Optimizing Forced Inventory Reduction – Part #3
By Jon and Matt Schreibfeder
Over the last several months we have been discussing how to prepare for a downturn in business.
Recent reports in the financial press predict a possible upcoming recession. It is imperative that
your company’s largest asset, inventory, is ready for an economic storm. Ready meaning that
you have no more cash than necessary tied up in inventory.
In the last two articles, we reviewed revising your approved stock list and adjusting safety stock
quantities. This month, we are going to examine your replenishment quantities. That is, the
amount of a product you buy from the supplier to replenish your stock.
There are several common methods for determining the replenishment quantity:
-
- A certain number of day’s, week’s or month’s supply. This is also known as “Up To”
replenishment because you are ordering enough of the product to bring the net
available quantity (On-Hand – Committed on Outgoing Orders + Currently on
Replenishment Orders) up to the specified time period’s supply. - An economic order quantity or “EOQ”. This is the amount of the product that will
minimize your “total” cost of inventory and maximize your profitability. - Enough to meet customer demand until you can place another replenishment order
with your supplier.
- A certain number of day’s, week’s or month’s supply. This is also known as “Up To”
The first method, “Up To” is subjective. Management or individual buyers decide on the
amount of inventory to have in stock that “feels right”; or provides a desired number of inventory
turns. We have observed that this method often leads to overstocking, as there is a natural
tendency to buy more than actually is needed. Consider your own experience. When a recipe
calls for six or seven potatoes will buy seven (or maybe even eight)? It doesn’t make sense to
use this method if you are trying to minimize expenditures.
The economic order quantity, or EOQ, balances the cost of material you buy with the cost of
carrying inventory (also known as the “K” cost) and the cost of reordering the item (also known
as the “R” cost). It is calculated with the formula:
Square Root of:
24 * COST OF REORDERING (R) * FORECAST DEMAND / COST OF CARRYING INVENTORY (K) * UNIT COST
Many people are intimidated by this equation. But it is not necessary that you can perform the
math. All you need to do is understand the results. Utilizing the EOQ will suggest you bring in
small quantities, more often, of items that have a lot of dollars moving through inventory. And
larger quantities of products that have few dollars moving through warehouse. Doesn’t make
sense to bring in a year’s supply of a product, if that quantity requires a total investment of only
ten or fifteen dollars? But bring in a week or two’s supply of an item that has thousands of
dollars moving through stock?
The EOQ does require accurate costs of reordering and carrying inventory. You can find questionnaires to determine these costs for your organization in the Resources section of our website, www.EffectiveInventory.com.
But while the EOQ will help you maximize profitability, it won’t result in minimizing your expenditures and total value of inventory; it would not be a good choice in a forced inventory reduction situation. Minimizing expenditures and total inventory investment can only be accomplished by just ordering enough of each item to satisfy customer demand until you can place and receive another replenishment order. This is the quantity necessary to bring the net available quantity up to the line point (also known as the reorder point). The line point is equal to:
Anticipated Lead Time Usage + Anticipated Order Cycle Usage + Safety Stock
Anticipated Lead Time Usage – The amount of a product you will sell or use during the time it takes to replenish your stock of the product.
Anticipated Order Cycle Usage – The amount of a product you will sell or use during the time between placing “target” orders with your vendor. The target order meets the supplier’s requirements for you to get the terms or discounts that allow you to competitively sell their products.
Safety Stock – Reserve inventory you maintain to protect against stockouts caused by unusual demand or delays in receiving a replenishment shipment.
While ordering up to the line point will minimize your expenditures, it will result in more receiving, handing of material and account payable activity. You probably will want to only utilize this method until your corporate finances recover.
Next month we will conclude this series by discussing what you can do when a vendor forces you to buy a lot more of a product that you need.
In the meantime, let us know if you have any questions or would like to discuss how EIM can help your organization achieve effective inventory management!