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Dealing with Items That Experience Sporadic Sales

by Jon Schreibfeder

Do the buyers in your company face a mountain of replenishment decisions every day? In the past several weeks I have worked with several firms that stocked more than 16,000 unique products in each of several warehouses. Their buyers seemed overwhelmed with the task of maintaining an adequate inventory of each of these items, most of which were not sold on a regular basis. At each company we worked to "tame the replenishment beast." In this article we'll look at how we decided to replenish items that are not sold or used on a regular basis. The first step in the process of developing a set of replenishment ground rules for these products is to separate items sold on a regular basis from those products that experience sporadic sales. To do this we sort all stocked products in each facility in descending sequence based on the number of times the product is sold, regardless of quantity. This process is commonly referred to as ranking by hits. Here is a summary of the 16,348 items stocked in one of our customer's warehouses: Number of Items Number of Hits 2,076 or 12.7% 2,501 or 15.3% 4,120 of 25.2% 7,651 or 46.8% 12 or more 6-11 2-5 Less than 2

Notice that only 2,076 or 12.7% of the items were sold, on average, at least once a month. The replenishment of these popular products should be micro-managed to maximize inventory turnover (i.e., the number of opportunities to earn a profit) while retaining a high level of customer service. Indeed most books and articles on inventory management (including ours) focus on maximizing the profitability of these items that customers request most often. Most if not all of the methods described in these publications involve a prediction of future demand based, at least in part, on a calculated average of past usage. Although the specific calculation may differ from method to method, most rely on the average or weighted average of the quantity sold or used over a specific period of time. But can these same rules be used to replenish items that are sold less than once a month? In this case that's 14,272 products or 87.3% of the stocked products in the

warehouse! Can you determine proper stocking level of these products based on an average of past usage? Let's look at an example. Consider an item with following usage history:

Ten pieces of the item were sold in December and another ten pieces were sold in March. The history displayed suggests that when customers order the product, they order 10 pieces. But any forecast demand formula based on an average (or weighted average) of past usage will calculate a forecast of future usage of less than ten pieces. To illustrate our point, we'll apply two common demand forecast formulas to our usage history: A. The Six Month Rolling Average Method that averages the usage recorded over the past six months: (10+0+0+10+0+0) 6 = Forecast of 3.3 units for April. This is well below the normal sales quantity of ten pieces. B. The Weighted Average Method that decreases the weight or emphasis of each month's usage history over the previous five months in the average usage calculation: Weight Usage (Emphasis) Extension 10 0 0 10 0 3.0 2.5 2.0 1.5 1.0 10 30 0 0 15 0 45

Month March February January December November Total

C. The total extension of 45 pieces is divided by the total weight of 10 pieces resulting in a forecast of April's demand of 4.5 units. Again this is well below the normal sales quantity of the product. We could apply other forecast demand formulas, but the results will probably be the same. The demand forecast will be less than the normal sales quantity of 10 pieces,

and as a result there will not be enough inventory on-hand to meet the customer's needs. An item experiences sporadic sales if its normal sales quantity is greater than the average quantity sold or used per month. In the example above, the normal sales quantity is 10 pieces while the average quantity sold per month is 3.3 pieces. If an item with sporadic sales should remain as a stocked product (the subject of next month' s article), its replenishment parameters normally cannot be determined using a forecast based on the average of past usage. A better way is to set minimum and maximum quantities based on the normal sales quantity. In the example above, you might set a minimum of 10 pieces and a maximum of 20 pieces. When the stock level of the product dropped down to 10 pieces (one normal sale quantity) a replenishment order would be issued for another normal sale quantity of the product. If due to the critical nature of the product (or to extended or inconsistent lead times) additional safety stock must be kept for the product, consider setting the minimum quantity to two normal sale quantities. On the other hand, if you are willing to risk a stock-out during the time it takes to order and receive a replenishment shipment set the minimum quantity to zero. In any case the minimum and maximum quantities for these items should be based on the normal sales quantity or the normal quantity used in an assembly or process. How do you determine the normal sales quantity? The easiest way is to divide the total number of pieces sold or used over the past 12 months by the number of orders for the product received over the same time period. For example: Total Pieces Sold or Used Over the Past 12 Months = 40 pieces Number of Sales and Requisitions = 4 pieces Average Sale Quantity = 10 pieces The average sale quantity often reflects the normal sale quantity. However its accuracy may be influenced by one or two unusual sales. A more accurate method of determining the normal sales quantity is to search transaction history for the mode in the transaction history of the product that is, the quantity that is most often sold or used. Although items with sporadic sales or usage do not (or should not) usually represent a large portion of your total inventory investment, stocking these items correctly is crucial to providing a high level of customer service. It does not make sense to stock these products unless you maintain the most commonly requested quantity in your warehouse. Next month, we'll look at when it is advantageous to stock items with sporadic sales, and how the cost of the item and vendor package quantities play a part in stocking decisions.
2001, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Liquidate All Slow-Moving Inventory?

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Liquidate All Slow-Moving Inventory?


by Jon Schreibfeder

You want to stock the products that your customers request most often in your warehouse(s). But what about products with sporadic sales, or no sales at all? A recent article (not by this author) suggested that you should discontinue and liquidate the stock of any product that is not sold or used on a regular basis. No exceptions. Clean them all out! Or so the author said. But do you really want to do this? We don't think so. Most distributors and manufacturers should maintain a stock of some slow-moving products, and even products that have never been sold, in order to maintain a high level of customer service and enhance their corporate profitability. Why?

A Product May Have "Critical" Qualities


What is a critical product? It is something that is needed to maintain the throughput or output of a manufacturing production line or is necessary to maintain a vital function or process. If this piece broke or was inadvertently removed from a machine or the production process, a company or its customer would suffer significant or even tremendous losses from lost production (or the temperature in someone's home would drop below freezing in the middle of winter). Even though a product is infrequently taken from stock (or may have never been taken off the shelf), the item must be available for immediate delivery if it is ever needed. Every business needs to create its list of critical repair products. But as you add each item to this list, consider two questions: Is the item "critical" or merely "important"? A critical part not only shuts down a machine, it shuts down an entire process or vital service. For example, one of our customers is a food processor. They have one large mixer that is used to combine the ingredients necessary to make any of 25 different products. If the mixer is out of service, none of the 25 products can be produced. The company keeps on-hand in their inventory a spare piece of every component of the mixer. On the other hand, the company has 10 identical wrapping machines. If one wrapping machine breaks down, its

workload can be reassigned to the other machines. Production might be delayed for a couple of hours, but the process would not be shut down. The spare parts for the mixer are critical inventory. Those for the wrapping machine are merely important and can be ordered as needed for next-day delivery. Keep in mind that a critical item has the potential, on its own, to shut down a process. When creating your critical item list be sure to note the process that is dependent on each product. How long can the company do without the process associated with this critical part? Will a stock-out of this item definitely result in a crisis? Another one of our customers is a utility company on a remote island. They have to keep more spare parts on hand than a utility company located in a metropolitan area. Why? Because the second company can get many parts from a number of local suppliers within an hour or two, while the island-based company has a minimum two- to three-day lead time for any product. Most consumers would tolerate (though with some annoyance) an hour-long blackout. But what about a power shortage lasting three days?

The Relative Cost or Profit of the Item


Besides being a critical item, it may be less expensive to stock an inexpensive product than to bring it in to fulfill specific customer orders. Imagine a faucet washer that costs ten cents. Your best customer uses two a year, but your normal vendor sells them in a package of 12. Buying 12 pieces provides you with a six-year supply of the item for $1.20. Maintaining this item in inventory is considerably less expensive than buying one or two pieces whenever they are needed from an alternate source of supply. Keeping several years' supply of selected inexpensive products on the shelf will not have a great effect on your company's overall profitability. And by putting a significant amount of these items in inventory, you won't waste your buyers' time forcing them to continually deal with these "nuisance" items. Concentrate on ensuring you have the optimal quantities of those items that have the most dollars flowing through your warehouse. High-profit, slow-moving items may also represent a good inventory investment. The gross profit that results from each sale may be so large that it offsets the cost of carrying the inventory for a prolonged period of time. But how can you be sure?

Use the Adjusted Margin Analysis To Justify Stocking All Slow-Moving Products
In the article, "Are You Making Money?", we introduced the concept of adjusted margin analysis. This analysis subtracts the cost of carrying inventory from the gross profits generated from the sale of specific items. Review this article and use its analysis to justify stocking each and every slow-moving product.

Critical items may not have an adjusted margin that is equal to or greater than the other costs the company incurs in the course of doing business. But they should be associated with other items whose profitability is large enough to compensate for carrying the average investment of these products. The adjusted margin analysis will also identify the actual profitability of slowmoving products that experience high gross margins.

Most companies have to maintain slow-moving products in inventory. However, you must be sure that each of these items improves your overall customer service and/or your company's net profitability. Next Month Should the stock in a branch location be replenished from a central warehouse or direct from a vendor?
2001, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Varying the Carrying Cost for Individual Products


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Varying the Carrying Cost for Individual Products


by Jon Schreibfeder

It is important to know your cost of carrying inventory. It is a critical factor in deciding what products to stock and when to reorder them, as well as the best quantity to order. Too often companies and organizations use an imprecise "rule of thumb" to estimate their cost of carrying inventory. The result: Bad inventory management decisions.

In a previous article, "The Mysterious Cost of Carrying Inventory," we gave you some direction for calculating an overall cost of carrying inventory for your entire company or an individual warehouse. The calculation considers these expenses and alternative opportunities for revenue:
y y y y y y

Moving material from the receiving dock to the proper bin location and shifting it to other warehouse locations as necessary. Rent and utilities for the portion of your warehouse used to store material. Inventory shrinkage and obsolescence. Physical inventory and cycle counting. Insurance and taxes on the inventory. Opportunity cost of the money invested in inventory that is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment. Or, if you finance your inventory purchases, the amount of interest that you pay the bank.

The sum of these factors is divided by the average inventory value to determine an overall carrying cost percentage that is, what it costs to maintain a dollar's worth of inventory in your warehouse for an entire year. But some companies find that it costs more to stock some items. Maybe they take up more space or are more susceptible to shrinkage and obsolescence. If the carrying cost percentage is used in so many critical inventory-related decisions, doesn't it make sense to calculate as accurate a carrying cost as possible for each product? If you believe that your cost of carrying inventory may vary for different segments of your inventory, consider calculating a cost of carrying inventory for each item.

Insurance, Taxes, and Opportunity Cost


To determine the specific carrying cost for a product, we first have to determine what factors of the carrying cost will not vary by item. These are the factors that are solely dependent on cost or value of the average on-hand quantity:
y y

Insurance and taxes Opportunity cost of the money invested in inventory

If you take the total amount of these two elements and divide it by the average inventory value, the result is the cost of these elements per dollar of your average inventory investment. We will call it the ITO (Insurance, Taxes, and Opportunity Cost) factor.

Shrinkage and Obsolescence


Shrinkage and obsolescence includes any stock material that is purchased but not sold, used to provide a service, or is part of an assembly or finished good. This

includes material that is lost, stolen, broken, scrap, or becomes obsolete in our warehouse. Some products are more susceptible to shrinkage and obsolescence than other items. We need to determine factors for these two important components of the carrying cost. To calculate a shrinkage factor for a specific item, divide the total amount of adjustments due to shrinkage (material lost, stolen, broken, or considered scrap) recorded in the past 12 months by the total stock receipts for the product during the same time period. Why don't we use the average inventory value in this calculation? Because all inventory adjustments are already reflected in the average inventory value. We want to determine how much of the total quantity of the inventory that was received could not be sold, used in production, or used to service a customer. Many companies calculate a shrinkage factor for an entire product line, rather than for individual items. This allows a shrinkage factor to be applied to products that have not yet been inventoried for a full 12 months. To get an accurate obsolescence factor, we usually have to use a longer time period. For example, if you normally consider inventory obsolete after it has been in your warehouse for 12 months, you might want to divide the amount of write-off adjustments made this year by the total amount of stock receipts for the item last year. Why? Because any material written off due to obsolescence this year was probably received last year. Again, it might be more meaningful if you calculate an obsolescence factor for an entire product line rather than an individual product. If you don't liquidate obsolete inventory on an ongoing basis, you may also want to vary the time periods you consider in this analysis. For example, one of our customers had a large obsolescence write-off last year that covered material that had been received anywhere from two to five years ago. To calculate their write-off factor, we divided the amount of adjustments due to obsolescence over the past two years by the total amount of stock receipts recorded in that two- to five-year period.

Physical Inventory and Cycle Counting


Most companies count their fast-moving items more often than their slow-moving products. And some products are easier to count than others. As a result, the "cost of counting" can vary from one item to another. In calculating the counting element of the carrying cost, we usually start by grouping similar stocked items that are stored in similar storage units. We then determine the average number of products in each group that can be counted in one hour as well as the labor cost of performing the count. This cost includes the time spent:
y y y

Performing the actual count Entering the count information into the computer system Reconciling any discrepancies in the count

The total cost per hour is divided by the number of products that can be counted in that hour. The result is then multiplied by the number of times each product is scheduled to be counted in a year to arrive at the total cost of counting a specific product.

Rent, Utilities, and Moving Material


Some items take up more space, and are harder to handle, than other products. Many companies feel that items that take up more space should absorb more of the total cost of carrying inventory. In order to apportion the cost of space and material movement to individual products or product groups, we must determine how much of the total space used to store products is being used by an individual item. 1. Calculate the total cost of rent and utilities for the portion of your facility used to store inventoried products as well as moving material in that area. 2. Determine the total cubic volume of space currently used to store stock material. This may not be the total cubic warehouse space. For example, if you just moved into a new warehouse and are using just 25% of the available space, the inventory stored in that area would still need to absorb 100% of the cost of rent, utilities, and moving material, not just 25% of the total cost. 3. Divide the total cost by the total cubes used to store material in order to determine the storage cost per cube. 4. Determine the total cubic volume assigned to a particular product a. If you are utilizing fixed bins (i.e., a specific space reserved for an specific item), this is the total cubic volume allocated to the product. b. If you are utilizing random bins (i.e., quantities of the product can be stored in any open warehouse location), determine the cubic volume of the average on-hand quantity of the product. c. Some companies store a particular product in both fixed and random bins and have to combine the two factors that is, they must add the cubic volume of the total fixed bin space allocated to a product to the cubic space necessary to store the average amount of the same product stored in random bins. 5. Multiply the cubic space assigned to an item by the cost per cube to determine the utilities rent and material movement expense that should be allocated to the item.

Accumulating the Costs


Now we can calculate the specific cost of carrying a specific product or group of products in inventory by totaling the five components:
y

Insurance, Taxes, and Opportunity Cost: Multiply the ITO factor (calculated above) by the average inventory investment of the item or group of items.

y y

Shrinkage Cost: Multiply the calculated shrinkage factor by the average inventory investment. If history is any indication, this portion of the average inventory value will eventually be lost, stolen, misplaced, or broken. Obsolescence Cost: Multiply the calculated obsolescence factor by the average inventory investment. Again, if history is any indication, this portion of the average inventory value will eventually be classified as obsolete inventory. Cost of Counting: Add the annual cost of counting the item. Cost of Rent, Utilities, and Moving Material: Add the calculated annual cost that was based on the cubic volume of space required to store the item.

Divide the sum by the average inventory investment for the item to determine the product's specific carrying cost percentage. Is this a lot of work? Of course. But if significantly different amounts of effort are necessary to maintain individual inventory items in your facility, the exercise may be worthwhile. Remember that the cost of carrying inventory is one of the keys to effective inventory management, and that accurate information usually leads to outstanding results!
2001, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: A Questionnaire for New Inventory Items


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A Questionnaire for New Inventory Items


by Jon Schreibfeder

In the past several months we've published several articles concerning the risk of new inventory items becoming dead stock. We've emphasized that you must carefully consider each new stocking opportunity. Unfortunately the decisions concerning stocking new products are usually still based on emotion. Several of our customers have asked us to help them turn these emotional decisions into rational business evaluations. In response to these requests we've developed a questionnaire for salespeople to fill out when requesting a new inventory be stocked. In this article, we present the questions contained in a sample questionnaire along with some advice for analyzing the responses. The questions are in bold letters and the commentaries are in italics. A brief discussion on the analysis of the sales of new inventory items follows the questionnaire along with some ideas for determining commission rates for these products.

Questionnaire
This questionnaire must be completely filled out by the appropriate salesperson. If a salesperson does not have the information necessary to fill out the questionnaire, he/she has not performed the analysis necessary to properly determine the market potential of the new product. Here is the content of a sample questionnaire, along with some suggestions for evaluating the responses: Date Salesperson What is this salesperson's track record (see the Analysis section below) for introducing successful new products? Speculating on what products might sell (especially products requiring a significant investment) is an activity that should be reserved for salespeople with a history of successful product introduction. Location What company locations should initially stock the product? Can it be testmarketed in one location? Customer or Potential Customers If the product is going to be used by only one customer, the risk of the product dying in inventory is much higher than if there were multiple potential customers. If the product is going to be bought by only one customer, be sure that that customer has met his previous commitments for purchasing special order products. If he/she has not, consider asking for a written commitment to purchase at least 75% of the initial purchase quantity. Product

Reason for the product to be added to inventory that is, how will the customer(s) use the product?
y

In an existing application or process?

If the product was previously purchased from another supplier, why did the customer decide to switch vendors? Be sure to have your accounts receivable department perform a credit check with the previous supplier to ensure that they are not on credit hold with that vendor. If the product is replacing another stock product, how will the remaining stock of the old product be liquidated? Has the purchasing department been notified to discontinue or modify the purchasing parameters of the old product?

