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Inventory Analysis Simplified: Turnover, Customer Service Level & Stockouts

Inventory analysis refers to a set of metrics used to optimize inventory levels -- minimizing stock outs without overstocking. To remain liquid, you must turn inventory into cash so you can pay your bills, including employee wages. The more frequently you can turn over inventory, the higher your gross profits. Stock outs and backorders cut into gross profits, but so do overstocked items, known as safety stock. These items take up valuable space and require extra operations that drain cash from the business. In order to help you better analyze and manage your inventory levels, we’ve broken inventory analysis into a set of three standard equations you can easily compute. 1.        Inventory Turnover. “Turnover” means the number of times you sell, or turn over,  in a 12-month period. Higher numbers are better because each turn creates an opportunity to make money. In order to calculate this number, you must track the goods you sell from stock versus the goods you have to order to fulfill a sale. Notice that you exclude direct shipments and non-stock sales - these would inflate turnover. By using cost of goods sold (COGS) for a full 12 months, you avoid seasonal distortions. To calculate average inventory, average together the ending inventories over the last 12 months. As a side note, although you may use LIFO or FIFO for tax purposes, you should use average costs when calculating inventory turnover. If you are a manufacturer, use standard costs or replacement costs. You must use the inventory turnover metric in context with other firms in your industry. If your turnover is below the average of your competitors, you will want to take steps to increase it; which might involve changes in your selling, purchasing or manufacturing operations. 2.         Customer Service Level. Customer service level (CSL) is the number of line items of stocked products you ship complete within the promise date divided by the total number of stock product line items ordered. CSL measures how often you can satisfy a customer order with in-stock inventory items, so a good CSL indicates you understand customer demand.             With CSL, you only get credit for complete shipments -- if you ship 13 items but must backorder two, you get no credit. If you’re wondering about “partial credit”, you don’t get any because: a)   Now the customer has to look elsewhere for the missing items -- maybe with a competitor b)   Your customer is inconvenienced by having to process multiple receipts and you have the cost of filling two orders from a single transaction CSL excludes order types that do not reflect your ability to meet customer demand on the first shot. The excluded order types include special orders and drop shipments -- shipments sent directly from vendor to customer. While you might want to strive for a CSL of 100 percent, this level is usually unrealistic. If you were to plot quantity ordered on a single order (on the x-axis) versus the number of orders for an item, you’d get a bell-shaped curve with a peak at the average quantity on most orders. If you concentrate on a 95 percent CSL, you disregard the two “tails” of the graph which represent unusual orders. For the upper tail, which represents the 2.5 percent of your orders that are unusually large, you’d have to create massive levels of safety stock to satisfy them with an on-time single shipment - an expensive undertaking. graph073113 (Source: http://www.effectiveinventory.com/part-one/[LT2] ) 3.         Number of Stock outs. CSL, while powerful, might seem like a hassle to track and calculate. You can substitute a simpler metric, number and length of stock outs. This is the number of times you have to create a backorder and the average length of time it takes to correct the stock out. This is especially important for your fastest-moving products. If you must backorder these, you are understocking products critical to your profit margin. You are actually tracking two different problems with this metric. If your number of stock outs is high, you are under-ordering or under-producing and must pick up the pace, even if it means extra costs. If your length of backorder is long, it means you are either not giving your suppliers enough lead-time or your manufacturing operations are not optimal. If you are a distributor or merchandizer, you need to have your purchasers improve your sources of supply. If you manufacture your inventory, you must remedy the problems that lead to shortages. CONCLUSION By utilizing these equations and analyzing your inventory, you will be able to better manage your inventory levels. Optimizing inventory levels and minimizing stock outs will help your business become more profitable. Wasp Inventory Control, the complete inventory tracking system for small businesses, solutions can help you get control of your inventory quickly and effectively.