Finding that middle ground between having too much inventory, and not enough, is never an easy endeavor. On one end of the spectrum are high inventory holding costs that accompany holding inventory without sales. On the other end are lost sales due to low inventory counts and levels. One involves high financing costs and the risks of inventory damage and obsolescence while the other involves losing sales and possibly customers, due to a lack of available inventory. One is a constant reminder of the company’s cost of capital and the other is a reminder of the costs of lost opportunities. Neither outcome is acceptable and finding that middle ground is paramount to success. So, what does it take to find that middle ground in inventory?
The Gap Between Inventory Counts and Market Demand:
If a company’s inventory costs could be broken down into two main cost drivers, the first would be "high inventory holding costs" and the second would be "lost sales cost of inventory". High inventory holding costs simply pertains to holding inventory for extended periods with little low sales volumes. In this case, it’s the company’s costs of holding that inventory without sales, and the risk of inventory obsolescence and damage, in addition to the high costs of financing.
Lost sales cost of inventory is equally as expensive and relates to lost gross profit on sales due to low inventory levels. In a large number of cases, companies incur additional costs by rushing parts and materials in to meet customer demand. Not wanting to lose the sale forces the company to incur vendor rush fees and high expedited freight costs.
I touched on both inventory cost drivers in the post Supply Chain Management: When Inventory Doesn’t Match Customer Demand. In it I went over how a number of companies seem to be alternating between either having too much or not enough inventory. If one were to graph the cyclical nature of inventory for these companies, and these two cost drivers of “high inventory holding costs” and “lost sales cost of inventory”, it would probably look something like the graph below.
The above video provides an explanation of the points in this article.
If one were to find that middle ground between these two aforementioned extremes, it would involve focusing on holding exactly what’s needed, when it’s needed. Granted, this is much easier said than done. Finding that middle ground is never easy. Companies have a hard time having exactly what customers need, when they need it. However, there are some simple strategies that can help your company find that happy medium between carrying too little or too much inventory.
1) Measure Inventory Holding Costs: Understand what your company’s inventory holding costs are relative to the time it takes your company to sell product. Holding costs are approx 3% a month. If your product has a 20% gross profit margin, but you must hold it for 6 months before selling it, then you’re only making 2%, if that.
2) Improve Sales Forecast Accuracy: Some companies rely too much on future sales forecasted volumes instead of analyzing historical trends such as seasonality and cyclical demand patterns. Combine your short-term and long-term forecasts with historical data. This will help improve your accuracy.
3) Use Safety Stock: Don’t be afraid to carry a safety stock. Maintaining a safety is advisable in instances where your holding costs aren’t as high because sales occur more frequently. For instance, if that aforementioned product was only held for 2 months before it was sold, instead of 6, then the company’s gross profit would be 14% (20% - 6%).
The table above is taken from the post: Determining Safety Stock & its Impact on Inventory Holding Costs
4) Track Lost Sales Cost of Inventory:Don’t ignore the importance of tracking lost sales due to low inventory counts and levels. Losing sales due to a lack of inventory is a cost to your company. Tracking these costs is the only way to improve forecast accuracy and find that happy medium in inventory.
This video is from the post: Inventory Carrying Costs vs. Lost Sales: Both Destroy Your Bottom Line
Finding that middle ground in inventory management is never easy. By no means am I implying that these five approaches will suddenly allow your company to hold just enough to meet sales, but not so much that it costs you more in financing costs. However, using these five approaches will improve your situation. Other approaches include incentivizing sales to move slow moving inventory, reducing financing costs through aggressive customer reward programs and using prompt payment initiatives to speed up customer payments. The thinking with these approaches is that each helps to increase inventory turnover rates, and that by speeding up these turnover rates, it will be easier to find that middle ground.
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