In a new application or process?

What is the customer's potential market for the new product? The smaller his/her potential market, the greater the chance the customer will not be able to meet his/her purchase commitments.

At what rate will the new product be used/consumed?


y y

What is the source of this prediction? How reliable has this source been in the past?

How much product will be purchased in the initial order? It is usually not a good idea to purchase more than a projected two-month supply of any new stock item. Because the forecast demand quantities of new stock items are historically inaccurate, there should be a substantial difference in cost to purchase a larger quantity of the product. Can a smaller initial quantity be purchased, even at a higher unit cost? It is normally better to lose money on a small quantity of a new product (i.e., a test market) than to obtain a low unit cost and end up with a large amount of dead inventory. If the small initial quantity sells within a reasonable amount of time, it is probably safe to issue a purchase order for a quantity that will provide the cost necessary to achieve the target gross margin. What is the liquidation cost/value of this material per unit?

If there is a cost of disposal for expired quantities of this product, the initial purchase should be for the smallest practical quantity for test-marketing purposes.

Compensation
Consider a two commission rate structure for new inventory items:
y y

If a product's sales meet or exceed sales projections (to date), the salesperson will earn a full commission on all sales of the product. If a product's sales fall below sales projections, the salesperson will earn a half commission on sales of the product, until sales meet or exceed the projections provided by the salesperson.

Analysis
Every week a report should be produced listing the status of every product that has been in stock for less than six months. The report should list the following information:
y y y y y y y y y y

Product number and description Current month sales (in units) Sales projection for the current month (provided by the salesperson before the item was added to inventory) Total sales (in units) to date Total sales projection to date (provided by the salesperson before the item was added to inventory) Current on-hand quantity Minimum stock level of the item Maximum stock level of the item Name of the salesperson who requested that the item be stocked Reason why the item was added to stock

Detailed records should be maintained, by salesperson and customer, for new stock items that do not meet six-month sale projections. Also track, by salesperson and customer, the recovered value and any disposal cost of liquidated quantities of new stock items.
2001, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: A Key to Accurate Demand Forecasting


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Effective Inventory Management, Inc. 120 S Denton Tap Rd, Ste 450-200 Coppell, TX 75019 (972) 304-3325 Fax: (972) 393-1310 Email: info@effectiveinventory.com

A Key to Accurate Demand Forecasting


by Jon Schreibfeder

I received a call from one of my customers this afternoon. "Jon, something is wrong with my demand forecast. We usually have a sharp drop in usage in January because several customers have shutdowns. But the forecast is recommending we stock almost twice as much as we did last year. We need a better forecasting model." We had worked extensively with this customer to develop a comprehensive set of forecasting models that I was pretty sure would provide reasonable estimates of future usage. I looked at the customer's data to try to determine why the system was producing an inaccurate forecast. I paid particular attention to the usage recorded in the previous November through March (the months surrounding January):

"Mike," I said, "I'm looking at last year's usage history and I don't see a decrease in usage in January. In fact, January's usage of 1,390 pieces is close to 15% higher than December's usage of 1,210 pieces." Mike quickly responded, "That's impossible. Let me look at the data." The phone was silent for a few minutes before Mike sheepishly came back on the line. "Now I remember what happened. Right after our year-end physical inventory we liquidated 790 pieces of excess stock with a broker. We never adjusted our usage history to take out that unusual sale." Today's competitive market requires accurate forecasts for the future demand of each product in inventory. We are constantly looking for ways to reduce the forecasting

error (i.e., the difference between a forecast and the resulting usage). But these efforts are often frustrated by unusual activity imbedded in historic usage data. Most computer systems realize the importance of usage history that is not exaggerated by unusual activity. They try to identify, and possibly correct, possible unusual usage. A common method used by many computer systems compares the usage recorded in the inventory period just completed to the total usage in the several previous inventory periods. One of the proponents of this method is recently retired inventory guru Gordon Graham. He long advocated that a company might have experienced unusual usage in the month just completed if the usage in that month was greater than the total usage in the five previous months*. For example:

The usage of 2,500 pieces in June is greater than the total usage of 1,825 (410+290+375+450+300) pieces recorded in the five previous months. But this method would not have identified my customer's January usage as unusual:

Note that January's usage of 1,390 pieces is not greater than the total usage of the five previous months. In fact, unless you knew about the anticipated drop in usage due to customer shutdowns, it would be hard to detect any unusual activity. For this reason, unusual usage should not be identified by comparing usage in the month just completed to the usage recorded in previous months. It should be identified by comparing usage in the month just completed to the forecast of usage in that month. There are software packages that compare the forecast of demand to actual usage and automatically adjust usage for any suspected unusual activity. One system presumes that any usage is greater than x%, or less than y%, of the current forecast represents unusual activity that probably will not recur. This system will correct the usage for the inventory period to equal the forecast plus x% or the forecast minus y%:

In the example above, both the high and low limits for unusual usage are set to 75%. The high limit for usage is the forecast of 164 pieces plus 75%, or 287 pieces. If the actual usage for the inventory period was more than 287 pieces, it would be corrected with a reduction to equal 287 pieces. The low limit is 164 pieces less 75%, or 41 pieces. If the actual usage for the inventory period was less than 41 pieces, it would be increased to equal 41 pieces. Other systems correct usage in a similar way using statistically calculated standard deviations. Unfortunately this method does not always accurately correct unusual usage activity. To understand why, we must look at the three reasons why actual usage might deviate significantly from the forecast: 1. Unusual usage activity that will probably not occur again in the future. 2. The start of a significant new trend in the usage of the product. 3. The wrong forecast formula or method being applied to the item. The process of automatically adjusting history for unusual usage will address most unusual activity that will probably not recur in the future. But if a product suddenly gains or loses popularity, automatic usage adjustment might actually remove significant usage history. For example, if a product suddenly experiences a 150% increase in usage in one month and the product is destined to remain popular, automatic adjustment will take sales that will probably occur again out of usage. The result will be future forecasts that will not accurately reflect your customers' needs. And, if a system continually corrects usage to be no more than a certain percentage of the forecast, how will you ever know if the usage activity is actually normal, but you are using the wrong forecasting method for the item? We have found a better method is for a computer system to identify, but not correct, items that might have experienced unusual usage activity. Buyers, planners, and/or salespeople review the list of items and determine whether unusual activity actually occurred, a significant new trend has begun, or the wrong forecasting method has been applied to the item. They can then manually adjust actual usage to reflect what usage would have been had no unusual activity occurred. For example, a system might list items whose usage was more than 300% (i.e. three times) of the forecast or less than 20% of the forecast. The buyer or other appropriate employee would then review the list of products and make usage adjustments as necessary. Advanced systems allow the user to vary the definition of unusual activity for different types of products. For fast moving "A-ranked" products it might be

important to see any situation where usage is more than twice the forecast (for example, if the forecast for an item was 10,000 pieces and actual usage exceeded 20,000 pieces). At the same time, unusual activity for a slow-moving product might be anything more than 400% of the forecast. The forecast for an item might be one piece, and unusual activity might be usage of more than four pieces in the month. Regardless of how your system identifies unusual usage, in order to accurately forecast future demand of products it is imperative that historical usage be corrected for any unusual activity.
*Graham, Gordon, Distribution Inventory Management for the 1990s, Inventory Management Press 1987, page 77. 2001, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Is It Sporadic or Is It Seasonal?


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Is It Sporadic or Is It Seasonal?
by Jon Schreibfeder

It is no secret that an accurate forecast of the future demand of a product is crucial in achieving the four "rights" of effective inventory management: that is, getting the right quantity of the right item to the right location at the right time. As we've discussed in previous articles, products with different patterns of usage require different forecasting methods. The forecast for items with recurring usage is usually based on four elements:
y y

Some sort of average of past usage. A trend derived from past usage.

y y

Future anticipated usage that is not revealed in past usage or trends. A forecast horizon reflecting when material ordered today can be received and the length of time for which inventory must be purchased.

If an item has recurring usage (that is, it is sold or used on a regular basis) we can test various formulas that apply different factors to each of the four elements to determine the best method of forecasting future demand of each item. But applying these elements to an item with sporadic activity (i.e. one that is not sold on a regular basis) produces strange results. Look at the usage history of this item:

This product is not sold that often, but when it is sold the customer wants 12 pieces. Any forecast formula that includes some sort of average of past usage will probably base the product's replenishment parameters on an average usage per month of about three pieces (36 pieces 12 months). Will stocking the product based on selling an average of three pieces per month satisfy our customer? Probably not. When they order the product they request 12 pieces. This typical purchase quantity should serve as the basis of our minimum and maximum quantities. Maybe we will reorder 12 pieces of the item when there are 12 left on the shelf. Or maybe we are willing to risk a stock out and will wait until the stock of the item is completely depleted before we order 12 more pieces. Because different methods are used to control the replenishment of products with recurring and sporadic usage, it is imperative that we are able to accurately and consistently identify whether each stocked product falls into one category or the other. Sporadic usage items are sold infrequently, maybe in less than six of the past 12 months. Can we say that any item with usage in less than six of the past 12 months has sporadic activity? The item in the above example meets this criterion, but so does this one:

The product is only sold in five months out of the year (June through October). But does it have sporadic sales? No. The product appears to have recurring sales during a specific season of the year. If the average sale quantity of the product was one piece, and we based our replenishment parameters on this "normal" transaction, our company would probably experience significant stocking problems. This item is probably best forecast using a seasonal formula that includes all four elements for forecasting items with recurring usage. But how do you differentiate between items with sporadic sales and seasonal items? Retired industry "guru" Gordon Graham in his book, Distributor Survival in the 21st Century, suggests that an item is usually seasonal if 80% or more of the sales in the

previous 12 months occurred in just a six-month time period*. The item in the last example meets Gordon's seasonal criteria, but look at the usage of this next item:

Four of the five pieces (i.e. 80% of the total) were sold in a six-month period. But this appears to be a product that experiences sporadic, not seasonal usage. Graham recognized this problem. He suggested that a buyer manually review each item selected by his 80% rule and determine whether it has seasonal or sporadic activity. For many companies that means sifting through thousands of product history records. That's a lot of work and there is a strong possibility that some items will be misidentified or overlooked. Other forecasting methods differentiate between seasonal items and those with sporadic sales by examining the total usage in a twelve-month period. Items with sporadic sales should have low total usage (say, less than 12 pieces per year). Right? Well, what if you sold a large quantity just two or three times a year:

Should the purchasing parameters of the above item be based on an average quantity sold per month of 100 pieces (1200 pieces 12) or the normal usage quantity of 600 pieces? The "Total Quantity" maxim doesn't reliably differentiate between items with a high volume of sales in a limited number of transactions and those that have recurring usage activity. We think we've found a better way to identify sporadic items. Actually, it is a simple, reliable way to identify items that do not have sporadic activity! We start by dividing the past 12 months into nine four-month groups:

If a product does not have usage in at least three of the four months or at least one of the nine four-month groups, it is identified as having sporadic usage. Let's take another look at the item in the last example:

Notice that none of the nine groups has usage in three or four months therefore it is correctly identified as having sporadic usage. Let's see if this method of identifying seasonal items will work with other items we've examined: Example #1:

Because no group contains usage in three or four months, this is a item with sporadic usage. Example #2:

Note that the item was sold in three or more months in groups five, six, seven, and eight. This product definitely has a seasonal usage pattern, not sporadic sales. Once we've determined that an item does not have sporadic usage, we can test several formulas (both seasonal and non-seasonal) to determine the best forecasting method for that particular item. Minimum and maximum quantities for the sporadic usage items will be based on the normal sales quantity.

It's easy to see that forecasting future usage of an item using an incorrect formula will result in stocking the wrong quantity of the wrong item in the wrong location at the wrong time. To achieve effective inventory management, it is essential to be able to differentiate between items with sporadic sales and those with recurring usage activity.
*Graham, Gordon, Distributor Survival in the 21st Century, Inventory Management Press 1992, page 40. 2002, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Achieving Cycle Counting Success


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Achieving Cycle Counting Success


by Jon Schreibfeder

In previous articles we've described cycle counting, the process of counting some stock items or warehouse locations every day, as a valuable tool in ensuring the accuracy of your perpetual inventory. We've seen numerous cases in which organizations, after implementing a comprehensive cycle counting program, have had a much more accurate perpetual inventory than they had when they performed full physical inventories. Because accurate on-hand quantities are vital to both providing outstanding customer service and maximizing inventory turnover, it is not surprising that more and more distributors and manufacturers are implementing cycle counting programs. But cycle counting programs can be difficult to maintain over a long period of time. Many firms become frustrated with the "coordination" problems inherent in cycle counting that are usually not found in a full physical inventory. When companies

conduct a full physical inventory, they temporarily halt all normal material movement that is, they stop filling orders, putting away stock receipts, shipping material, etc. Before this is done, a special effort is made to ship as many orders as possible and put away all stock receipts. During the actual counting process the business is virtually closed down. Counters do not have to worry about someone doing something that will affect the quantity in stock during the full physical inventory process. Extensive preparation is necessary for a full physical inventory. It is not practical to complete this preparation before each daily cycle count. It is equally difficult to conduct cycle counts only when a business is closed and there is no material movement. After all, cycle counting should be performed every day. Even if a company counts before or after normal working hours when there is little or no material movement, paperwork involving items being counted can be "floating" somewhere in the warehouse or office. For example, a quantity of an item may have been pulled from the shelf but not yet shipped. Or a stock receipt for a product may have been put away but not yet entered into the computer system. Because of these issues, it is necessary to reconcile cycle counts to determine if a particular count discrepancy is an actual shortage or overage, or just the result of floating paperwork. Because paperwork is often scattered in numerous places throughout the office and warehouse, it is not surprising that many firms spend more time reconciling a cycle count than they do actually counting products. Some firms have found the process so frustrating that they have abandoned their cycle counting programs. The implementation of radio-frequency (RF) bar code equipment can almost eliminate cycle count reconciliation problems. In most RF warehouse systems, the on-hand quantity in the computer is updated as soon as material is added to, or removed from, a bin location. There is no "time lag" in updating computer records. Therefore whenever someone cycle counts a product, their count should match the computer's on-hand quantity. But RF systems are cost-prohibitive for many companies. Is there a way to implement a successful cycle counting program without RF equipment or devoting an inordinate amount of time to the reconciliation process? The answer is yes. Here is an outline of a set of procedures we developed to accomplish this task: 1. Early each morning (or just before leaving on the previous day) the cycle counter receives the list of products to be counted that day. 2. As soon as he or she receives the list, the counter goes to each warehouse location containing a product to be counted and puts a temporary label on the bin reading "Product Being Cycle Counted". The counter also places a card in the bin to record all material movement of the product before the cycle counting process is completed. This card contains the following information in the header: o Date o Item o Bin Location

Four columns on the card allow anyone removing material or placing stock in the bin to record that transaction: Time Type of Transaction (Normal Order, Handwritten Order, Confirmed Order, Stock Receipt, Sample, etc.) o Order Number o Quantity After the cards and labels have been distributed, the counter will note the time, and print the count sheet to record the quantities of the items being cycle counted. He or she will then proceed to count the items. Whenever an employee fills an order or puts away a stock receipt for an item being counted, he or she will note the time, type of transaction, order number, and quantity involved on the card that was previously placed in the bin. As an item is cycle counted, the cycle counter will look at the transactions listed on the card, comparing the time of each transaction to the time of the count: o Quantities on customer orders, work orders, outgoing transfers, and other material disbursements removed from the bin before the count was taken will be added to the quantity actually counted. The result represents the on-hand quantity of the product when the cycle counting process began. The computer's on-hand quantity for these orders has not yet been reduced, but the material has been removed from the shelf. o Quantities on stock receipts placed in the bin before the count is taken will be subtracted from the count quantity. These quantities were not included in the computer's on-hand quantity at the beginning of the cycle counting process. If there is a discrepancy between the quantity listed on the cycle count sheet and the on-hand quantity, the cycle counter will note the discrepancy, not the actual quantity on hand. For example, he or she might note "-2 pieces" if the sheet says there should be 42 pieces and the actual on-hand quantity is 40 pieces. Noting the difference rather than the actual quantity will allow the perpetual inventory system to be updated any time after the cycle count has been completed, even after additional transactions for the item have been processed! As the counter finishes the count of each item, he or she will remove the count label and count card from the bin. If there are discrepancies between the computer's perpetual on-hand quantity and the quantity actually counted, the counter will proceed to the staged orders, will call, and tag and hold areas of the warehouse. All paperwork for these filled but still-open orders should be kept in one place. The counter will look through the orders looking for any quantities of items that were counted that day but not yet confirmed in the system. These quantities will be added to the quantity he or she actually counted. If this process is cumbersome and time consuming, consider developing a computer report that lists, by part number, all outstanding orders.
o o

3.

4.

5.

6.

7. 8.

