Inventory Methods and Metrics
Every organization that is engaged in the production, sale or trading of products holds inventory in one form or the other form. Manufacturing organizations typically hold raw material, work-in-progress, and finished goods inventories. Each category of inventory should be actively managed using appropriate methods and metrics.
Order Quantity and Timing
Raw material inventory management essentially deals with two major functions: inventory planning and inventory tracking. Inventory planners analyze demand and decide when and how much to order. A traditional inventory management approach can consist of a combination of the following three replenishment methods:
- EOQ: Economic Order Quantity method determines the optimal order quantity that will minimize the total inventory cost.
- Continuous Order Model: works on fixed order quantity basis where a trigger for fixed quantity replenishment is released whenever the inventory level reaches the predetermined safety level and triggers reordering.
- Periodic System Model: This model works on the basis of placing an order after a fixed period of time.
Each of the above methods involves analyzing and coordinating delivery capacity, lead times and delivery schedules of suppliers, and logistical processes and transit timelines involved in transporting and warehousing raw materials before they are ready to be supplied to the production shop floor.
Inventory in any organization can involve thousands of part numbers and millions of parts in quantity. Therefore, inventory is required to be classified logically in order to prioritize and facilitate management. In many organizations, inventory is categorized according to the ABC Classification Method. This method is based on 80/20 principles involving the relative value of the inventory units on hand. An illustration of the classification follows:
- A-Category Items Comprise 20% of SKU & Contribute to 80% of the dollar usage.
- B-Category Items Comprise 30% of SKU & Contribute to 15% of the dollar usage.
- C-Category Items Comprise 50% of SKU & Contribute to 5% of the dollar usage.
This kind of categorization of inventory helps to manage the entire volume and assign relative priority to the right category. For example, A Class items are the high value items; therefore, companies should monitor the inventory of this category closely to ensure the inventory level is maintained at optimum levels. Any excess inventory can have a significant adverse financial impact.
While inventory classification of raw materials for inventory management purposes can apply the ABC Classification, finished goods inventory is classified under additional categories based on various attributes including sales volumes/patterns, functional attributes, and operational requirements. At the very basic level, finished goods are manufactured and stocked separately, depending upon unique business unit and sales channel requirements.
Inventory Turnover is calculated by taking the Total Cost of Goods Sold, divided by Average Inventory. Adding beginning and ending inventory and dividing by 2 calculates Average Inventory.
A higher inventory turnover generally suggests a healthy trend of increased sales and the need to maintain adequate inventory levels to avoid stock outs. Inadequate stock can result in the loss of business opportunities and is something that management must monitor closely. On the other hand, a lower inventory turnover shows that either sales of the targeted inventory are slowing down or that the unused inventory is building up within the system somewhere. A slow inventory turn can help an inventory manager focus on finding non-moving, obsolete and slow-moving inventory items, and steps can be taken proactively to deal with the issues appropriately.
Inventory turnover also reflects the carrying cost that is incurred in managing inventory. Increased inventory turns reduce the carrying costs. The costs, especially fixed costs like warehouse rent, get distributed over higher inventory throughput; therefore, the unit cost of inventory transactions is reduced.
Inventory turnover is also indicative of the health of inventory operations. When inventory turnover is higher, all inventory operating efficiencies must be elevated in order to be responsive to market demand and customer satisfaction.