while they catch up on the delayed orders. This can cause you to lose a lot of time money and effort and make you look bad to your customers and employees. When calculating basic stock, you must also think about your lead time or the the length of time between reordering and receiving a product. For instance, if your lead time is 6 weeks and a particular product line sells 10 units a week, then you must reorder before the basic inventory level falls below 40 units. If you do not reorder until you actually need the stock, you’ll have to wait four weeks without the product. This can lead to insufficient inventory and then you run into the same problem we discussed above. Excess Inventory can also hurt your business. When running low on a particular product it may make sense to just order one huge shipment that will last you longer. This can really screw up a business such as Insight with seasonal clothing. If you order to much of a particular product you can end up sitting on excess products and end up having to try and get rid of it any way you can. The first idea that may come to mind might be to lower prices or add a discount to get the product out of there. This will actually cause you to lose money in the long run and force you to totally change your entire business plan. Inventory can make or break a business. This is why it is so important to keep an eye on your inventory and make sure you are always staying on top of it. If you pay attention to inventory, your sales and have a well thought out business plan your business can be a success. – MM