This simple process has the potential to dramatically cut the time necessary to perform daily cycle counting. No longer will people roam around your facility trying

to determine if a particular order was picked or put away before or after a product was cycle counted. The result: More accurate inventories with less effort and frustration, a winning combination for any organization. Why not try this method? It could turn out to be a very valuable tool in your quest to achieve effective inventory management!
2002, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Adjusting Usage for Lost Sales


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Adjusting Usage for Lost Sales


by Jon Schreibfeder

A customer requests a product and it's not in stock. They can't wait for you to obtain the item so they purchase it elsewhere. You've lost a sale. That means you have lost the opportunity to earn a profit, disappointed the customer, and probably put some doubt in his or her mind about your reliability as a supplier. A lost sale is not a good thing. But a lost sale is made even worse if you don't use it as an opportunity to evaluate and possibly revise the replenishment parameters for a product tThat is, to try to prevent future lost sales. Indeed, many companies try to capture all unfulfilled customer requests and add them to the actual usage recorded for a specific inventory period. They believe that by including these lost sales in usage history, future demand forecasts will be adequate to cover the unfulfilled sales or usage experienced during the current inventory period. But there are some inherent flaws in this practice:

Your Salespeople May Not Consistently and Accurately Record Lost Sales: Most companies do not experience a consistent level of sales activity throughout the day. Often, customer orders (or customers themselves) arrive in spurts. During these hectic periods, salespeople may not have the time to accurately record what customers request. They are too busy processing actual orders. A Single Request May Be Repeated: A customer calls today and asks for a product that is not in stock. A lost sale is recorded. They call again tomorrow to see if the item has been received, but they talk to a different salesperson. The product is still out of stock and another lost sale is recorded. You have recorded two lost sales for the same request. If lost sales are automatically added to usage, you have captured false or "phantom" demand for the product. An Area-Wide Shortage May Cause a Greater Than Normal Number of Requests: If your competitors are also out of a product, their customers may call your salespeople looking for the item. If all of these requests are treated as lost sales and added to usage, you may again capture phantom demand for the product. As part of a comprehensive customer relationship management (CRM) program, it is important to capture lost sales in order to see what customers are not being adequately served. Indeed, your sales manager probably wants to know if your most important customer requested an out-of-stock product five days in a row. But as we've seen, adding lost sale quantities to actual usage may not truly reflect the quantities of a product actually needed. The adjusted figures may distort future demand forecasts and result in either additional lost sales or excess inventory. We've found that there is a better way to adjust actual usage for lost sales. This method does not require sales people to accurately record customer requests and protects you from capturing phantom demand. As with other aspects of our inventory management philosophy, we have different recommendations for items with recurring activity (i.e. those that are sold or used on a regular basis) and those with sporadic usage.

Recurring Items
These products are sold on a regular basis. As these are the products customers request most often, it is important to correct for out-of-stock situations in order to ensure a high level of customer service. 1. Specify whether each of these inventory items will or will not accumulate backorders. If an item will accumulate backorders, customers will wait for you to receive the product. As a result, these items tend not to experience lost sales. If the product will not accumulate backorders, customers will go elsewhere to obtain the item. These are the items that will probably experience lost sales. 2. At the end of each inventory period (i.e. week, month, four-week period, etc.), record the number of days each product was out of stock.

3. For items that will not accumulate backorders, multiply the days out-of-stock by the forecast demand/day and adjust monthly usage by this quantity. For example, say a very competitive popular product was out of stock for six days during the month that just ended and the forecast for the item was seven pieces/day. Forty-two pieces (six days x seven pieces/day) will be added to the month's actual usage to compensate for possible lost sales.

Sporadic Items
These are items that are not sold on a regular basis and whose replenishment parameters are based on the normal quantity sold or used in one transaction as opposed to the forecast demand for an upcoming inventory period. 1. Record the number of times a product is out of stock (or its available quantity drops below the normal or average sales quantity). 2. If the product is out of stock more than one or two times in a six month period, automatically increase the minimum quantity for the product by the normal quantity sold or used in one transaction. For example, a specific type of seal is used when a certain engine is rebuilt. As two seals are required in the process, a distributor maintains the stock of the item with these replenishment parameters: Minimum Quantity = 3 Maximum Quantity = 4 When the available quantity falls below the minimum of three pieces (i.e. when two seals are left on the shelf), another two pieces will be ordered to bring the maximum stock quantity to four pieces. But because the item was out of stock two times in a six month period, the system will increase the minimum to five pieces and the maximum to six pieces. Now the item will be reordered when the available quantity falls to four pieces that is, when there is still enough stock to rebuild two engines. Note that to avoid an unrealistically large inventory investment, most organizations will tolerate a certain number of stock-outs of non-critical sporadic-usage items. That is why we normally will wait for several stock-outs to occur over a certain period before making the adjustment. However, this rule is not "cast in stone," and should be adapted to each company's specific situation and needs. As I've said many times, a good forecast is the foundation of an effective inventory management program. The better the prediction of future demand of a product, the easier it will be to provide a superior level of customer service while minimizing your overall inventory investment. Correcting actual usage for lost sales opportunities is an essential part of the forecasting process. But to be effective, these corrections must predict, as accurately as possible, what would have been sold or used had the item continuously been in stock.

2002, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Controlling Open-Stock Inventory


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Controlling Open-Stock Inventory


by Jon Schreibfeder

When the stock level of an item falls below the minimum quantity, it is time to reorder the product, right? But we've found some instances where it is difficult to maintain accurate stock levels because it is impractical to record each individual material disbursement. For example:
y y y y

Items like pencils, pens, and other office supplies stored in a supply cabinet. Nails, screws, and similar items that are sold from open containers in hardware stores. Fasteners, solvents, and other items that are used as needed in an assembly or repair process. Sugar packets, complementary bottles of shampoo, and other amenities provided to guests in restaurants and hotels.

These are usually very inexpensive products that are taken from stock as needed by the user. But most of these items do have significant usage. And in many cases, a company would suffer a hardship in the event of a stock-out. After all, a product does not have to be expensive in order to shut down production or to be deemed important by customers. If each material disbursement is not recorded, how do you know when to reorder the product? How does a buyer know when the stock level of the item falls below its

minimum quantity? How do you record usage to forecast future demand of the item? In other words, how do you maintain effective inventory management of these items without accurately recording every material disbursement? It is easy. We change our focus and don't concentrate on what people are using or buying. We track the rate at which we have to replenish the "open stock" available to consumers or other users of the product. The on-hand quantity in the computer system reflects the total quantity in unopened containers (boxes, cartons, gallon bottles, etc.) in "bulk storage" that have not yet been released for sale or use. Note that bulk storage could be a locked cabinet, a high shelf, or a bin location in the back room or warehouse. It just has to be a location that is not accessible by end users of the product. This bulk storage inventory is used to replenish the "open stock" of the item (i.e., the stock available to consumers). As a container is taken from bulk storage and made available to workers or customers, the on-hand quantity is reduced by the container quantity. Therefore the on-hand quantity in the computer reflects an accurate count of the quantity in bulk storage. When the on-hand quantity drops below the minimum stock level or order point, the product should be reordered. Usage history of the product reflects the number of containers of the product that were released from bulk storage in a day, week, month, or other significant inventory period. This usage history can be utilized to forecast future demand for each bulkstorage item. Unexpected increases in replenishment from bulk storage should be reported to management as it might reflect pilferage or some other problem that should be investigated. From an accounting point of view, we are "consuming" the entire quantity when it is released to consumers. That is, the total inventory value is being reduced by the value of the container, though the product is still in your facility in an "open" bin. Is this a "perfect" solution to maintaining an accurate inventory? No. But the world is not perfect. And we have found it both difficult and counterproductive to have:
y y y

Workers in a fabrication shop carefully account for every nut, bolt, and piece of sandpaper they use. Hotel chambermaids carefully record which rooms receive a new bar of soap on a given day. Cashiers verify that customers correctly recorded the right item number when they filled their own order from one of several kegs of nails.

Even though the on-hand quantity of open-stock items is not reduced when an individual piece is sold or consumed, customers or projects often must still be charged for the items. This can be accomplished in several ways including: Issuing a special charge based on the average amount of open-stock material consumed on each order or in the course of a month. Most consumers are now used to their automobile dealers adding a line item on repair or maintenance invoices for "fluids and other consumable maintenance items." And many companies charge each department for a share of the total office supplies consumed in a month based on the number of people in that department. Utilize a special type of inventory item in the computer system for open-stock products. These items can be billed out to a customer on an invoice (i.e., nails being

purchased in bulk at a hardware store), but an individual sale does not reduce the onhand quantity of the item. Because they are usually small, inexpensive, and/or hard to count, open-stock items have proved to be a nightmare for many manufacturers, distributors, and retailers. Unfortunately they are often necessary elements in a manufacturing process or crucial in maintaining a high level of customer service. Our goal should be to maintain an adequate inventory of each of these products with the least amount of effort.
2002, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Handling Maintenance Repairs and Operations Inventory


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Handling Maintenance Repairs and Operations Inventory


by Jon Schreibfeder

Most of the articles on our website involve inventory that is either assembled or stocked for resale to other companies or organizations. In recent months we've received a lot of inquiries about managing products that are going to be consumed internally by an organization. This is normally referred to as maintenance, repairs, and operations (MRO) inventory. Typical questions we receive include:
y y

How do we decide what products we should stock to maintain our operations? What quantities of these products should be kept on hand?

In this article we'll address these questions and help you develop an action plan for achieving effective MRO inventory management.

What Products Should be Stocked?


Many organizations have too much inventory in their maintenance and repairs inventory. Unlike inventory for resale, MRO inventory is not an investment; it is an expense of doing business. Make sure that you are not adding to this expense with unneeded items. Be sure that there is a valid need or justification for stocking every one of the products in your current MRO inventory:
y y y

The product cannot be obtained in the time period necessary to fill a need once the need has been determined. The product must be purchased in a quantity greater than what is needed to fill a particular need. The cost of carrying a product in inventory is less than the procurement cost.

Often companies will have spare parts in stock for machinery that is no longer in service. When they retired a piece of equipment, no one bothered to check to be sure that all of the spares for the machine were removed from the parts room. That is why we recommend that once a year you examine each of the products currently in your MRO inventory that have not been used in the past 12 months. Question whether it is absolutely necessary to continue to maintain a quantity of each one of them. It is also a good idea to develop a spreadsheet listing each MRO product, the machine(s) or operation(s) it supports, and the quantity of the product normally needed for a repair or maintenance activity. That way, when you discontinue a process in the future, you can easily identify the replacement parts that can be removed from your MRO inventory.

How Much of Each Item Should be Maintained in Inventory


You can separate your MRO inventory into three categories:
y y y

Continual-Use Items These are maintenance items and other products that are continually used. Specific-Need Inventory Though not continually used, these items are used on a regularly scheduled basis. Emergency-Repair Parts These are parts whose use sporadic usage cannot be predicted.

Every one of your MRO stocked products should be assigned to one of these categories. Continual-use items are just like the recurring stock products we address in other articles and our books. Please refer to these resources to determine how to

calculate a forecast of future demand and other purchasing parameters for these items. Most organizations have too much money invested in the other two types of MRO inventory. Specific-need inventory products are required for scheduled maintenance operations. Unless these are very inexpensive items (i.e., they don't cost much to carry in stock), most companies are best off acquiring just what they need before each scheduled task. Emergency-repair parts are a different story. Since you don't know when each of them will be required, how can you determine how many of each one to stock? Part of developing your MRO stock list was defining where each spare part is used in your operations. Now we must determine the "critical nature" of each one of these items. We've found it helpful to assign each of these items into one of three categories: Very Critical Parts The operation or machine this product supports is critical to the success of your company. There are no readily available "workarounds." Lack of this part will cause a major, expensive problem for your company. For example, one of our customers is a food processor with one large (actually room-size) mixer. If this machine breaks down, all production stops. Therefore, any part that is necessary for this machine's operation is very critical. Somewhat Critical Parts The loss of the machine or operation these parts support will shut down an important machine or operation. The same company has 14 wrapping machines. If one of these machines breaks down, it may delay the completion of a production run, but it would not completely shut down operations. While processing delays over an extended period of time would cause major problems, the company can limp along for a day or two without one or two of the wrapping machines. Non-Critical Parts The loss of the machine or operation these parts support will have no or little effect on overall production. There are available workarounds that can be utilized for an extended period of time.

The target stock level of a repair part is determined by a combination of its "critical nature" and lead time. In the following matrix, we define the number of normal-use quantities that should be maintained in stock for each repair part:

For very critical parts that can completely shut down operations, we will keep one normal-use quantity of each item in inventory even though we can get a replacement part in less than a day. And if the lead time of a very critical part is greater than a week, we will probably want to keep three normal-use quantities on the shelf in our parts room. The cost of this "insurance" is the annual cost of carrying inventory

(normally 20% to 25% of the inventory value of the target stock level). You must weigh this expense against the cost of shutting down operations. Notice that we are not even considering maintaining an inventory of a non-critical part unless it has an extended lead time. The average-use quantity suggestions in this table are not "cast in stone" and should be adjusted for your organization's specific needs. However, if you must reduce the value of your spare-parts inventory, we strongly suggest you discontinue or reduce your stock of non-critical and somewhat critical parts before reducing the target stock level of any of the very critical items. After all, these products support the lifeblood of your vital operations. With proper management of MRO inventory, an organization can maintain an outstanding level of productivity at the lowest possible overall cost. But like any other process, it cannot be accomplished without a logical, methodical action plan.
2002, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Why Weekly Forecasting?


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Why Weekly Forecasting?


(Part One)
by Jon Schreibfeder

Recently I received a call from a distributor who had a dilemma. They were running out of a particular popular product every month. The buyer's frustration vibrated through the phone line as I spoke to her.

She explained, "We're doing a pretty good job at estimating future demand of the product. The average difference between the forecast demand for the month and actual usage is less than 10%." I explored another area. "How consistent are the lead times? Could shipment delays be causing the stock-out problems?" "No," she sighed, "the vendor always delivers four business days after we order the product." "How many customers do you have for the item?" "We have several large customers who place a large order for the item each month, and several smaller customers who pick up a few pieces when they need them." "When do you receive the large-customer orders?" "Usually in the first 10 days of the month." The buyer had just uncovered the problem. Her replenishment system forecast demand of future usage by month. For example, in September it predicted sales of 550 pieces or about 25 pieces per business day (assuming 22 business days in the month). Actual usage was 539 pieces. Her system automatically calculated the following order point for the item: Order Point = Anticipated Lead Time Demand + Safety Stock Anticipated Lead Time Demand = 25 pieces/day x 4-day lead time = 100 pieces Safety Stock = 50% of lead-time usage = 50 pieces Order Point = 100 pieces + 50 pieces = 150 pieces The order point is a "minimum" quantity for the product, and is equal to anticipated demand during the lead time plus a safety stock quantity. Safety stock is insurance inventory to protect customer service from unusually large usage or shipment delays during the time it takes to replenish inventory. When the stock level falls below the order point of 150 pieces, a replenishment shipment would be issued to the vendor. The problem is that the distributor does not sell 25 pieces per day throughout the month. Here is the weekly usage recorded for the September:
Week Business Days Weekly Usage Usage/Business Day 1 2 3 4 5 5 324 132 40 81.0 26.4 8.0

4 5

5 1

33 10

6.6 10.0

The majority of the demand for the product (324 pieces, or 60.1% of total monthly usage) occurs in the first week of the month. The order point of 150 pieces represents less than a two-day supply in the busy first week of the month. If we reorder a product when there is a two-day supply on the shelf and it takes four days to receive a replenishment shipment, it is not surprising that the item experiences regular stockouts. We recommended that the company change the time period of their forecast from months to weeks. Analyzing history over the past 12 months, we found that a formula that averaged usage for the same week in each month over the past four months resulted in the least forecast error. We went back and reforecast the five weeks of September. Note that the fifth week included one business day for September and four business days for October (i.e. the start of the next high volume time period):
Week Week 1 (Sept) Week 2 (Sept) Week 3 (Sept) Week 4 (Sept) Week 5 (Sept) + Week 1 (Oct) Weekly Forecast Business Days Forecast/Day 331 pieces 135 pieces 37 pieces 47 pieces 336 pieces 4 5 5 5 1+4 82.8/day 27.0/day 7.4/day 9.4/day 67.2/day

Each week would have had its own order point:


Week Lead-Time Usage Safety Stock Order Point 166 54 15 497 162 45

Week 1 82.8/day x 4 days = 331 Week 2 27.0/day x 4 days = 108 Week 3 7.4/day x 4 days = 30

Week 4

9.4/day x 4 days = 38

19 168

57 504

Week 5 67.2/day x 5 days = 336

Each new order point becomes effective at a date equal to the first business day of the week minus the lead time. So, four business days before the start of week one, if the stock level of the product was less than 497 pieces, a replenishment order would be issued. If the stock level was equal to or greater than 497 pieces, the buyer would leave the item alone because he has plenty of stock available to see him through the first week of the month. The result: The distributor will have this critical item available when their customers want it. Also notice that the order point drops during the period of the month with less usage activity. We are not ordering the material far in advance of when it will be needed. This will help improve the inventory turnover and overall profitability of the distributor. Weekly forecasting works well for products that experience cyclical patterns of usage throughout a month. Next month, we will examine two additional applications for weekly forecasting: new stock items and products whose sales or usage is dependent on a particular event.
2002, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Part Two


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Why Weekly Forecasting?


(Part Two)
by Jon Schreibfeder

"What you sold or used in the past is usually a good indication of what you will sell or use in the future". This is one of the basic "truths" of forecasting future demand of stocked items. In our last article, "Why Weekly Forecasting (Part One)," we examined why, for some products or industries, maintaining usage history by week rather than by month will result in more accurate forecasts. These tended to be items whose usage followed a cyclical pattern throughout the month. For example look at a bar graph of the usage, by week, of this item over a three-month period:

Notice that 50% - 53% of total usage each month occurs in the first week of the month. If we are to base our stocking decisions on selling an average of 5.0 - 5.6 pieces per day, we would probably not have enough stock for the first week in each month where usage is 10.7 to 12.9 pieces per day. As a result, the demand forecast for this item should be based on weekly usage. There are other situations where maintaining usage by week is necessary for accurate forecasts of future demand. In this article we will look at two of them: new stock items and products whose usage is dependent on a specific event.

