How do you know if you have too much, too little, or just the right amount of stock inventory? One way is to compare the value of your current inventory to an “ideal inventory investment.” In this article we will discuss how to calculate the value of this “right” amount of inventory. As with many of our other inventory analysis tools, calculating the ideal inventory investment requires that we first separate those inventory items with recurring demand from those items with sporadic usage.
Recurring Usage Items
Recurring usage products are sold or used on a regular basis. Typically these items:
- Have had usage in at least eight of the last twelve months.
- Have had usage in at least four continuous months in the last twelve months (this second condition identifies seasonal items that are only sold during certain times of the year).
Replenishment of these items is normally based on safety stock quantities, order points, line points, and standard order quantities:
- Safety Stock Quantity: The “insurance” inventory maintained in stock to protect you from stock outs resulting from unexpected customer demand or vendor shipment delays.
- Order Point: The Safety Stock Quantity plus predicted demand during the anticipated lead time.
- Line Point: The Order Point plus predicted demand during the supplier review or order cycle; the normal length of time between typical replenishment orders with the supplier.
These terms are explained in more detail in some of our other articles and books. Replenishment orders are typically placed with a supplier when the Replenishment Position (On Hand – Committed on Current Outgoing Orders + On Current Incoming Replenishment Orders) of an item is between its Order Point and Line Point:
Stock receipts for these replenishment orders will normally be received when the replenishment position is somewhere between a point equal to the Line Point – Anticipated Lead Time Demand and the Safety Stock quantity:
For example, if we ordered a product when its replenishment position was just below the line point, we’d receive the shipment when the available stock quantity equaled the Line Point minus Anticipated Lead Time Demand. But if we didn’t order the item until the replenishment position equaled the Order Point, the receipt would probably arrive when the available inventory equaled the Safety Stock. Therefore we can estimate that the “average” quantity on hand at the time of stock receipt will be the average of the Line Point – Anticipated Lead Time Usage and the Safety Stock quantity.
The stock receipt of products with recurring usage will normally be equal to the specified Standard Order Quantity (SOQ) of the product. The average quantity of this SOQ on hand during the time it takes to sell the entire SOQ will be equal to half the SOQ:
Therefore the ideal average on hand quantity of an item with recurring usage should be equal to the average quantity on hand at the time of stock receipt plus half the SOQ:
| [(Line Point – Anticipated Lead Time Usage) + Safety Stock] | + | SOQ |
| 2 | 2 |
You can multiply the ideal average on hand quantity of each item with recurring usage by its average cost and compare it to the current inventory value of the product to determine whether you are currently over stocked or under stocked.
Sporadic Usage Items
In many organizations more than 50% of stocked products have sporadic usage – that is, they are not sold or used on a regular, predictable basis. In other words you have no idea when they will be sold or used. In previous articles we have suggested that you base the inventory of sporadic usage products on a multiple of the normal or typical order quantity. For example, if you normally sell or use two of the items in a transaction, you would set the “target” stock level equal to two pieces (if you wanted to maintain one transaction in stock) or four pieces (if you wanted to maintain two transactions in stock).
You might think that like recurring items, the average or ideal value of sporadic inventory items should be some average of the normal quantity on hand, perhaps the target stock level divided by two. But because sporadic usage items are not consumed or sold on a predictable basis, it is very difficult to calculate an “average” investment for these items. After all, you might have the two or four pieces of a sporadic usage item in stock for a week, a month, or for more than a year! Therefore we have to consider the “ideal” value of sporadic inventory items to be equal to the target stock level quantity times the average cost. It’s true that because we will occasionally use some of the stock of some sporadic items, the value of the target inventory will overstate the average value of some items. But this is the most accurate method we know of determining the ideal value of sporadic inventory items.
Unfortunately the value of the inventory of a sporadic inventory item will often exceed the value of the target stock level. Why? Because you may have to order a vendor package quantity of a product when replenishing stock. And the vendor package quantity may not have any relationship to the normal customer order quantity. For example, say that the normal customer order quantity of a product is three pieces and we want to maintain two normal order quantities in stock. The target stock level is six pieces (2 orders x 3 pieces per order). Whenever the replenishment position of the item falls below six pieces, a replenishment order is issued. If we must order a vendor package of 10 pieces, the product’s stock level after we receive the replenishment shipment will probably be greater than the target stock level of six pieces.
Because sporadic inventory is not sold on a recurring basis, we must carefully monitor the value of any amount of sporadic inventory in excess of the target stock level, particularly for those items with a high unit cost. We can define “planned excess” of sporadic inventory items as a quantity equal to:
One of our goals should be to minimize the value of this planned excess. If a sporadic inventory item has a high planned excess value consider:
- Ordering an amount of the product close to the normal order quantity, even if you have to pay a higher price per unit.
- Discontinuing the product from stock inventory and ordering it only as necessary to fill specific requirements.
- Sharing one vendor package quantity among several stocking locations.
- Substituting a slightly more expensive item without passing the additional cost to the customer. Saving the carrying cost of excess inventory of one sporadic inventory item may more than compensate from the reduced profit on the resulting sale.
One of the best inventory metrics involves comparing the value of your current inventory to the sum of the values of the ideal stock level for each product. If the values are not close to one another, your buyers or inventory planners are probably not following the replenishment recommendations generated by your computer system. Are the system recommendations inadequate to provide your desired level of customer service and inventory turnover? Or do your buyers need more training in using your system to help your company maximize the return you receive from your investment in inventory? Either way, comparing your actual inventory to the “ideal” will lead you to action that can lead to improved profitability.
In our next article we will explore what you can do if your calculated ideal stock level is too high and needs to be reduced in order to achieve your organization’s inventory turnover and profitability goals.