The 4 Principles of Successful Inventory Management
Managing inventory is always a struggle. Too much, or too little is never good, and finding that middle ground seems next to impossible. Having too much inventory means our carrying charges will be higher as we will hold inventory longer. Having too little, and we’ll miss important sales that could generate gross profit. So, with both ends of the spectrum representing high costs and lost profit, how exactly does a company find that middle ground? Is there a way to balance out the scale? Well, there is no guarantee, but there are four principles that all companies should follow when it comes to managing their inventory. Doing so might just get your company that much closer to your ideal inventory levels. First, we’ll review what goes into your inventory costs, and then we’ll look at the four principles of successful inventory management.
Understand all the costs of your inventory:
Companies often misunderstand, or don’t properly assess their costs of inventory. A company’s inventory costs are made up of more than just the product on the shelf. They also include the per unit freight costs of every part and material in your warehouse. In addition, any time you move product from one warehouse location to another, it also adds to the costs. Holding inventory for extended periods is an additional cost. Electricity, and even heating and air-conditioning, are also costs. Damage to inventory is yet another cost, as is obsolete inventory that can’t be sold anymore. A basic rule of thumb is that inventory ties up money that you might otherwise be able to use in other parts of your business. Having money tied up in inventory that isn’t moving, or doesn’t sell fast enough, is a cost to your company every day, week and month. A number of companies simply ignore these factors and keep their analysis to the basic cost of the product or material on the shelf. However, inventory costs go well beyond that.
- Use your economies of scale and don’t get fixated on short term inventory costs:
Every company wants to have low inventory costs. It makes perfect sense not to want to have too much inventory. However, mistakes are often made when companies become so fixated with monthly inventory costs that they actually ignore potential savings that can be accrued with better vendor pricing with larger volumes per order. By no means are we implying that month to month inventory costs aren’t important. They are very important. Rather, what we are saying is be cognizant of the savings your company can achieve when purchasing larger volumes, relative to how long that inventory will remain in your warehouse. A good rule of thumb is to remember that monthly carrying charges for inventory are usually around 3% of the inventory value on hand. So, if purchasing double your volume allows for a 10% reduction in pricing, but means you hold onto the inventory for an additional month, it makes sense to do so. Your two months of inventory will cost you a total of 6%, but your price will go down 10%. Your company is still ahead 4% in costs. Granted, this is a simple example, but there are bound to be those items you can double your volume on.
- Include every cost variable and manage costs by quarter:
You’ll never be able to improve how you manage your inventory, and its costs, without first being sure to include all the necessary variables. It’s all or nothing when it comes to inventory costs. Be sure to include all the variables we previously mentioned, and set a plan in motion to reduce those costs. When you have all your costs mapped out, you are always in a better position to identify areas that need to be immediately addressed. Take the time to put all this information down in a table, and extend your analysis to looking at these costs over a quarter. You can still set plans in motion to improve costs month to month, but give yourself plenty of time to see the results of your actions. Measure the impact of your cost cutting measures by quarter, and take a longer term view of your inventory costs.
- Eliminate redundancy and obsolescence:
Surprisingly, it’s really not that hard to improve your ability to tackle the problem of obsolete or outdated inventory. It’s simply a question of discipline and better coordination between sales and inventory management. What needs to happen is that you set some boundaries by which your company will not deviate from. Make sure the common parts in your inventory have multiple customers who could take that inventory. While it really depends upon the industry, a good rule of thumb is to keep inventory of common parts as long as your sales has the ability to sell that inventory to a minimum 3 or 4 customers. For all non-standard parts, that business should be “made to order” business only. In this case, you don’t hold inventory of the product, and only ship what is ordered by your customer. Of course, there is a lead time for the product, but it never remains in your inventory and therefore doesn’t add to your inventory costs. It’s up to your sales team to properly manage customer expectations and have them incorporate the lead time into their order patterns. Aside from these two areas, if you do entertain holding inventory for just one customer, make sure to have an iron clad agreement in place securing the inventory and protecting your interests.
- Negotiate favorable supply agreements with vendors:
Understand that damage to your inventory is a huge impact on your overall inventory costs. Holding inventory for extended periods is not only a cost per month, but also represents an additional cost if those parts are accidently damaged. If damaged in your warehouse, your company is liable for that cost. However, if the risk of that damage is removed, then your costs will go down. How can you reduce the potential for damage to inventory, and at the same time reduce your month to month carrying costs? You accomplish both by negotiating a contractual blanket order agreement with your vendors that allows you to only take inventory when you are certain you’ll either use it, or sell it immediately. Granted, you won’t be able to do this with your entire inventory, and will have to abide by our first principle of using your economies of scale, but there will be items you can use these agreements with. Just be aware that your supplier will have their own monthly carrying charges and will likely put a limit to how long they retain your product. However, having your customer keep your inventory for you, frees up some of your cash, and protects against damage to that inventory in your warehouse.
Trying to keep inventory at manageable levels is never easy. It requires stronger cohesion between your sales, purchasing and inventory management departments. However, by using some simple rules your chances at lowering your costs of inventory greatly increase. Over time, you’ll begin to see what works, and what doesn’t. By managing your inventory with long term goals in mind, you’ll be able to identify those products where using your economies of scale is beneficial, and those products where contractual agreements make more sense.