New Stock Items


It is common for new stock items to have a spike in sales or usage volume soon after they are introduced. This temporary high volume may be due to:
y y y

Promotions for the new item or salespeople featuring the new item in sales calls. Customers wanting to try the new product. Customers establishing a normal stock quantity of the product in their inventory.

Whatever the cause, this spike in sales is often followed by a dramatic decrease in usage:

Though the duration of the temporary increase will vary, it can usually be measured in weeks rather than months. Look at the usage of a specific new item that was added to inventory in January:

The item will be overstocked if we base the stocking decision for February on January's usage of 295 pieces. Because it is hard to predict when the "peak" of the new item usage will occur (as well as the subsequent "trough"), buyers should review the usage of new items every week (and make any necessary adjustments to replenishment parameters) until a consistent pattern of usage is observed.

Items Associated with a Specific Event


Lights for Christmas trees, fireworks for the Fourth of July, and pumpkins carved for Halloween are examples of items associated with a specific event but all specificevent items are not necessarily "holiday goods." Several of our clients sell industrial supplies. Many of their manufacturing customers schedule plant shutdowns and maintenance around July 4th and the week between Christmas and New Year's Day. Again, for many items, we see a usage pattern in which the quantity sold in one or two specific weeks in July and December is very different from the usage in other weeks of the month:

As in our other examples, if we were to stock based on monthly usage (i.e., four or five pieces per day), we would not be adequately stocked for the scheduled plant shutdown weeks. Accurate forecasting for these seasonal events again requires examining weekly usage that is, the quantity sold or used in the same week last year, adjusted for increasing or decreasing trends in business. An accurate demand forecast allows use to meet or exceed customer expectations of product availability with the least amount of inventory. While few demand forecasts are 100% accurate, we must continue to strive to reduce the forecast error (i.e., the difference between the forecast and actual usage) to better predict future demand of products. After all, no major league baseball player has ever achieved a batting average of 1,000 but this fact does not stop them from trying to improve and play better baseball. Shouldn't you also continually do your utmost to improve the profitability and productivity of your investment in inventory? One of the ways to do this is to apply forecasts based on weekly usage whenever it is appropriate.
2003, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Reconciling Cycle Counts


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Reconciling Cycle Counts


by Jon Schreibfeder

Cycle counting is the process of verifying the on-hand quantity of a specific number of stock products every day. In previous articles, I have described how to set up and maintain an effective cycle counting program and why this process is usually better than a full physical inventory for maintaining an accurate perpetual inventory in your computer system. But verifying on-hand quantities is only one of the advantages of cycle counting. The other benefit of a cycle counting program is to improve your business processes, including:
y y y y

Making sure that all material movement is properly recorded. Ensuring that stock receipts are put away in the proper location. Verifying that the right quantity of the right item is shipped on outgoing orders or is pulled from stock for an assembly. Preventing shrinkage from theft and the mishandling of stocked items.

Process improvement results from carefully analyzing significant stock discrepancies. A discrepancy is the percentage difference between the actual quantity physically counted and the stock level in the computer system at the time of the count: [Absolute Value of (Quantity Counted Current Stock Level)] Current Stock Level Including the "absolute value" of "Quantity Counted Current Stock Level" in this equation signifies that a discrepancy should be analyzed if significantly more or less inventory is found during the cycle counting process. For example, assume that a distributor has a cycle count tolerance percentage of 5%.

Note: Most distributors, manufacturers, and retailers use a cycle count tolerance percentage of 2% 5%. The percentage may vary by item. Inexpensive items that are stocked in bulk quantities should have a higher tolerance percentage than expensive items that normally have few pieces in stock.

This means that any actual count that is more than 5% greater or more than 5% less than the current stock level should be analyzed and investigated: Stock Counted Need to Level Quantity Difference (%) Investigate? 100 55 18 91 54 16 -9.0% -1.8% -11.1% Yes No Yes

Item A1005 B7324 A4509

C3467

24

31

+29.2%

Yes

Many distributors will also investigate discrepancies if the difference in monetary value between the stock level and the counted quantity exceeds a certain number of dollars. Investigating cycle count discrepancies can uncover procedural mistakes made in your warehouse, including:
y y y y y y y y

Wrong quantity taken to fill an order. Wrong product taken to fill an order. Products filled from the wrong stocking location. Stock put away in the wrong bin location. Units of measure confused or misrepresented. Data entry errors. Damaged material mixed with good stock. Material movement not properly recorded.

Let's discuss some of the things that can indicate these specific reasons behind inaccurate stock levels, and actions you can take to improve material-handling policies and prevent future stock discrepancies.

Wrong Quantity Taken to Fill an Order


Indicator:
y

There is no offsetting quantity of a similar inventory item.

Actions to Take:
y

y y y y

Review recent transactions. Did the order picker(s) count out the pieces to be shipped, or did he or she ship sealed cartons? o Are specific pickers associated with frequent discrepancies? o Can you detect a pattern of sealed cartons from a specific vendor not containing the proper quantity of a product? Make sure employees know how to properly measure or count quantities to fill orders. Allow only certain employees to fill orders for hard-to-count items. "Spot check" quantities in sealed containers from questionable vendors. Increase the frequency of cycle counting these items.

Wrong Product Taken to Fill an Order


Indicators:
y y

There is an offsetting quantity of a similar item. There is an offsetting quantity of an unrelated item in a nearby bin location.

There is an offsetting quantity of an item that is normally substituted for this item.

Actions to Take:
y y y

y y

Monitor how often each picker makes this type of error. Ensure that bin locations and/or products are clearly marked. Do not store very similar items next to each other. If items have long or complicated vendor part numbers, consider adding a four-character randomly generated identification number to the description of the item and place the same number on the bin. This will help pickers verify that they are picking the right item. Train employees in the differences between similar items. Simplify the process of recording when one item is substituted for another.

Products Filled from the Wrong Stocking Location (in systems where quantities are maintained by bin location)
Indicator:
y

There is an offsetting quantity of the item in another location that contains the same product.

Actions to Take:
y y

Emphasize the importance of filling orders from the proper bin location. Increase the frequency of replenishing stock in the primary bin location from bulk storage that is, don't give pickers the opportunity to pick the item from the wrong location.

Stock Put Away in the Wrong Bin Location


Indicators:
y y y

There is an offsetting quantity of the item in another bin containing the item. There is an offsetting quantity of the item in a bin assigned to another product. A bin location contains a quantity of this or another item that belongs in another bin.

Actions to Take:
y y y y

Ensure that your most experienced warehouse people are assigned to receiving, stock put-away, and verifying the accuracy of picked orders. Have new employees pick orders under careful supervision. Ensure that bin locations are logically assigned and well marked. Establish a "no-fault" area in your warehouse. If an employee does not know where material belongs, he or she may place it in the no-fault area. Every day,

an experienced warehouse person puts away any material that has been placed in the no-fault area.

Unit of Measure Confused or Misrepresented


Indicators:
y y

The count quantity matches the stock level expressed in a different unit of measure. The product involved is purchased in one unit of measure and is issued in a different unit of measure.

Actions to Take:
y y

Instruct all employees in the difference between the purchasing and issuing units of measure. Place a warning message in the bin containing the item emphasizing the proper issuing unit of measure.

Data Entry Errors


Indicator:
y

An actual count quantity agrees with the stock level but was incorrectly entered into the computer system.

Actions to Take:
y y

Provide more training in data entry. Use a method like "check digits" to verify that data is being correctly entered into the system. For example, the operator might have to compare the sum of the count quantities listed on the cycle count sheet to the sum of the quantities he or she has entered into the computer system. Record material movement with bar code readers, eliminating the need for manual data entry.

Damaged Material Mixed with Good Stock


Indicator:
y

The count is accurate, but some or all of the material is not in usable condition.

Actions to Take:

y y

Simplify the procedure for separating damaged material from "good" inventory. Discuss with employees the importance of properly identifying and accounting for damaged stock.

Material Movement Not Properly Recorded


Indicator:
y

You have no idea why material is missing.

Actions to Take:
y

Ensure that you have documented procedures and paperwork for every type of material movement. Ask employees to think of ways material can be removed from stock without being properly recorded. And whenever possible, simplify the process of recording transactions. Conduct a security check of your warehouse. Determine how easy is it for employees, customers, and/or outsiders to remove material without the proper paperwork and without being detected. Establish an unbreakable policy: No material ever leaves your warehouse without the proper paperwork. Violating this policy is grounds for immediate dismissal or arrest.

It is impossible to achieve effective inventory management without accurate stock levels in your computer system. A comprehensive cycle counting program is a valuable tool for ensuring that the quantities in your computer system agree with what is physically in the warehouse. But to be certain that stock levels remain accurate over time, you must investigate significant stock discrepancies and take corrective action to prevent similar problems from reoccurring in the future that is, you must utilize cycle counting to improve the way you run your business!
2003, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Your Ideal Inventory Investment


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Your Ideal Inventory Investment


by Jon Schreibfeder

How do you know if you have too much, too little, or just the right amount of stock inventory? One way is to compare the value of your current inventory to an "ideal inventory investment." In this article we will discuss how to calculate the value of this "right" amount of inventory. As with many of our other inventory analysis tools, calculating the ideal inventory investment requires that we first separate those inventory items with recurring demand from those items with sporadic usage.

Recurring Usage Items


Recurring usage products are sold or used on a regular basis. Typically these items:
y y

Have had usage in at least eight of the last twelve months. Have had usage in at least four continuous months in the last twelve months (this second condition identifies seasonal items that are only sold during certain times of the year).

Replenishment of these items is normally based on safety stock quantities, order points, line points, and standard order quantities:
y

y y

Safety Stock Quantity: The "insurance" inventory maintained in stock to protect you from stock outs resulting from unexpected customer demand or vendor shipment delays. Order Point: The Safety Stock Quantity plus predicted demand during the anticipated lead time. Line Point: The Order Point plus predicted demand during the supplier review or order cycle; the normal length of time between typical replenishment orders with the supplier.

These terms are explained in more detail in some of our other articles and books. Replenishment orders are typically placed with a supplier when the Replenishment Position (On Hand - Committed on Current Outgoing Orders + On Current Incoming Replenishment Orders) of an item is between its Order Point and Line Point:

Stock receipts for these replenishment orders will normally be received when the replenishment position is somewhere between a point equal to the Line Point Anticipated Lead Time Demand and the Safety Stock quantity:

For example, if we ordered a product when its replenishment position was just below the line point, we'd receive the shipment when the available stock quantity equaled the Line Point minus Anticipated Lead Time Demand. But if we didn't order the item until the replenishment position equaled the Order Point, the receipt would probably arrive when the available inventory equaled the Safety Stock. Therefore we can estimate that the "average" quantity on hand at the time of stock receipt will be the

average of the Line Point - Anticipated Lead Time Usage and the Safety Stock quantity. The stock receipt of products with recurring usage will normally be equal to the specified Standard Order Quantity (SOQ) of the product. The average quantity of this SOQ on hand during the time it takes to sell the entire SOQ will be equal to half the SOQ:

Therefore the ideal average on hand quantity of an item with recurring usage should be equal to the average quantity on hand at the time of stock receipt plus half the SOQ: [(Line Point - Anticipated Lead Time Usage) + Safety Stock] SOQ + 2 2 You can multiply the ideal average on hand quantity of each item with recurring usage by its average cost and compare it to the current inventory value of the product to determine whether you are currently over stocked or under stocked.

Sporadic Usage Items


In many organizations more than 50% of stocked products have sporadic usage that is, they are not sold or used on a regular, predictable basis. In other words you have no idea when they will be sold or used. In previous articles we have suggested that you base the inventory of sporadic usage products on a multiple of the normal or typical order quantity. For example, if you normally sell or use two of the items in a transaction, you would set the "target" stock level equal to two pieces (if you wanted to maintain one transaction in stock) or four pieces (if you wanted to maintain two transactions in stock). You might think that like recurring items, the average or ideal value of sporadic inventory items should be some average of the normal quantity on hand, perhaps the target stock level divided by two. But because sporadic usage items are not consumed or sold on a predictable basis, it is very difficult to calculate an "average" investment for these items. After all, you might have the two or four pieces of a sporadic usage item in stock for a week, a month, or for more than a year! Therefore we have to consider the "ideal" value of sporadic inventory items to be equal to the target stock level quantity times the average cost. It's true that because we will occasionally use some of the stock of some sporadic items, the value of the target inventory will overstate the average value of some items. But this is the most accurate method we know of determining the ideal value of sporadic inventory items.

Unfortunately the value of the inventory of a sporadic inventory item will often exceed the value of the target stock level. Why? Because you may have to order a vendor package quantity of a product when replenishing stock. And the vendor package quantity may not have any relationship to the normal customer order quantity. For example, say that the normal customer order quantity of a product is three pieces and we want to maintain two normal order quantities in stock. The target stock level is six pieces (2 orders x 3 pieces per order). Whenever the replenishment position of the item falls below six pieces, a replenishment order is issued. If we must order a vendor package of 10 pieces, the product's stock level after we receive the replenishment shipment will probably be greater than the target stock level of six pieces. Because sporadic inventory is not sold on a recurring basis, we must carefully monitor the value of any amount of sporadic inventory in excess of the target stock level, particularly for those items with a high unit cost. We can define "planned excess" of sporadic inventory items as a quantity equal to: (Target Stock Level - Normal Order Quantity) + Vendor Package Quantity One of our goals should be to minimize the value of this planned excess. If a sporadic inventory item has a high planned excess value consider:
y y y y

Ordering an amount of the product close to the normal order quantity, even if you have to pay a higher price per unit. Discontinuing the product from stock inventory and ordering it only as necessary to fill specific requirements. Sharing one vendor package quantity among several stocking locations. Substituting a slightly more expensive item without passing the additional cost to the customer. Saving the carrying cost of excess inventory of one sporadic inventory item may more than compensate from the reduced profit on the resulting sale.

One of the best inventory metrics involves comparing the value of your current inventory to the sum of the values of the ideal stock level for each product. If the values are not close to one another, your buyers or inventory planners are probably not following the replenishment recommendations generated by your computer system. Are the system recommendations inadequate to provide your desired level of customer service and inventory turnover? Or do your buyers need more training in using your system to help your company maximize the return you receive from your investment in inventory? Either way, comparing your actual inventory to the "ideal" will lead you to action that can lead to improved profitability. In our next article we will explore what you can do if your calculated ideal stock level is too high and needs to be reduced in order to achieve your organization's inventory turnover and profitability goals.
2004, Effective Inventory Management, Inc. All rights reserved. This article may not be distributed, reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Achieving Lean Distribution


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Achieving Lean Distribution


by Jon Schreibfeder

Lean manufacturing is helping producers throughout the world reduce inventories, lower labor costs, and increase their overall efficiencies. The same concepts embraced by lean manufacturing practitioners can help distributors achieve the goal of effective inventory management: "Effective inventory management allows an organization to meet or exceed customers' expectations of product availability with the amount of each item that will maximize net profits or minimize costs." In this article we'll look at three of the concepts of lean manufacturing and how they can help distributors maximize the efficiency and effectiveness of their operations.

Record and Analyze Mistakes


There is a common philosophy that states, "The definition of insanity is repeatedly doing the same procedure, the same way, expecting different results." Are there reoccurring problems in your warehouse? Do you have a way for warehouse employees to record these errors for analysis? For example, is there an easy to record damaged or stock inventory that for some reason cannot be used? This material includes:
y y y

Damaged material found in the warehouse. Unintentional scrap created when a mistake was made in filling an order. "Drops" or quantities of a product that are too small to be sold or used.

In many organizations, damaged or unusable inventory is hidden. Maybe it is thrown in a scrap pile or discarded. But the best-run organizations encourage or (better yet) insist that employees record these "unquality events." Recorded events are analyzed to determine if polices or procedures can be changed to prevent the same mistakes from occurring again in the future. For example: Damaged material found in the warehouse
y y y

Was the material damaged because it was not stored in its proper bin location? Was the material damaged in its designated storage location? Is there a better way to store the product? Was the material damaged when it was received from the supplier? Do we need to ask the vendor to improve packaging or use alternative shipping methods? Is a particular employee careless in the way he or she handles material?

Unintentional scrap created when a mistake was made in filling an order


y

y y

Are the proper tools not available for filling an order? For example, it is difficult to measure a long length of pipe with a short ruler, just as it is nearly impossible to create a precise, clean cut with a dull saw. Is an employee not paying proper attention to what he or she is doing? Are there environmental problems? That is: Is lighting adequate? Is there adequate space to properly deal with the material?

"Drops" or leftover quantities of a product that are too small to be sold or used
y y y

Should a customer be forced to purchase a whole unit so no drops are created? Should the price the customer pays include the cost of any leftover drops so that this unusable material has been paid for? Can a more appropriate quantity of the product be ordered from the supplier?

