A few months ago we published an article entitled “Trimming Inventory While Maintaining a High Level of Customer Service.” In that article, we suggested that you “micro-manage” your fast-moving products by ensuring that forecasts are accurate and that the “safety stock” is monitored.
In this article, I am advising you to reevaluate the Economic Order Quantity (EOQ) and the order-cycle quantities for your high-cost items with recurring usage that are supplied by a reliable vendor.
The EOQ is that quantity of a product that will minimize your total cost of inventory per piece. The EOQ is typically applied to items with recurring usage that are items sold or used on a regular basis. It “balances” the three costs you incur as you buy and maintain the stock of a product in your warehouse:
- The cost of the material (plus freight and other costs associated directly with a particular replenishment shipment).
- The cost of carrying inventory.
- The cost of issuing a replenishment order and processing the stock receipt.
There are many versions of the EOQ formula. All of them are designed to maximize profitability. However, 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, closely examine the EOQ quantities calculated by your computer system in terms of the day’s supply of inventory it represents:
EOQ ÷ (Monthly Forecast ÷ 30)
The monthly forecast is divided by 30 to calculate an approximate forecast per day. For example:
EOQ = 60
Monthly Forecast = 45
60 ÷ (45 ÷ 30)
60 ÷ 1.5/Day = 40-Day Supply
A monthly forecast of 45 pieces is about 1.5 pieces per day. The EOQ of 60 represents a 40-day supply (60 ÷ 1.5/day). 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 for this line every 10 days. If you include this item on each order, you can order a ten-day supply (10 Days x 1.5/Day = 15 pieces). Compare the value of the EOQ and order cycle replenishment quantities. This particular product costs $7.50 per piece:
EOQ Value = 60 x $7.50 = $450
Order Cycle Quantity Value = 10 x $7.50 = $75
This lower 10-day reorder quantity of this product results in buying $375 less inventory and would not affect either anticipated lead-time usage or safety-stock quantity. These are elements of the minimum or “order point” quantity which will ensure that you reorder the product at the “right” time in order to avoid a stockout. As a result:
- Replacing the EOQ with the order-cycle quantity for many items can substantially reduce the amount of money you have to invest in inventory.
- Although you will not be buying to achieve the lowest total cost for each piece of the product and maximize your profitability, buying just enough to last during the order cycle (especially for high cost items) will reduce necessary cash outlays and increase your inventory turnover (i.e., your opportunities to earn a profit from every dollar of your average inventory investment). This may be just the remedy for a company having cash-flow challenges.
- Because the elements of the minimum or “order point” are not affected, “order cycle” replenishment should not have a detrimental effect on customer service!