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*** This article is the second in a series of three articles on inventory management. If you missed the previous article, click the link shown below. ***
Back to Part 1
Last week I covered the importance of tracking sales and ordering information related to your products. Most of the time, your accounting software can provide the information you need. However, be careful about putting too much faith in the Quantity on Hand reported by your software. Every once in a while, you should conduct a physical inventory to determine how many items are really in stock. The physical inventory is your opportunity to adjust for unexpected losses due to things like breakage and theft. Failing to account for these losses eventually catches up to you.
For an accurate Quantity on Hand figure, you or your software should adjust your inventory count as follows:
- Sales: decrease for each item you sell.
- Returns: increase for each item returned.
- Orders Received: increase by the quantity you receive from your supplier.
- Physical Inventory: increase or decrease to match the physical count.
So far, this may sound like pretty basic stuff, but as with most things, failure to nail down the basics comes back to haunt you later when you try to build upon them. You should integrate inventory adjustments and tracking into your standard operating procedures. If they are not integrated, they will fall through the cracks.
Speaking of standard procedures, this is a good time to talk about how often you place orders. Perhaps you operate in a reactionary mode, where you don't order things until you see that you are running low. That might work okay if you have few items and can guess how many you have at a glance. I'm going to show you some tricks let you operate in a proactive mode instead. Rather than react to a low stock situation or try to guess how many items you might need to order, I'll show you how to use your inventory statistics to accurately determine when and what you need to order. The first step in the process is determining your minimum stocking level, which defines your reorder point.
To simplify the calculations involved, the first thing you should do is establish a standard ordering period. I'm assuming that you don't have time to figure out what you need to order on a daily basis, so pick a time period that works well with the rest of your work load (e.g. weekly, biweekly, or monthly). There's a trade-off to keep in mind here: the longer your ordering period, the more inventory you have to keep on hand. Be sure to use your standard ordering period when determining your average and maximum sales figures.
The next thing you should do is figure out your order lead-time, and express it in ordering periods (round up any fractions). For example, your ordering period may be weekly, but if it takes ten days to receive an order, your order lead-time is actually two ordering periods. Keep in mind that order lead-time can vary by supplier and even by item in some cases. When you multiply your order lead-time (in periods) by your average number of sales (per period), you get Lead Time Sales, which is the number of sales you expect to have while you are waiting for an order to arrive.
A safety quantity is another thing you should consider in calculating your reorder point. Your safety quantity is the minimum quantity you want to have on hand in case you get more sales than usual. A conservative approach is to subtract the average number of sales you get during an ordering period from the maximum number sales you've experienced. That gives you enough to cover near-record sales. Alternatively, you can use zero as your minimum quantity and assume your sales will always be average.
Now you can easily calculate your minimum stocking level. This figure should be the minimum quantity on hand necessary to make it through to your next order. Just add your safety quantity to your lead time sales.
To boil it down, here's a summary of the terms we just covered:
- Ordering Period: The frequency with which you place orders.
- Order Lead-Time: The number of Ordering Periods that pass while you are waiting for an order (round up fractions).
- Lead-Time Sales: Average sales per period multiplied by Order Lead-Time.
- Safety Quantity (conservative): Maximum sales per period minus average sales per period. Adjust according to your own sense of risk aversion.
- Minimum Stocking Level: Lead-Time Sales plus Safety Quantity.
Note that you don't have to go through all of the calculations I just covered every time you place orders. You can just reuse your figures until you feel a need to update them due to changes in your business environment. In the next article, I'll show you how to use these figures along with your current period statistics to determine whether or not you need to place an order, and if so, how many items you need.
What's Your Time Worth?
Do you like the idea of managing your inventory in Excel,
but you don't have the confidence or time to set up a worksheet yourself?
Do you wish you had more background information on how and why the worksheet
works? We have a solution for you. Through the Logical Expressions Store, you can purchase the worksheet
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as well as an explanation of the inventory management theory behind the calculations. These two items
come packaged in an installation file that you can download and use immediately.
The Inventory Worksheet Package includes a more robust worksheet than the simplified one
demonstrated in this article series. It's additional features include:
- A product ID cell so you can note the product's part number.
- Bulk quantity cells so you can order by the case or other bulk unit of measure.
- Support for vendor-mandated minimum order quantity.
Save yourself some time. Buy the Inventory Worksheet Package today!
Continue to Part 3
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