Reorganize your Warehouse to Minimize the Cost of Filling Orders


In all probability, the most expensive pieces of equipment in your warehouse are people. But it is amazing how little attention most firms pay to the amount of time warehouse employees are idle or performing non-productive tasks. I recently visited a large distribution center and found that more than 75% of warehouse workers' time was involved in activities that contributed nothing to the company's profitability. They were very busy, but not producing. Hard to believe? Well, consider some of the causes:
y

Products were arranged by product line, in the vendor's item-number sequence. The vendor assigned part numbers based on characteristics such as size, style, and color. The sales or usage of each item was not a factor. And each vendor supplied some fast-moving products, some items with moderate sales, and some that were really "dogs" with little or no sales. As a result, popular products were scattered throughout the warehouse. Order pickers often walked the length of the warehouse when filling orders. The warehouse

manager maintained this was a good way to find things "After all, most large retail stores place similar items next to each other." I pointed out that product placement in retail stores cannot be compared to material organization in warehouses. In a warehouse, employees fill orders; in a retail store customers normally shop for themselves. When customers fill their own orders, they must be able to find material without the benefit of pick tickets or Radio Frequency devices that designate bin location codes and picking sequence numbers. There is also little incentive for a retailer to speed the customer through the order picking process the longer he or she is in the store, the more they probably will buy. Products were stored wherever there was adequate space. Best-practice distributors carefully choose their storage systems and, within each storage medium (shelves, pallet racks, cantilever trees, etc.) reserve the most accessible locations for the products with the most hits. ("Hits" represent the number of times an item appears on an order to be filled, regardless of the quantity ordered.) They also consider locating products that regularly appear on the same order near each other. Finally, most best-practice distributors effectively utilize bulk storage. The most accessible storage locations in a warehouse are often referred to as the "gold zone." You want to store as many frequent-sale products as possible in this area. So it is probably a good idea to limit the amount of space allocated to each item in this primary pick zone to a one- to two-day supply (for warehouses with a high volume of orders) to a one-to two-week supply (for warehouses that have a moderate order volume). The balance of the stock of these products should be maintained in a bulkstorage location. It is far more efficient to restock the primary pick locations once a day or once a week than to have employees constantly walking through your warehouse as they fill each individual order. They rejected new technology out of hand as being too expensive and focused on associated implementation problems. When considering the purchase of new technology, practitioners of lean distribution don't concentrate on the purchase price, they focus on the labor savings. One of my customers has a 154-year-old warehouse. The building is the property of the owners and is the "symbol" of the business, appearing on catalogs and the company letterhead. Unfortunately the dimensions of warehouse are not conducive to productivity. It is a long, skinny building. For years the owners balked at the cost and trouble of putting in an automated conveyor system. But a quick study indicated that the conveyor system, combined with some warehouseautomation software that facilitated zone picking (specific employees assigned to pick all orders in a certain warehouse area), could eliminate the company's second shift. The cost of the added automation could be recovered from labor savings alone within ten months of the implementation. In addition: o The company would no longer face the unique management challenges of a multiple shift operation. o They could finally meet customer requests of same day shipments for orders received before 3:30 in the afternoon.

Communicate, Communicate, Communicate

In a traditional manufacturing environment, each department has its own production goals. It produces what it is told to make without regard to the immediate needs of other departments. As a result, material commonly known as "work in process" piles up between departments. In lean manufacturing, the focus is not on monthly production goals, but on the requirements to produce an individual unit. No department builds a subassembly until it is asked to do so by the subsequent department (i.e., the next one down the production line). As a result, there is no buildup of work in process between departments, and material throughput is maximized. Communication is equally important for distributors. One of my customers is a large distributor of consumer electronics. Their buyers are aggressive. Whenever they find a low price or exceptional discount on merchandise they take advantage of it. Unfortunately these buyers rarely check with the warehouse manager to see if there is available storage space for the material they want to buy. On my last visit to the facility we determined that the warehouse was stuffed to 120% of capacity, with material lining the aisles in risk of being damaged by fork-lift trucks. Shortly after our discovery the warehouse manager burst into the office screaming that 17 forty-foot containers had just arrived filled with television sets. When questioned, the buyer defended his purchase by pointing out the additional discount he received. He was oblivious to the fact that his purchase caused management to have to rent temporary storage space for this material. In fact, the cost of this warehouse space (and additional material handling) was far greater than the savings from the "exceptional" discount received by the buyer. In a lean distribution environment, the space needed to maintain the normal quantities of stocked products is known to both purchasing and warehouse management. The remaining space in the warehouse is designated for "special purchases." Buyers must reserve the portion of this area that they need for extraordinary buys with the warehouse manager before issuing the purchase order. Everything that is ordered has a designated storage location reserved for it in the warehouse. Communication is also crucial in scheduling the receiving of full container shipments. Most warehouses have a limited capacity for processing large shipments. For example, they might be able to handle 14 or 16 trailer loads. Unless there is communication and these receipts are scheduled, some days the receiving department may be overwhelmed while on other days its employees might be idle. Few processes cannot be improved. Distributors who believe in the philosophy "if it isn't broken, don't fix it" fall behind as new technologies and techniques are embraced by their competitors. We've discussed three of the many lean manufacturing principles that can help distributors. You can learn from these companies even though they aren't "in your business." You may be surprised at the many ideas originating outside of your industry that can help improve your organization's profitability. Never stop looking.
2004, Effective Inventory Management, Inc. All rights reserved. This article may not be distributed, reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Do You Have an Early Warning System?

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Do You Have an Early Warning System?


by Jon Schreibfeder

Most computer systems provide buyers with out-of-stock reports. These are listings of stocked products with no available inventory. Because the stock-out sales orders cannot be filled, salespeople cannot provide the service their customers expect. Buyers scramble to obtain inventory to prevent the "crisis" of the out-of-stock situation from becoming the "catastrophe" of losing those valuable customers. Out-of-stock reports are, in fact, "gotcha" reports: They inform a buyer of a problem that already exists. Wouldn't it be better if a computer system warned a buyer of an impending crisis? That is the goal of an "early warning system." It is unbelievable that the report writers available in almost every system have the ability to create "early warning" stock-out reports, but few organizations utilize them. Check with your IT department or software company to see if the following reports or inquiries can be created for your top-selling "A"-ranked items as well as for other products that are crucial to maintaining a high level of customer service: The available quantity (on-hand current committed) is below the safety stock level. Safety stock is "insurance" inventory designed to fill unusual customer demand during the lead time or to compensate for delays in receiving replenishment shipments. Buyers should be informed if reserve inventory is being used to fill orders so they can expedite existing incoming shipments or obtain the product from an alternate source. At the very least, if a stock-out does occur, the buyers will not be caught off guard; they will have information in hand as to when the out-of-stock product will be available.

The actual usage by the 7th day of the current month is greater than 50% of the forecast demand for the month. Often, a buyer will be unaware of a surge in sales of a particular product until it is out of stock. If buyers know that sales of a product have suddenly "taken off," they can bring more of the product into inventory before a stock-out occurs. The actual usage by the 14th day of the current month is greater than 75% of the forecast demand for the month. This is another check to identify products that suddenly have an unexpected dramatic increase in sales or usage activity. The actual lead time for the just-received stock receipt is more than 50% over the anticipated lead time. The buyers can contact the vendors to determine if the delivery of the latest stock receipt is reflective of future lead times for the item. If so, the buyers can issue replenishment orders for the item earlier than they have done in the past to avoid a future stock-out. The available quantity of the item at the time of stock receipt is less than an "x"day supply. You didn't quite run out of the product during this replenishment cycle, but what is the possibility of a future stock-out? Does the forecast, lead time, safety stock quantity, or some other replenishment parameter for the item need to be adjusted? Restricting the early warning system to fast-moving items and products that are critical to your corporate image will ensure that your buyers aren't buried in data. They won't receive a multitude of alerts, but every one they do get will require their attention. When we propose early warning reporting to our customers, their buyers, inventory planners, and purchasing agents often ask, "Why haven't we had this type of notification all along?" Some buyers prefer alerts in a daily end-of-day report, others as an inquiry, and still others as an email as soon as the situation is identified. The format doesn't matter as much as getting the information. Tell your software people that you want to immediately implement this critical reporting. Countries need an early warning system to prevent attack from foreign powers; you need one to protect something that is crucial to the survival and success of your firm: your customer service!!!
2004, Effective Inventory Management, Inc. All rights reserved. This article may not be distributed, reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: The Advantages of a Corporate Replenishment Department


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The Advantages of a Corporate Replenishment Department


by Jon Schreibfeder

About this time last year I worked with two large distributors that allow their individual branches to completely control the replenishment of the products they stock. Each location's management, buyers, and/or salespeople could replenish stock whenever they felt it was necessary with either a vendor purchase order or a transfer from another company location. Management at both firms was convinced that this policy allowed for the quickest possible response to customers' needs and served as the cornerstone of outstanding service. However neither of these companies was providing great customer service or was meeting profitability goals. They suffered from several, apparently conflicting, inventory problems:
y y y

Frequent stockouts of critical products. Large quantities (and value) of excess inventory and dead stock. Inaccurate product availability information in the computer system.

Executives at both firms were surprised to learn that the underlying cause of these problems was the strategy they hoped would enhance their ability to effectively serve customers. Let's look at some of the reasons why their branch replenishment policies were doing more harm than good: Any available stock could be transferred out of any other branch at any time if it was needed to fulfill an immediate customer need. On the surface this policy may make sense. Why keep four units of a product on the shelf in one location if it can be sold by another branch? Isn't that what inventory turnover and customer service is all about? But the logic of this policy breaks down when we look at a specific example: Branch A normally sells 10 pieces of product #A100 per day. The item has a sevenday lead time and the branch manager always issues a replenishment order when there are 90 to 100 pieces in stock (i.e., a nine- to ten-day supply). This provides some safety stock in case of unusual demand or a delay in receiving the replenishment shipment. Branch B isn't as well organized. They often don't reorder part #A100 until they experience a stockout. Then they transfer quantities of the item in from other

locations (including branch A) to satisfy their customers' needs. Suppose that one day branch A is awaiting a replenishment order and has only 30 pieces of the product left in inventory. If branch B takes all or part of this stock to fill an existing customer order, branch A may also experience a stockout before the replenishment shipment arrives. The branch that didn't manage its inventory well looks like a hero to its customers while branch A suffers lost sales and disappoints its clientele. In the future branch A will probably begin to stock defensively that is, they will plan to stock both the quantity necessary to meet their customer forecast and what they think other branches might pull from their inventory. It is easy to see how this situation can easily get out of hand if any salesperson in any branch can sell any available inventory. But wouldn't the practice of defensive stocking actually improve customer service because every branch would be overstocked with critical parts? Not necessarily. We have found that salespeople, when faced with the prospect of other branches taking inventory that might be needed by one of their preferred customers, will go to great lengths to protect this material. One common method is to enter false sales orders to commit material they do not want to be taken by other locations. As a result the available quantity (On Hand - Committed) in the computer system does not accurately reflect the quantity actually available for sale. The falsely committed material cannot be used to fill the needs of other customers in the branch that owns the material. I have even seen situations where the customer for whom specific material was "hidden" fails to receive the secreted product. This happens when the only salesperson who knows about the false orders is out to lunch or on vacation and the salesperson who actually takes the order doesn't know anything about the material hidden for this particular customer. Salespeople buy because they know what customers really need. Successful salespeople like to interact with customers, and their compensation is often based on earned commissions. Any replenishment work they must do is often relegated to off hours or times of crisis. The most common cause of one of these crises: a stockout of a popular or critical item. Effective buyers know that when you buy products is the critical element to achieving a high level of customer service. Replenishment orders must be issued as soon as the net stock quantity or replenishment position of an item [On-Hand - Committed + Currently on Replenishment Order] falls below the reorder point quantity. This reorder point quantity is equal to the anticipated usage during the lead time plus a safety stock quantity to protect against unanticipated demand during the lead time or delays in receiving the replenishment shipment. Though the salesperson may issue an emergency as soon as the crisis occurs, the results are still often negative:
y

An emergency shipment often doesn't meet a vendor's requirement for a "good" or "target" order and the material has to be purchased at a higher unit cost (often with the addition of airfreight), reducing the company's profits. Customers may not be satisfied with an emergency shipment from the vendor if they expected the material to be in stock and available for immediate delivery.

Branches may overbuy in order to place vendor "target" purchase orders on a regular basis. A target order meets a vendor's requirements that enable a company to receive the discounts or terms that allow them to competitively sell the vendor's products. If each branch has to meet the vendor's target requirement when placing a replenishment order, they may have to purchase more of a popular item than they would if they could split shipments with other branches. They also might have to buy full package quantities of slow-moving products as opposed to "sharing" a package with other company locations. At these two companies, these problems and others were solved by putting specific buyers in charge of replenishing inventory of specific product lines in all customer locations. These individuals had both customer service and inventory turnover goals they were expected to meet or exceed. In order to do this they:
y

Ensured that replenishment orders were issued as soon as the replenishment position of a product fell below its order point (lead time usage + safety stock or reserve inventory). This avoided customer backorders and crisis replenishment orders. Split replenishment orders between branches and centrally-warehoused slower-moving items. Because the central warehouse serves as the branches' normal source of supply of these products, they buy enough from the vendor to meet the needs of both their own and the branches' customers. The result: vendor purchase orders are issued more frequently and several branches can "share" one vendor package of a slow-moving product. Possible unusual usage is identified and analyzed. Salespeople and/or customers are interviewed to determine if an unexpected increase or decrease in usage is the result of sales activity that will probably not reoccur or a new evolving sales trend. Future forecasts are adjusted to reflect the obtained information. Buyers approve all inter-branch transfers. After all, they are responsible for maximizing both customer service (i.e., minimizing stockouts) and inventory turnover. For example, it may be advantageous to move the surplus stock of a popular product from a branch that is a considerable distance from the location that needs the material than a smaller quantity from a closer branch if it will maximize overall corporate profitability.

Both of these companies established central purchasing authorities. All buyers were not necessarily physically located in the same office, but each was responsible for specific product lines throughout their company. As a result we achieved the results that every company desires: a maximization of both customer service and corporate profitability through effective inventory management.
2004, Effective Inventory Management, Inc. All rights reserved. This article may not be distributed, reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: One Product Ranking Is Not Enough!


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One Product Ranking Is Not Enough!


by Jon Schreibfeder

Distributors, manufacturers, and retailers often stock thousands of products. Properly managing the physical inventory and replenishment of these items is a challenging task. While most buyers and salespeople realize that not all items are equally important to customers or their company, it often difficult to identify those products that demand the most attention. About a hundred years ago, an Italian economist, Vilfredo Pareto, conducted some research on income distribution in Italy. He found that 80% of the income was earned by 20% of the people. You may find this interesting, but you may wonder at the same time: What does this have to do with separating your stock from your stuff? Well, other academics did some further research and found that, in general, 80% of the results of any process are produced by 20% of the contributing factors. As a result the "80-20" rule was established. This tenet suggests that:
y y y

80% of your sales are generated by 20% of your salespeople. 80% of your sales come from 20% of your customers. 80% of your stock sales involve 20% of your inventory items.

But this rule is not always true. In fact we have found that, for many companies, 80% of sales are generated by only 10% to 13% of stocked inventory items! Don't assume that 20% of your stocked products account for 80% of your sales. Rank or classify your products based on their contribution to total sales. The products that account for 80% of your sales are typically referred to as "A" ranked items. This may be 5%, 10%, or 20% of your products. The items responsible for the remaining 20% of sales are often assigned ranks as follows:

Items responsible for the next 15% of sales Items responsible for the next 4% of sales

Ranked "B" Ranked "C"

Items responsible for the last 1% of sales Items responsible for no sales

Ranked "D" Ranked "X"

Many computer software packages rank products using this (or very similar) criteria. Unfortunately many of these systems only rank products based on the cost of goods sold from the sale of stock products during the previous twelve months or some other time period that is, what you paid for the products either you sold to customers or you used to provide services to customers. While this type of ranking is important to identify those products that have the most potential for inventory turnover (i.e., opportunities to earn a profit), it is not as valuable in answering other inventoryrelated questions, such as:
y y

What products should be maintained in stock? Where should a specific inventory item be located in your warehouse?

Consider the following three items: Annual Orders Total Annual (Transactions) Qty Sold Cost per Piece Annual Cost of Goods Sold

Item

A100 B200 C300

2 4 50

10,000 4 500

$2.50 $7,500.00 $2.00

$25,000 $30,000 $1,000

Products A100 and B200 both have relatively high cost of goods sold, but these sales resulted from few transactions. Instead of maintaining these items in inventory, could they be reclassified as special-order products? A special-order item is not maintained in stock inventory, but is ordered and received to fulfill a specific customer requirement. On the other hand, product C300 was sold 50 times in the past year. Though the annual cost of goods sold is low, customers requested the item about once a week. It is probably important to have this product in stock to maintain a high level of customer service. When deciding what products to stock in a warehouse it is more important to know how often the product was requested by customers rather than the value of material moving through your warehouse. This is why it is important to rank by "hits" as well as by cost of goods sold. A "hit" is an order or a request for a product, regardless of the actual quantity ordered. Whether a customer orders one, ten, or one thousand pieces on a single order, it is considered one hit. The more hits an item accumulates, the more reason you have to stock the product. Item C300 in the chart above might be a "C"-ranked product based on cost of goods sold, but it's an "A"-ranked product based on hits.

