Properly managing inventory means to track its cost drivers and mitigate their impact. However, the question often becomes: “What is the best way to track a company's inventory costs?” In order to answer this question, I thought I would come up with a list of five simple inventory KPI (Key Performance Indicators) for the small business owner. However, in order to use these KPI, small businesses must first understand the two main costs of inventory; holding costs and lost sales.
The Two Primary Costs of Inventory
Holding Costs: When thinking of holding costs, think about the costs of retaining inventory without sufficient sales. These costs include storage and handling, financing, inventory damage, inventory obsolescence, in addition to the costs of freight on incoming and outgoing shipments of materials, consumables and finished goods. Holding costs also include pilferage (theft), counting, electricity, rent and a number of other miscellaneous warehouse expenses. Ultimately, holding costs increase the longer inventory is held.
Lost Sales: Most companies focus entirely on these aforementioned holding costs, while ignoring the impact of lost sales. In fact, most are completely unaware that losing sales due to low finished good counts is a direct cost of managing inventory. So, why is lost sales a cost of inventory?
In order to answer that aforementioned question, think about the implications of losing sales. Ultimately, lost sales means lost gross profit, lost customers and eventually, lost market share. However, the real costs come from what companies do when faced with an inventory stock out. Not wanting to lose a sale, companies rush material in to meet customer demand. They pay expedite fees to secure the shipment, overtime in shipping and receiving, overtime in manufacturing, and they often have to cover the costs of freight out to the customer's location for being late.
To learn more about holding costs and lost sales cost of inventory, please read: Inventory Carrying Costs vs. Lost Sales: Both Destroy Your Bottom Line
Five Simple Inventory Key Performance Indicators
Our list of inventory KPIs will be focused on identifying our aforementioned cost drivers. After each listed KPI, I’ve included a link to other articles that will help provide some insight on how to reduce the impact of these issues within your warehouse. So, when it comes to small business inventory management, what are the most important inventory KPIs?
1. Damage to Inventory
We’ll start off our list of inventory KPIs with one that is well understood by small businesses. While most understand the impact of inventory damage, few take proactive steps to reduce its impact. In most cases, inventory damage becomes a complete write-off. After all, there is little way to recoup damaged inventory other than to sell it for scrap.
The best companies focus on ensuring that damage is less likely to occur by never allowing slow moving inventory to remain within their warehouse for extended periods. The longer inventory is held, the more likely it is to get damaged. You must empower your sales team to sell slow moving inventory. This KPI must define the amount of slow moving inventory within your warehouse in any given month. To read more about mitigating the impact of damaged inventory, please read: The Importance of Immediately Liquidating Dead Stock
2. Antiquated (Obsolete) Inventory
These first two inventory KPIs are very closely related to each other. The longer a company holds inventory, the more likely it will become outdated or damaged beyond repair. Either way, the losses are substantial. Companies must track the value of their outdated inventory. This can be done on a monthly or quarterly basis. A good rule of thumb is to use the product’s sales cycle in order to determine when it becomes outdated. If the sales cycle is typically within a week, and suddenly there are no sales for a month, then it’s a sure sign the product is becoming obsolete. To read more about how inventory becomes obsolete, please read: At What Point Does Slow Moving Inventory Become Dead Inventory?
3. Sales Forecast Accuracy
Inaccurate sales forecasts means small businesses either have too much, or too little inventory. Too much inventory, and the company’s holding costs erode gross profit. Too little inventory and the small business misses sales. A company’s sales department plays a vital role in how much inventory the company should carry. While sales forecasting will never be an exact science, there are some simple solutions to making your forecasts more accurate. A more accurate forecast is one where your finished good inventory count matches your market's demand.
To improve how your small business forecasts sales, please read: How Do I Improve Our Sales Forecast Accuracy?
4. Cost of Freight
Granted, buying too much inventory, and holding it for too long, is extremely costly. However, not buying enough is just as costly. If there is one issue I’ve seen repeated at all my customers, it’s how they don't take advantage of their economies of scale by lowering their prices and freight on purchases. This is one inventory KPI that must be handled properly. The cost of freight is an extremely important cost of inventory. Lowering that cost either through vendor consolidation practices, or bulk shipments, is essential to reducing inventory expenditures.
The above video explains how to measure holding costs versus larger purchases. It is taken from the post: Inventory Carrying Costs Versus Higher Volume Purchases
5. Incidence of Stock Outs
Stock outs and material shortages drive up the costs of inventory because they force companies to pay expedite fees by rushing in parts and materials to meet demand. Regardless of whether you're a manufacturer faced with a raw material shortage, or a company lacking the proper counts on finished goods, a stock out can directly impact your inventory costs. In the end, stock outs can immediately turn a good month into a bad month. When tracking this KPI, be sure to track how often stock outs occur and the costs involved in remedying the situation.
A safety stock isn't just a staple of Min-Max. It also applies to Just in Time supply chains as a little bit of "Just in Case" inventory is always needed. To read about calculating a buffer stock, please see: Determining Safety Stock & its Impact on Inventory Holding Costs
Small business inventory management must first start with an understanding that the company’s costs involve more than just the price it pays for parts and materials. Companies use inventory KPIs in order to expand their perspective on inventory costs. Unfortunately, a number of companies lack the ability to define their total inventory cost of ownership.
In a number of cases, companies assume that reducing costs means to keep inventory levels low. However, they fail to track the costs of low inventory on their per-unit prices and per-unit cost of freight. Use these five simple inventory KPIs to broaden your perspective on your company's real inventory cost drivers.
To read about the impact of low inventory, please read: Best Business Practices: Avoiding The High Costs of Low Inventory
Comments