In today’s economy we see many companies emphasizing “cash flow management” over profitability. That is, they are willing to sacrifice some profit dollars in order to invest smaller amounts in inventory. If you find yourself in this situation, I have an alternative reordering strategy that may meet this need for many of you.
When placing a replenishment order, how do your buyers decide how much of each item to order? Often, reorder quantities are based on “habit” (i.e., “this is the way we’ve always done it”) rather than logic. However, most computer systems will allow you to reorder using an economic order quantity (EOQ). This is the quantity that will minimize the total cost of inventory for each piece of each product with recurring usage that you buy. The EOQ balances four factors:
- The current forecast demand for the product.
- The cost of carrying inventory (also known as the “K” cost).
- The cost of issuing a replenishment order (also known as the “R” cost).
- The replacement or landed cost per piece of the item.
It is important that these four factors of the EOQ are accurate. In previous newsletters we’ve discussed forecast accuracy. We also provide free help in calculating your “K” and “R” costs in the articles “The Mysterious Cost of Carrying Inventory” and “How Much Does it Cost You to Buy.” By utilizing an accurate EOQ you will ensure that you are buying the quantity that will maximize your corporate profitability.
You might think it is always a good idea to maximize profitability – that is, buying a larger quantity at a lower total unit cost to maximize profit dollars. And it probably is… if you have the cash to do so.
However in today’s economy we see many companies willing to sacrifice some profit dollars in order to invest smaller amounts in inventory. If you find yourself in this situation, closely examine the EOQ quantities calculated by your computer system in terms of the day’s supply of inventory. Compare the results to the value of the product sold or used during the order cycle for each supplier. The order cycle (also known as the “review cycle”) is the typical length of time between replenishment shipments being received from the vendor. For example, you may receive shipments from the primary vendor of a particular product line every ten days. If you include this item on each order you can order a ten-day supply and have enough inventory on hand to meet your customers’ expectations of product availability.
This order cycle reorder quantity:
- is usually less than the EOQ quantity, and so will reduce cash outlays for inventory and increase inventory turnover (your opportunities to earn a profit).
- does not affect customer service, since it does not affect either anticipated lead time usage or safety stock quantity.
Replacing the EOQ with the order cycle quantity for many items may substantially reduce the amount of cash invested in inventory. This may be just the remedy for a company having cash flow challenges!