Hits ranking is also a good tool for determining where stocked products should be located in your warehouse. Products that are requested most by customers should be assigned to the most accessible bin locations. Reorder quantities of a product with a high cost of goods sold ranking should be carefully determined to achieve a high level of inventory turnover. At the same time you might consider maintaining additional safety stock for products with a high hit rank to minimize the chance of stock-outs. You also might want to include a third type of ranking in your classification analysis, one based on profitability. Wouldn't it be helpful to let salespeople and management know what products carry the highest gross or adjusted margins? Categorizing each product utilizing all three ranks provides a comprehensive analysis that no single ranking can provide. For example, product A100 is assigned an "A" rank based on annual cost of goods sold. But a "three-way ranking" provides a more complete picture: COGS Rank Hits Rank Profitability Rank

This is a product that is ordered frequently by customers and has a lot of dollars moving through inventory but does not generate a lot of profits. This may be a lossleader that should drive additional profitable sales. Consider the three-way ranking of another product assigned an "A" rank based on annual cost of goods sold: COGS Rank Hits Rank Profitability Rank

This is a much more profitable item, but it experiences fewer hits. You might ask your salespeople if anything can be done to encourage more sales of this product. What would the ranking of your "best" products look like? Well, consider the threeway ranking for the following item: COGS Rank Hits Rank Profitability Rank

This is a highly profitable item that is sold quite often. But because it is low in cost, it does not require a high-dollar investment. Ranking products based only on annual cost of goods sold provides an incomplete picture of inventory performance. Three-way ranking provides valuable information concerning each stocked product's contribution to the overall profitability of your

organization, information that is vital in your quest to achieve Effective Inventory Management. Ask your IT or computer-support people about implementing this tool today.
2005, Effective Inventory Management, Inc. All rights reserved. This article may not be distributed, reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Returns Management


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Returns Management
by Jon Schreibfeder

Returns are a problem for many organizations. Often returns are dumped in a pile to be "sorted out when time permits." Dust and dirt cover this material as workers have more important tasks to perform. During a physical inventory or warehouse cleanup, the entire heap of returned merchandise may be thrown out while management vows to process returned merchandise in a timely manner in the future. We have found that the root of many organizations' problems with returns lies in the lack of a specific set of procedures related to these transactions. In this article we'd like to present a three-step process that you might be able to utilize in designing an effective returns program. Step #1: Determine What Can Be Returned. Most organizations limit returns to goods that are currently stocked. Any special order or discontinued products usually are not eligible for return. Customers should be told what items cannot be returned as they order or buy the products. This information should also be noted on all packing slips and invoices. Only designated members of management can override this policy.

These decisions should be based on the specific customer's contributions to your company's profitability. Step #2: Process Returns Like Any Other Stock Receipts. Returned material should not be dumped and forgotten. If possible, require and issue return material authorizations (RMA's) to customers. These documents list the items (and quantities of those items) that you have authorized to be returned by the customer. A copy of the RMA should accompany the physical return of the material. The RMA can serve as a packing slip to be utilized by your receiving people. All material received should be divided into one of four categories:
y

Item can be resold or used in its present condition. Like any other stock receipt, this material should be put away in its normal stock location within 24 hours of delivery. The item must be repackaged or repaired before being returned to stock. The item should immediately be sent to the department that will perform whatever is necessary to prepare the item for resale or use. In many organizations the cost of repairing or repackaging the item will be deducted from the credit issued to the customer. The item will be returned to the supplier. The item should immediately be sent to the vendor or staged (with appropriate paperwork prepared) to be sent to the vendor at a later date. The item will be thrown out or scrapped. The product should immediately be sent to the dumpster, the "scrap pile," or a disassembly area so that any salvageable parts can be removed.

Step #3: Calculate What It Costs to Process a Return. How much time does it take a receiving person to check in a line item on a material return? How much time does it take to return the material to its normal storage location? How much time does it take the clerical person to issue the credit memo? You can divide an employee's hourly wage (plus benefits) by the average number of line items he or she can process or put away in an hour. For example: Receiver's Time Hourly Wage = $20 per hour Line Items Processed per Hour = 30 Cost per Line = $0.67 Stocker's Time Hourly Wage = $15 per hour Line Items Put Away per Hour = 20 Cost per Line = $0.75 Administrative Time to Issue Credit Memo Hourly Wage = $18 Line Items Processed per Hour = 6 Cost per Line = $3.00 The total cost per line is $4.42 ($0.67 + $0.75 + $3.00). If we picked up the material or provided freight we would add an additional amount to the total cost.

Note that we calculate the cost of a return per line item. Why? Because it costs a lot more to process a return containing 18 line items (regardless of the actual quantity returned of each item) than a return with only one item. If a customer returned 18 different products and it cost us $4.42 per line to process the credit, the total cost to issue the credit would be $79.56! Also note the relatively high administrative cost. This includes the time necessary to research if and when the customer actually bought the product from us and the price-per-unit they actually paid. Many organizations try to recover the cost of processing returns by assessing a handling charge on the credit memo. Unfortunately it is not often practical to express this charge as a dollar amount. After all, if the customer returned a relatively inexpensive $2.00 item and it cost $4.42 to process the credit, we would end up charging the customer $2.42 to accept the material back into our inventory. For this reason, handling charges are usually expressed as a percentage of the price the customer originally paid for the material. To determine the proper percentage for your company, divide the total cost of handling receipts for a specific time period (e.g. a month) by the value of the goods returned (at the sales price) during this time period. Lets look at an example: Line Items Returned = 120 Cost per Line Item = $4.42 Total Sales Price of Goods Returned = $14,220.00 $530.40 $14,220.00 = 3.7% The cost of processing the return of an item is approximately 3.7% of its sales price. Note that the cost of repackaging or repairing a specific line item should be added to this cost. Even if you do not charge this fee to the customer, it should be considered in determining the customer's overall profitability. Handling returns is not a pleasant task. But it can be kept under control by establishing some basic policies and procedures. By minimizing the time and effort necessary to perform this task, we can devote more effort to those activities that produce profits.
2005, Effective Inventory Management, Inc. All rights reserved. This article may not be distributed, reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: How Clean Is Your Usage?


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Effective Inventory Management, Inc.


It's easy to turn cash into inventory... the challenge is to turn inventory back into cash!

How Clean Is Your Usage?


by Jon Schreibfeder
When we founded Effective Inventory Management (EIM) in 1996, our goal was to help organizations throughout the world achieve the goal of effective inventory management that is, to meet or exceed customers' expectations of product availability while maximizing the organization's net profits or minimizing its inventory related costs. One of our primary areas of concentration has been the improvement of future predictions of product sales or usage, otherwise known as "demand forecasts." In previous articles and in Achieving Effective Inventory Management 3rd Edition we discuss how to develop demand forecasts and replenishment plans for: y y y y Items with sporadic usage Items with recurring usage New inventory items Products maintained specifically for one customer

But as we have discussed before, the accuracy of any demand forecast is dependent on the "goodness" of your sales or usage history. Does this data truly reflect what would have been sold or used under "normal" circumstances? Many software packages identify possible unusual usage at the end of each week, month, or other inventory period. The simplest of these systems compare usage in the month just completed to the total usage recorded over the previous "x" months, or inform you if you were out of stock for more than "y" days. More advanced systems bring to the attention of a buyer significant differences between the demand forecast and actual sales or usage recorded during the inventory period just completed. A common feature of both methods is a belief that usage history has been recorded correctly. But is it safe to make this assumption? As we will see in this article, how usage is actually recorded in your system can have a significant effect on the accuracy of your forecasts.

Usage and Substitutes


Usage should normally be recorded for the product ordered or requested, not the product actually shipped. If you are out of the product your customer orders, you've

probably disappointed the customer. If you provide another item in its place and record usage for the substituted product instead of the product originally requested, you are setting your company up to disappoint the customer again. Unfortunately most systems record usage based on what was shipped, not what was ordered. If your computer software does not have the capability to properly record usage when a product is substituted, check to see if your sales entry program can be modified to allow the salesperson to hit a function key to specify an alternate product that should receive the usage history for a specific line item.

Record Usage When a Customer Wanted the Product


The following chart records, by week, quantities of a product due to customers, on hand in our warehouse, and actually delivered to customers: Week 1 Product Due On Hand Product Delivered 10 30 10 Week 2 20 20 20 Week 3 15 0 0 Week 4 12 0 0 Week 5 22 51 49

Notice that the company was out of stock in the third and fourth weeks. All quantities ordered during this time period were backordered and shipped when stock was replenished in week five. If we record usage when product was shipped, usage history will reflect a "blip" in usage in week five following no usage in weeks three and four. But this is not when customers actually wanted the product. We don't want to replenish inventory to satisfy this pattern of product usage. To avoid repeating stocking mistakes in the future, usage should be recorded when customers wanted a product, not when it was actually delivered. To accomplish this some systems will record usage at the time of shipment based on the customer's required date for the material. Other systems will record usage at the time of order entry.

Usage and Superseding Products


A superseding product replaces an existing stock item. A useful utility program allows a user to add the usage history of a discontinued item to the usage history of a designated superseding item: Product Discontinued A100 Usage Superseding A102 Usage Total A102 Usage Jul 100 0 100 Aug 20 84 104 Sep 12 93 105 Oct 2 104 106 Nov 0 110 110

Notice that the usage of product A100 is added to the Usage of item A102. This allows you to accurately account for both the decreasing usage of A100 and the increasing usage of the superseding item. There is an old expression, "What we sold in the past is a good indication of what we will sell in the future." This attitude leads to many stocking problems. In order to help develop the most accurate forecast possible, replace the "old" expression with a

commitment to be sure that usage is recorded for the product in the time period and in the location to best meet your customers' future needs. 2005 Effective Inventory Management, Inc. All rights reserved. This article may not be distributed, reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

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Ensuring This Years Physical Inventory Is a Success


by Jon Schreibfeder

Last month, we looked at the preparation necessary for a successful physical inventory. In the second of this three-article series, we look at how to effectively administer the actual counting process. As we said at the beginning of the first article in this series, no one who is of sound mind enjoys taking a physical inventory. In fact, many people prefer a visit to the dentist to spending a weekend counting every piece of every item in their warehouse. Even worse than a physical inventory is a physical inventory which results in an inaccurate count of what is in stock. After all, the primary purpose of an annual physical is to ensure that the product on-hand quantities in your computer reflect what is actually on the shelves in your warehouse. If, during the counting process, your people overlook certain products and miscount others, the considerable amount of money involved in taking the physical is totally wasted. In fact, most distributors would be better off with no physical inventory than one which results in inaccurate counts. In the last article, we discussed preparing for an effective physical inventory. Now its time to examine how careful supervision and administration can result in an accurate

count. Examine the following "better management" practices and determine how they can be adapted to fit into your companys procedures. The first step is to break up the physical into a series of small physicals. Counting five, ten, twenty, or thirty thousand products is a formidable task. Your employees can easily become overwhelmed and discouraged by the volume of data that needs to be collected. I have seen many instances in which people become so frustrated that their only goal is to quickly "finish the [expletive deleted] physical and go home." Its not surprising that under these conditions some aisles, bins, surplus quantities, or entire products are missed. To prevent this situation: Create a map of your warehouse Include every shelving unit, pallet rack, and all other places where material is stored. Be sure to include the tag and hold bin, receiving dock, and vendor return area. Remember that all material in your warehouse at the time of the physical inventory must be counted. Divide the warehouse into counting areas A physical inventory is a "wall-to-wall" count of your warehouse. Counters should be assigned to geographic areas of the warehouse, not product lines. If you organize your count by product line, some parts, located between major lines, may be missed. Also, if you count by product line, it is more difficult to account for misplaced material. That is, the one piece of one product line stuck in the middle of the products of another line. When establishing count areas, remember that a count team should normally be able to count between 50 and 120 items in an hour. Hard-to-count products, such as those that need to be weighed or closely examined, take more time. On the other hand, boxed items with just a few pieces on hand can be counted in a few seconds. Consider counting surplus areas and slow-moving products before the scheduled physical inventory Most distributors try to count all of their products in just one day. Thats a lot of work. And usually there is significant pressure to finish so that normal business can resume. The resulting tense atmosphere naturally leads to errors. If some items can be counted in advance, the pressure is reduced. The possibility is small that significant amounts of your dead stock, slow moving inventory, and surplus material will move during the week preceding your physical. So why not the bins containing these items before the day of the "big count"? Be sure to mark bins and shelves that are pre-counted. And, keep in mind that you must have some mechanism for adjusting these quantities if some amount of a product is sold or received after the bin has been counted. Ship everything you can before the physical begins If it isnt in your warehouse, you dont have to count it. Pay particular attention to the tag and hold and vendor return areas. This is the perfect time to clean out the cobwebs and tackle the work that everyone has put aside. Dont move misplaced material while you count The time to clean up your warehouse is before the physical begins. Do not move material while people are counting. You run the risk of counting it twice, or not at all. Record misplaced

material where it lies, and mark it so it can be moved as soon as the physical is completed. Dont fill orders or receive material during the count process It is very difficult to hit a moving target. If material is moving while you are performing a "wall-towall" count, you again run the risk of missing or double-counting some products. Sure, one of your customers may have an emergency while your physical is in progress, and a small order may have to be filled. If this occurs, an auditor must determine how the emergency order affects the physical. She must determine:
y

Was the bin containing the product counted before the order was filled? If so, no adjustment is necessary if the emergency sales order will be processed after the physical is completed. Was the order filled before the counters reached the bin? This will require an adjustment. The quantity taken must be added back into inventory to ensure that your stock balances, after the physical is completed, are accurate.

Audit while people are still counting As soon as counters are finished with a small section of bins or shelves, an auditor can verify the counts of selected products. Dont choose these products at random; instead, concentrate on your "A" items. These are the items that have the most dollars flowing through inventory. Experience shows that counting errors occur much more frequently with fast-moving products than slowmoving items or dead stock. As soon as an auditor verifies that the counts in an area are accurate, the quantities can be entered in your computer. If the auditor finds several counting errors in an area, the entire section should be recounted. Ordering a recount probably will not make the auditor a popular person, so be sure that people charged with this difficult task realize the importance of an accurate physical and are committed to the success of the project. Print and review discrepancy reports Some distributors feel that if they conscientiously audit counts, the physical will be accurate. But errors may also result from things that are not related to the actual counting such as:
y y

Mistakes made as counts are entered into the computer. Unit-of-measure errors in computer records. For example, a product may be counted in pieces, but maintained in the system in pounds.

After all counts have been entered in your computer system, discrepancy reports should be printed. These reports should list any item with a significant difference between the on-hand balance in the computer (before the physical) and the counted quantity. Good discrepancy reports highlight items with significant differences in value (i.e. differences in the on-hand quantity times cost). You should thoroughly research these "challenges" before the physical inventory is completed. Review your success, record your procedures After youve finished your physical count, updated your records, and reopened for business, you have one more thing to do before forgetting about physical inventories for another 10 months or so. Sit down with everyone who participated and discuss what happened. What worked? What didnt? Who should perform what tasks next year? What could be changed to make things easier and produce a more accurate count? Place these suggestions in your

physical inventory file and review them when it comes time to begin preparations for your next count. Good Luck In these articles on physical inventory, weve tried to provide you with some guidelines which hopefully will make this years count less stressful and more accurate. In one word: successful! Next month well look at another method for maintaining accurate computer inventory levels. One which may even eliminate the need for a full physical count! Its called "cycle counting." Jon Schreibfeder is President of Effective Inventory Management, Inc., a firm dedicated to helping distributors get the most benefit from their investment in inventory.
1997, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Cycle Counting Can Eliminate Your Annual Physical Inventory!
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Cycle Counting Can Eliminate Your Annual Physical Inventory!


(Part One)
by Jon Schreibfeder

In the previous two articles, we outlined some steps you can take to help ensure that your annual physical inventory results in an accurate count of what is in your warehouse. In this article we examine an alternative to the annual physical, continual cycle counting.

Without accurate stock level information in your computer, effective inventory management is impossible. No matter what sophisticated tools you have in your inventory management system, if the computer thinks you have 100 pieces of an item, and there are really only three on the shelf, the system wont replenish your inventory when it should or order the right quantity. Unfortunately, most distributors only verify the stock balances in their computer once a year, when they perform a physical inventory. During the physical count, every item is counted and, if necessary, the balance in the computer is adjusted to reflect the actual quantity on the shelf. Even if you assume that the physical inventory results in an accurate count of each stocked product (a big assumption for many distributors), how long do the counts remain accurate? One month? Two months? Six months? Eleven months after the physical count, what percentage of stocked products still have an accurate available quantity in the computer? In order to receive all of the benefits from a good inventory management system, stock balances must be at least 97% accurate, every day of the year. This means that the actual available quantity of every item in the warehouse is no more than 3% greater or less than the available quantity displayed on your computer inquiry screens. If the computer says there are 100 pieces of an item on the shelf, there should be no less than 97, nor more than 103. Note that 97% is the minimum acceptable standard. One hundred per cent accuracy is the optimal goal that you should strive to attain. The best way to ensure that a minimum of 97% accuracy is maintained is to continually count your products. That is, count part of your inventory every day, and count each item several times per year. This process is called "cycle counting." If the answer is so simple, why doesnt every distributor abandon their annual physical inventory and cycle count? Do distributors enjoy the annual wall-to-wall count so much that they refuse to give it up? I dont think so. In fact, many distributors have implemented cycle counting programs only to abandon them when they see that their inventory accuracy hasnt improved, it may even have gotten worse! For all of its benefits, there is one logistical problem which makes cycle counting more difficult than a complete inventory. That problem is material movement. Think of the environment that exists (if you follow the guidelines in the previous two articles) when you conduct an annual physical inventory:
y y y y y

All stock receipts have been placed in their proper bin location. All printed sales orders and transfers for stock material have been filled. Computer records for these receipts, sales orders, and transfers have been updated. All customer returns have been processed and the material returned to stock. No customer orders are filled nor material moved until the counting of all products in the warehouse is completed

All material movement has stopped. You are counting a fixed target.

It would be nearly impossible to recreate these conditions every day when you cycle count. After all, you have to continually receive material and fill customers orders to remain in business. As a result, cycle counting is like trying to count a moving target. How difficult is this? Well, go down to your local pet store and try to count the goldfish in a tank. How do you know that some quantity of the products you are counting today isnt sitting on your receiving dock having just been entered in the computer? Or, is it possible that an order for an item being counted has just been filled but the computer records wont be updated until tomorrow? Its no wonder that many well-intentioned distributors throw up their arms in frustration and abandon cycle counting programs after only a few days and weeks. Like the procedures necessary for a successful annual physical count, there are several necessary guidelines for a cycle counting program to produce the desired results: Decide which cycle counting method to use. A good plan for determining the frequency with which products are counted ensures that no items will be skipped, or counted more often than necessary. There are two methods for determining when to cycle count items that can form the basis for a good plan:
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The Geographic Method The Ranking Method

Using the Geographic Method, you start at one end of your warehouse and count a certain number of products each day until you reach the other end of your the building. This results in counting all of your items an equal number of times per year. Because you are systematically examining the contents of each shelf and bin, the Geographic Method facilitates the "discovery" of misplaced or lost material, especially the stuff that has been "stashed" between bins. If you implement a geographic count system, try to count each stocked item at least four times per year. The other method is the Ranking Method. Research shows that the more often a product is received or shipped, the less accurate its computer stock balance. This makes sense. Every time someone goes to the bin is an opportunity for a mistake (or to coin the new term, an "unquality event") to occur. For example, material can be put away in the wrong bin, or the wrong product can be taken to fill an order. The Ranking Method directs you to count the items with a large number of dollars flowing through inventory (i.e. with the highest annual cost of goods sold) more often than slower-moving products. The ranking is based on "Paretos Law" (named for the late Italian economist Vilfredo Pareto) which basically states that, in general, 80% of the results of any process is produced by 20% of the contributing factors. Applied to inventory, this means that approximately 20% of your inventory items are responsible for 80% of your stock sales. Though Pareto came up with this theory nearly 100 years ago, it still is generally true. And, for the reasons we talked about, we want to count these items (i.e. the top 20%) more often: "A" rank items (responsible for the top 80% of sales) count six times per year "B" rank items (responsible for the next 15% of sales) count three times per year

"C" rank items (responsible for the next 4% of sales) count twice per year "D" rank items (responsible for the last 1% of sales) and products with no sales count once per year Though not as effective in finding lost material, the Ranking Method usually works best for maintaining accurate inventory counts. Because the primary purpose of cycle counting is to verify the quantity on-hand of each item, most distributors prefer the Ranking Method. When should cycle counting be performed? Most distributors experience some time during the day when material is not moving. Usually this is just before, or after, normal working hours. The chance of counting errors is reduced if cycle counting is performed during these "off" hours. Consider counting for one hour each morning before your warehouse opens for business. Or, if you prefer, counting can be done for an hour each afternoon, after the last order has been filled. Most distributors are open for business about 250 days per year. This means that if you use the geographic cycle count method, and have 10,000 items in inventory, you will have to count about 160 products per day: 10,000 items counted four times per year = 40,000 counts 40,000 counts / 250 days = 160 products counted per year Though how fast items can be counted is dependent on many factors, one conscientious, experienced person can usually count between 100 and 150 products in an hour. The number of products counted each day using the Ranking Method will vary depending on the number of products that are assigned to each rank. To give you some idea of how this method works, well look at another distributor with 10,000 stocked items:
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Rank "A" contains 2,000 products Rank "B" contains 3,000 products Rank "C" contains 4,000 products Rank "D" and the dead stock category contain 1,000 products

Notice that, in our example, the Ranking Method requires fewer products be counted each day: 2,000 "A" items counted six times per year = 12,000 counts 3,000 "B" items counted three times per year = 9,000 counts 4,000 "C" items counted twice per year = 8,000 counts 1,000 "D" items counted once per year = 1,000 counts Total 30,000 counts 30,000 counts / 250 counting days = 120 products counted per day

Greater inventory accuracy resulting from 25% fewer counts! No wonder rank based cycle counting is a popular alternative to geographic counts or an annual physical inventory. Determine who should count. When you conduct a physical inventory, you have to count every piece of every item in your warehouse in a short period of time. To accomplish this task, most distributors draft, and put to work, anyone in their organization who can breath and count at the same time. Cycle counting is different. Only a limited number of items are counted each day. To ensure the counts are accurate, only knowledgeable, experienced warehouse people should do the counting. Sure, youll have to put them on a slightly different schedule. That is, theyll have to come in early or stay late. But the one or two hours of their time spent counting each day will be well worth the investment. Think about how good youll feel when you, and all of your employees, have confidence in the stock balances in your computer! As I hope you can see, there are some definite advantages to implementing a cycle counting program. In our next article, well look at cycle counting procedures, as well as the differences between counting with and without bar-coding equipment. Jon Schreibfeder is president of Effective Inventory Management, Inc. (EIM) of Coppell, Texas. Author of the Effective Inventory Management Guide series, Jon offers seminars on inventory management and works with individual distributors throughout North America.
1997, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Part Two

Cycle Counting Can Eliminate Your Annual Physical Inventory!


(Part Two)
by Jon Schreibfeder

Counting inventory in your warehouse is neither a pleasant nor an easy task. Over the last four months weve discussed various methods of counting your products in order to maintain accurate information about whats in your warehouse and available for

sale. Last month, we looked at implementing a cycle counting program as an alternative to an annual physical inventory. While we discussed the advantages of cycle counting, we didnt have enough time to completely describe how to set up a cycle counting program. In this article well look at determining when to count items as well as how to resolve discrepancies caused by "floating" paperwork. Well also explore the advantages of using bar-code equipment to facilitate the counting process.

Develop Your Count Schedule


On what specific days should each product be counted? In the last article, we described two methods for cycle counting: the geographic method and the ranking method. The geographic method is a wall-to-wall count in which each product is counted four times per year. The ranking method counts those items with the most dollars moving through inventory more often than slower moving items. To develop a count schedule for a geographic program, first calculate the number of products you will have to count each day. We will use an example of a company with 10,000 products in its warehouse:
10,000 items counted four times per year = 40,000 counts 40,000 counts / 250 counting days = 160 products counted per day

Start at one end of your warehouse, assign the first 160 products to "Day 1," the next 160 products to "Day 2," and so on until the last 80 products on the list, along with the first 80 products, are counted on "Day 63." On the next day products 81-240 are counted and the process continues. Cycle counting is one job in your company that should never be completed. There will always be products to count tomorrow! Please note that unless you have a computer system that can maintain multiple onhand quantities for an item (i.e. the quantity in each of several bin locations), you should count all locations for an item on the day that item is scheduled to be counted. So, when you count the primary location for a product, be sure to count all surplus and bulk storage locations as well. If your system supports multiple on-hand quantities, treat each location as though it were a separate part, and make sure you accurately record how much of the item is in each bin. What happens if there is a situation one day which prevents you from counting all of the scheduled items? Well, you need to count more items on the next day in order to "catch up" to where you should be in the schedule. Catching up may require you to have one or two people work some additional overtime. But, this is a small price to pay to ensure that the inventory availability information in your computer is accurate. It is a bit more complicated to establish a count schedule for a rank-based cycle counting program than the geographic method, but its certainly possible. Keep in mind that in order for a rank-based cycle count program to be successful and more accurate than a geographic count, it is imperative that all items are assigned to the proper rank. So be sure that your stocked products are re-ranked (based on annual cost

of goods sold) on a regular basis. Many distributors assign ranks according to the following criteria after the items have been sorted in descending cost of goods sold order:
Items responsible for the first 80% of sales Ranked "A" Items responsible for the next 15% of sales Ranked "B" Items responsible for the next 4% of sales Items responsible for the last 1% of sales Ranked "C" Ranked "D"

The old Pareto principle, that approximately 20% of inventory items account for 80% of sales, applies to most distributors inventories. Lets look at a sample rank-based count schedule. Once more there are 10,000 items in his warehouse:
2,000 "A" items counted six times per year = 12,000 counts 3,000 "B" items counted three times per year = 9,000 counts 4,000 "C" items counted twice per year = 8,000 counts 1,000 "D" items counted once per year = 1,000 counts Total of 30,000 counts / 250 counting days = 120 products counted per day

Here is a rank-based cycle counting schedule for the distributor that will attain the desired number of counts for each product. Note that on some "transition days" items from two groups will be counted:
Day 1-17 Day 18-42 Day 42-59 Day 59-74 Day 75-91 Day 92-116 Count "A" items Count "B" items Count "A" items Count 1st half of "C" items Count "A" items Count "B" items

Day 117-133 Count "A" items Day 134-149 Count 2nd half of "C" items Day 150-166 Count "A" items Day 167-174 Count "D" items

Day 175-199 Count "B" items Day 200-216 Count "A" items Day 217-250 Count "C" items

As with the geographic method, when you get to "Day 250," go back to the beginning. Its like painting the Golden Gate Bridge, the work is never completed!

Reconciling Cycle Counts


As we discussed last month, cycle counting should be performed by knowledgeable, experienced warehouse people, during "off-hours" when material is not moving. But unless you have installed a radio frequency ("RF") bar-coding system (discussed in the next section), your counting process may be hampered by paper work or material in process. While it is important to process all sales orders, stock receipts, and customer returns in a timely manner, it is not always possible to complete all paperwork before starting the cycle count for the day. For this reason, the shelf count must sometimes be adjusted before it is compared to the on-hand quantity in the computer. While the specific adjustments will vary depending on when quantities are updated in your computer, there are some general rules to follow, and some situations to look for: Sales orders that have been filled, but have not been confirmed in the computer. The confirmation process reduces the on-hand quantity in the computer by the quantity shipped on the sales order. If a customer order or outgoing transfer has been filled but not confirmed, the quantity shipped of the item must added to the quantity physically counted before that amount is compared to the on-hand figure in the computer. Stock receipts entered in the system, but not yet placed in the proper bin location. Again the quantities on these stock receipts must be added to the counted quantity before being compared to the on-hand amount in the computer. Stock receipts placed in the proper bin location, but not yet entered in the system. These amounts must be subtracted from the counted quantity before that amount is compared to the on-hand quantity in the computer. "Floating" paperwork is the most common reason for cycle count discrepancies. To facilitate the count process, it is a good idea for counters to receive a list of open transactions for the items being counted each day.

The Advantages of Bar-Coding Equipment


Bar-coding equipment speeds up the both physical inventories and cycle counting. There are two basic types of bar-coding equipment: standard equipment where count information is temporarily stored in the bar code reader/collection device, and radiofrequency (or "RF") devices which immediately transmit data to your computer as it is entered. When using bar-coding equipment, the counter simply scans the bar-code label on the shelf, and keys in the on-hand quantity. Note that in the hard-goods distribution industry, shelves or bins are usually bar-coded, not the individual pieces or boxes of each product. At first glance, bar-coding may seem like nifty new technology, but hardly worth the cost of the necessary equipment and computer software. However, the implementation of bar-coding can lead to major savings of time and money! In addition to faster counting, benefits result from the fact that count quantities do not have to be manually re-entered into the computer. Instead the count information is electronically downloaded from the bar-coding device into your computer system and your inventory records are automatically updated. Not only does bar-coding speed up the counting process, but it eliminates the possibility of human data entry errors as the information is loaded into the computer. In fact, when radio-frequency bar-coding equipment is implemented throughout a distributors order filling and stock receipts processes, cycle counts can usually be conducted anytime ... even in the middle of your business day! How is this possible? When every warehouse person has a RF bar-code reader, all material movement is instantaneously transmitted to the computer. It is possible to maintain an accurate shelf-count quantity in the computer, in addition to the traditional on-hand amount. Whenever a new shipment is placed on the shelf, the computer is immediately notified. And, as material is removed to fill an order, the shelf quantity in the computer is reduced. As a result, when cycle counting takes place, the computer knows exactly what to expect to find on the shelf. No paperwork reconciliation is necessary. Although RF equipment still represents a sizable investment, it is becoming an option for more and more distributors. If you are in the process of looking for a new computer system, be sure it has the capability to work with RF bar-code equipment. Well, with these four articles, you now have the knowledge necessary to conduct physical inventory and cycle counting programs to maintain accurate stock balance information in your computer. If you think cycle counting is not worth the trouble, you need to reflect on the value you place on your stock inventory. After all, some people feel that its actually worth some money ... Jon Schreibfeder is president of Effective Inventory Management, Inc. (EIM) of Coppell, Texas. Author of the Effective Inventory Management Guide series, Jon

offers seminars on inventory management and works with individual distributors throughout North America.
1997, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Vendor Managed Inventory: Theres More To It Than Just Selling Products
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Vendor Managed Inventory


Theres More To It Than Just Selling Products
by Jon Schreibfeder

A customer agrees to give you all of his business. All you have to do is maintain an adequate inventory of the products he uses at his facility. What a deal!!!! Large, frequent orders from a customer. No one "nickel and dimeing" you to death. Wouldnt any distributor jump at the chance to get as much of this type of business as possible? Many distributors have jumped at the chance to get these "vendor managed inventory" or VMI contracts... jumped right into a pool of problems and losses. I heard about one of these unfortunate companies last weekend. This is a true story. But like the old TV show Dragnet, all of the names have been changed. But this time, to protect the guilty. Six months ago, the outside salesman for Smokey Supply was very excited. He had just finished negotiating a VMI contract with one of his largest customers, Ajax Chemical. In exchange for maintaining a completely stocked parts supply room, Smokey Supply would receive all of Ajax Chemicals business for industrial supplies. The contract stated that Ajax would buy stock products at 16% above Smokey Supplys actual cost. "Sure these are low margins," the salesman told management, "but think of the volume of business well do with these folks." Smokeys management agreed that it made sense to give up the 25% gross margin they had previously made on sales to Ajax to capture all of their business. Well, last week Ajax Chemical canceled the VMI contract stating that they couldnt live with the problems which resulted from Smokey Supplys management of their inventory. And, when Smokeys management conducted an after-the-fact inquiry into

what went wrong, they discovered that in addition to the service problems reported by the customer, they had lost money on the contract in each of the six months the contract was in effect! Lets look at what happened and see how Smokey lost both money and customer goodwill on a deal that was supposed to be a sure-fire, unquestionable success. Hopefully you can avoid this distributors mistakes.

Problem #1: Ajax Chemicals Existing Inventory


One of the last items discussed in the negotiations for the VMI contract was what to do with Ajax Chemicals existing inventory. To expedite matters, Smokeys salesman agreed to give the customer full credit on the return of their existing stock. Ajax had paid $2,000 for this material. Why was this a problem? Smokey was in effect giving back the profit made on $2,000 worth of sales. Looking at it another way, Ajax was receiving a credit of $2,000, but Smokey was receiving back only $1,500 worth of material (the value at their cost). And the $1,500 didnt include:
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The $400 (at Smokeys cost) worth of discontinued items and the $200 worth of material Ajax had purchased from Smokeys competitors. Though Smokey gave the customer credit for this material, it could not be resold. The eight hours necessary for a Smokey employee to physically count the stock in Ajaxs parts room. Using a conservative labor cost of $15 per hour, this process cost Smokey $120.

Instead of getting $1,500 of material for a $2,000 credit, Smokey actually received $780. In other words, this last-minute concession cost the distributor $1,220! What Smokey Should Have Done: The disposition of a customers existing inventory should be one of the first topics discussed when negotiating a VMI contract. A distributor needs to know how much it will cost him (and it always costs him something), so that he can make sure that the gross profits earned under the new agreement will cover this expense and provide a return on investment. And Smokey should have separated the "good" stock from the "dead" stock, and given the customer full credit only on the material that could be resold.

Problem #2: The Cost of Maintaining Inventory in Ajax Chemicals Parts Room
Before entering into the vendor managed inventory agreement, Smokey Supplys sales manager and upper management reviewed Ajax Chemicals $44,200 worth of purchases (at cost) over the past 12 months. Thats an average of $850 per week. At a 16% mark up, Smokeys projected revenues to be $986 per week, or $51,272 per year, and the annual gross profit would be $7,072.

But when dealing with maintenance, repairs, and operations, the customers engineers usually dont know what they will need in advance. The parts room had to have an ample stock of parts, not only for routine maintenance, but also for emergencies that might occur. Smokey couldnt just deliver $850 of material per week. They needed to maintain an inventory worth $1,600 in Ajaxs parts room. Because Smokey was not warehousing the material in their own facility, they felt that they didnt have many of the inventory carrying costs normally experienced by distributors. Furthermore, that investment of $1,600 was reasonable considering the profit they would receive from the contract. After all, if you consider the cost of money to be about 10%, it cost about $160 to maintain the inventory in Ajaxs parts room. They saw that as "chicken feed" when they considered the total worth of the contract. What Smokey failed to consider was the cost of labor necessary to maintain the inventory in the parts room. The distributor not only had to restock the shelves once a week, but also:
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Cycle count the inventory to be sure that the Ajaxs material requisitions reflected what was taken from the shelf. Provide emergency delivery service, at no additional charge, when Ajax experienced a stock out between normal deliveries.

In all, it took one Smokey employee an average of eight hours to service the Ajax contract each week. At $15 per hour, this was $120 per week, or $6,240 per year. A bleak picture is painted if you consider all of Smokeys costs: Projected Annual Gross Profit $7,072 Cost of Inventory Return $1,020 Cost of Money Tied Up in Inventory $160 Labor Cost To Administer Contract $6,240 Net Profit (End of 1st Year) -$348

And these numbers dont include the cost of billing the customer or commissions paid to the salesman. What Smokey Should Have Done: Its obvious that Smokeys management didnt have a good handle on their costs before they went into negotiations with Ajax. They probably didnt fully consider the benefits that Ajax would derive from this relationship:
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Reduced labor cost in the stock room Reduced labor cost in the purchasing department Emergency delivery service, at no charge, when a needed part wasnt on the shelf

Ajax saw a terrific opportunity. Smokey was willing to cut their prices, and provide "free" labor in exchange for an exclusive contract to deliver material. What customer wouldn't be attracted by this kind of offer?

Smokey should have realized, before the contract was negotiated, that they were not going sell material to Ajax as much as they were going to operate a "mini-warehouse" in the customers manufacturing plant. They based their markup of 16% on the costs they normally incurred when filling stock orders out of their own warehouse. They needed to consider all of the costs associated with operating a remote branch location.

Problem #3: Despite a 97% Order Fill Rate, Ajax Canceled the Contract Because They Were Dissatisfied with the Service Provided by Smokey Supply
Each month, Smokey Supplys salesman and management reviewed the number of backorders on requisitions from the Ajax parts room stock. They were very pleased that over a four-month time period, 782 out of 803 requests for material had been completed filled from parts room stock. Fifteen of the other 21 requests had been filled within four hours, and the remaining six requests had been delivered within 48 hours. With what appeared to be outstanding performance, why was the customer upset? Well, two of the 21 requests that couldnt be filled from shelf stock caused a manufacturing line to shut down. When management at Ajax asked for the reason for the shutdown, their engineers responded that the repair parts needed werent in the parts room the parts room maintained by Smokey Supply. When two parts-related shutdowns occurred within six weeks, Ajaxs management decided to look for a more "reliable" supplier. What Smokey Should Have Done: When Smokeys salesman reviewed Ajax Chemicals needs, he looked at what they had purchased in the past 12 months. He did not sit down with the customers engineering staff and determine what items should be considered "critical repair parts." If Smokey had known what parts were crucial to keeping the manufacturing process going, they could have planned to maintain additional "safety allowance" inventory of these items. The real problem was that Smokeys management and Ajax Chemicals management had two very different measurements for the success of the VMI agreement. Smokey was concerned with the percentage of requests that could be completely filled from shelf stock. If this percentage was high, they assumed that the customer was happy. Ajax viewed success in terms of keeping the production lines in their chemical plant operating. Whenever a critical part wasnt available, they viewed the distributors performance as inadequate. During negotiations, they should both have agreed on a definition of "success" and made it part of the agreement.

Summary: What You Can Do To Achieve Success in VMI Agreements


Learn from Smokey Supplys mistakes. When negotiating a VMI contract with a customer, consider such things as:
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Your actual cost for buying back their existing stock The cost (especially the labor cost) of maintaining inventory at their location The fact that you need to know what parts are critical to their operation

There is nothing wrong with vendor managed inventory agreements. But, in order to ensure profitability and customer satisfaction, a distributor must realize that they are not merely selling supplies, but are operating a small branch for the exclusive use of a very demanding customer. Jon Schreibfeder is president of Effective Inventory Management, Inc. (EIM) of Coppell, Texas. Author of the Effective Inventory Management Guide series, Jon offers seminars on inventory management and works with individual distributors throughout North America.
1997, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Encouraging Inventory Accuracy


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Encouraging Inventory Accuracy


by Jon Schreibfeder

Most distributors realize the importance of inventory accuracy that is, having the available quantity of an item in your computer agree with what is actually on the shelf in your warehouse. Management realizes the bad things that happen when inventory accuracy doesnt exist:
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Wasted Time: If your inside salespeople constantly have to go out to the warehouse to check stock, theyre wasting time. They cant walk out to the warehouse and answer phone calls at the same time. And, your customers time is also wasted as they sit on hold while you dash out to check stock. Do

they really enjoy listening to "muzak" or to a ten-minute advertisement describing your commitment to customer service? Wasted Money: If inventory is lost in your warehouse, whether through misplacement, theft, or breakage, it must be replaced. Buying replacement material is an expense. And, like payroll, rent, or any other expense, the replacement material must be paid for with part of the distributors net profits. For example, if $100 of material is lost per week ($5,200 per year), this $5,200 comes off of your bottom line. If your net profit before taxes is 4%, it takes $130,000 in new sales to make up for this loss ($130,000 x .04 = $5,200)! Disappointed Customers: If you promise material to a customer based on what your computer says is in stock, but the material isnt actually available in your warehouse, the result is often a disappointed customer. Youll lose your reputation as a reliable supplier. And not being a reliable supplier is the best way to increase your competitors sales.

Theres little doubt that management realizes the importance of inventory accuracy. But, how do you convince your employees that inventory accuracy is important? Well, there are two ways:
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Convince them that inventory accuracy is a crucial element for the success of your company and that their professional futures are dependent on the success of your company. Provide economic incentives for maintaining accurate inventory.

Whats Good for the Company Is Good for the Employee


Many distribution employees behave as though they work for the government. Their paychecks are not dependent on how well they perform their jobs. Further, they are convinced that the companys profits are two, three, or four times what is actually on the bottom line! It is imperative that all of your employees, from the guy who sweeps the floor on up, realize that your company makes money by buying material at one price and selling it to other companies or individuals at a higher price. Gross profits are the primary source of funds the company has to pay expenses. And, the company is pressured by customers and competition to keep prices low, resulting in small gross profits. One category of expenses is wages, benefits, and salaries. If you buy material, but its lost before it can be sold, it doesnt contribute to gross profits (that pile of money available to pay employees and other expenses). In fact, when material is broken or lost, money must be taken out of the pile to pay for replacement material. If too much material is lost, there wont be enough money in the pile to meet the payroll. Management does not have the option of printing more cash in the back room (without risking a long, all-expense-paid vacation at a federal government facility)!

At the end of every month, let everyone know what the material lost that month cost the company how much money was wasted instead of being available to pay salaries, benefits, and other worthwhile expenses.

Rewarding Good Performance


In a perfect world, all of your employees would realize that their future is tied to the success of your company, and they would protect your inventory and other assets as if they were their own. But the world isnt perfect. And, like it or not, people will tend to do things for which they are rewarded. So, you may be faced with a challenge to develop an incentive program tied to inventory accuracy. Weve studied several inventory-accuracy-related compensation programs, and we've found that the most successful are tied to the cycle counting. Cycle counting is the process of physically counting part of your inventory every day and comparing the quantity found on the shelf to the on-hand quantity in your computer. In one instance we implemented a program in which we changed the compensation program for all of a companys warehouse employees. The distributor involved was loosing one-tenth of his inventory to theft every year. And, we determined that the majority of the pilferage was committed by employees. Because of the transient nature of the local workforce (the company was located in a resort area) we determined that it would be difficult, if not impossible, to convince the employees with words alone that their long-term future was tied to the profitability of the company. The new compensation plan was radical, to say the least. Instead of paying everyone by the hour, a significant portion of every warehouse employees compensation was now dependent on the accuracy of the inventory counts in the warehouse. Management cycle-counted part of the inventory every day. And, employees didnt know in advance when a particular item would be counted. The inventory accuracy goal was titled the "97-3" rule. If 97% of the counts in a two-week period were within 3% of the quantity that the computer determined should have been in inventory, every employee received an incentive bonus. If the cycle counts fell short of the goal, no employee received the bonus. When the bonus was earned, warehouse employees earned 10% more than they did before the program was implemented. When the goal wasnt met, they earned 10% less. The program resulted in every warehouse employee becoming an "inventory watchdog." They realized that if there was an inventory shortage, the result would be a reduction in their next paycheck. If they saw someone stealing, they viewed that person as stealing from them personally, not from the company. The result was that inventory shortages decreased substantially.

Summary

Most, if not all distributors realize that they must encourage inventory accuracy. If you can convince your employees that their long-term security is directly tied to protecting your assets, great. If not, dont give up. You must take a different approach. Employees must personally feel the benefit of good inventory accuracy (i.e. a bonus), or the cost of missing material (i.e. a reduction in compensation). In either case, the distributor cannot maximize productivity and profitability unless inventory accuracy is achieved. Jon Schreibfeder is president of Effective Inventory Management, Inc. (EIM) of Coppell, Texas. Author of the Effective Inventory Management Guide series, Jon offers seminars on inventory management and works with individual distributors throughout North America.
1997, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Calculating Your Target Inventory Investment


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Calculating Your Target Inventory Investment


by Jon Schreibfeder

Most distributors spend a lot of time developing sales projections and budgets for expenses. Each month these forecasts are compared to actual sales and expenses. If sales are lower, or expenses higher than what was projected, management will usually take corrective action to ensure that the company remains profitable. Budgets are good management tools. Unfortunately, few distributors maintain budgets and projections for what is probably their largest asset, inventory. It is critical to the success of your inventory management system, and your business in general, to develop a budget for the value of stocked inventory maintained in each warehouse. This budget is referred to as the "target inventory investment." To calculate your target inventory investment, we use a variation of the formula used to calculate inventory turnover:
Target Inventory Investment = Projected Annual Cost of Goods Sold from Stock Sales

Target Inventory Turnover

Projected Annual Cost of Goods Sold from Stock Sales: What is a realistic projection of what your sales from warehouse stock will be (at cost) during the next 12 months? Target Inventory Turnover: Most hard-goods distributors earning gross margins between 20% and 30% would like to receive five to six inventory turns in a main warehouse, and ten to twelve turns in a branch location. But these optimal goals cannot be achieved overnight. A realistic "incremental" goal is to increase your current turnover rate by 1/10th turn per month. And as we will see, it will probably take three months, after you begin an effective inventory management program, to start to see results. So, if the inventory of stocked products in your warehouse is currently turning three times annually, and your company initiated an effective inventory management program three months ago, you should try to achieve 3.1 turns next month, 3.2 turns the month after, etc. This gradual increase in inventory turns is usually the result of an aggressive, but achievable, program to reduce the quantity of unneeded material in your warehouse. Let's look at an example which illustrates how increased stock turnover leads to lower inventory investment: Projected Annual Target Target Inventory Inventory Sales (At Cost) Inventory Turns Investment Reduction $10,000,000 $10,000,000 $10,000,000
......

4.0 4.1 4.2


..

$2,500,000 $2,439,000 $2,380,952


......

Current Inventory $61,000 $119,048


.....

$10,000,000

5.0

$2,000,000

$500,000

The figures in the table illustrate our goal of a gradual increase in inventory turns resulting in a continuous decrease in inventory investment. By the time we achieve our eventual goal of five inventory turns, our target inventory investment will be $2,000,000 ($10,000,000/5 turns). It may take a year or more to achieve this goal. So, the sooner we get started, the better!

What Items Do You Want To Stock?

OK, you've developed a target inventory investment. Now you have to decide what products will comprise this investment. Let's start by dividing your inventory into three categories: Dead Inventory: Inventory with no sales or recurring transfers during the past 12 months. Slow-Moving Inventory: Inventory that has had some movement, but less than one and a half turns a year. That is, you've sold the normal shelf quantity less than 1-1/2 times in the past 12 months. Other Items: Items whose stocked inventory will turn more than one and a half times per year. That is, your "good" inventory. Please note that depending on your specific market, "good" inventory might have to turn more than 1-1/2 times a year. For some companies, "good" inventory must turn 12 times a year. If you have questions about what your particular situation, please contact us. If you need to reduce your overall inventory investment to meet your turnover goals, a good place to start is to look at the dead stock and slow-moving items that are stocked in your warehouse. Of course, there are some valid reasons to maintain an inventory of items that don't currently sell on a regular basis. But, you must realize that if an item doesn't sell, it doesn't directly contribute to generating the profits necessary for you to remain in business. It is an expense. And, like a new truck, a computer system, new shelving, your payroll, or any other expense, non-moving inventory must indirectly contribute to the current or future profitability of your company. How can it do this?
y

It might be a repair part or other item that you must have on hand to handle customer emergencies. That is, it contributes to your reputation as a reliable supplier. It may be an item that you're fairly certain will sell in the future. You've invested in the product today, to receive profits in the future.

As with any other expense, you must control the amount of dead stock and slowmoving inventory you maintain in your warehouse. You can only afford so much of it. In the following discussion, we'll guide you in establishing a budget for the amount of this inventory that you can reasonably maintain. Just one more note before we go on. You must separately categorize dead stock and slow-moving inventory for each company warehouse or location. An item might have a lot of activity in one branch, but be as "dead as the market for eight-track tapes" in another location. If you're too young to know about eight-track tapes, don't worry. Just realize that you can't go down to the music department in Walmart, Target, or another store and find them next to the CDs and cassettes. But they were very popular just 25 years ago...

Dead Inventory
These items have had no sales or transfers during the previous 12 months. As we said before, there are two reasons to maintain stock of these products:
y y

They are critical repair parts They are new stock items that a customer has committed to buy, or a salesman has committed to sell

If an item does not meet one of these criteria, you should probably discontinue it and dispose of your current stock.

Slow-Moving Inventory
Slow-moving items are similar to dead stock items, but they have experienced some (but not much) customer demand during the past 12 months. These items may also be candidates for being discontinued. Carefully review each of these items and ask yourself, or your sales department, these questions:
y y y

Do we expect customer demand for this product to continue or increase during the next 12 months? Do our customers expect us to always have the item on the shelf and available for immediate delivery? Is there another source (an alternate vendor, company branch, or even a competitor) for this item that will allow us to meet our customers' expectations without maintaining warehouse inventory? Is the product very inexpensive, and therefore does not require a significant investment in inventory?

You may receive the response, "Go through all of these items? You must be kidding! There are just too many of them!" If someone says this, ask them if they were to go to Las Vegas and win $1,000 in quarters from a slot machine, would they try to collect all 4,000 coins from the floor? Many companies agonize over the purchase of a $1,000 computer, but will not spend the time necessary to analyze dead stock and slow-moving inventory. This is strange, illogical thinking. The same asset (i.e. available cash) that is used to purchase new goods is literally tied up in dust-covered stuff in your warehouse. If you stock more items than you can keep track of, you're stocking too many products... or you need more help in inventory management!

Budget for Dead Stock and Slow-Moving Inventory

It's tempting to continue maintaining all of your dead stock and slow-moving items in stock. There is a "warm and fuzzy" feeling associated with knowing you have, in stock, anything any of your customers could possibly want. But can you afford this feeling? Remember that maintaining inventory that doesn't sell is a cost of doing business. We need to set up a budget for this expense. The first step in calculating this budget is to calculate the average value of all of the dead stock and slow-moving inventory you plan to continue to maintain in each of your company's warehouses. Consider the value of dead and slow-moving inventory to be equal to the current available quantity of each item times its average cost. If you don't have the average cost for an item, you may substitute the product's replacement cost. Is this a conservative measurement? Yes. After all, dead stock and slow-moving items are sold on occasion. So the available quantity of at least some of these items will decrease during the year. You may even sell an entire vendor package! If you want to calculate the actual average value of the inventory of each of these items, fine. But most distributors only have the time and resources to perform this analysis based on the current inventory value. Let's consider an item that you feel is a "critical repair part" and should always be on the shelf, available for immediate delivery. The cost of the product is $15.00. At first glance, $15.00 does not seem to be a lot of money to maintain an item in inventory, especially an item that has been designated as a "critical repair part." But if you consider the hundreds or thousands of slow-moving or dead stock items stocked by many distributors, as the late Senator Everett Dirksen once said, "a million here, a million there, pretty soon you're talking about real money." Most distributors should limit the total amount of money they have tied up in nonmoving inventory (i.e. dead stock) to no more than 10-15% of their total inventory investment. And, slow-moving inventory usually should not exceed an additional 15% to 20% of total inventory. If your investment in dead stock and slow-moving items exceeds the budget amount, you have two choices:
y y

Go back and discontinue more items. Reduce your target inventory turns so that the value of dead stock and slowmoving inventory you plan to maintain equals 35%, or more, of your target inventory investment. But, make sure everyone involved in the decision of which products to stock is aware of the negative effect this action will have on corporate profits.

Next month, we'll look at how to dispose of this inventory and receive the most return. We'll also look at identifying surplus quantities of popular products. In the meantime, get those lists of items to be liquidated ready! Jon Schreibfeder is president of Effective Inventory Management, Inc. (EIM) of Coppell, Texas. Author of the Effective Inventory Management Guide series, Jon offers seminars on inventory management and works with individual distributors throughout North America.

1997, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article may be distributed within a company or school for the benefit of its employees/students, but it may not be reprinted in a publication for sale, reproduced in a website, or be used in conjunction with consulting services without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Liquidating Non-Moving Inventory


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Liquidating Non-Moving Inventory


by Jon Schreibfeder

Last month, we began a discussion of your investment in stocked inventory. Were going to continue that discussion in this article as we look at the liquidation of unwanted inventory. Remember that purchased inventory is a "sunk" cost. Youve paid for it. No matter what its worth now, your moneys still gone. Compare it to shares of stock you may purchase in a company. The securities have "paper" value, but no real monetary value until they are sold and turned back into cash. Inventory slated for liquidation can be compared to shares of stock you own in a company headed for bankruptcy. When you first bought the stock, you thought it was a good investment. But market conditions, or other factors, changed the situation. The longer you hold onto the security, the less it is worth. Selling the shares of stock for less money than you paid for them may be your best alternative. At least youll get some cash back from your investment. While it does not produce the most desirable result, liquidating dead inventory sure beats losing all of your money. Sure its painful. It hurts so much that some distributors cant bring themselves to do it. They are emotionally tied to their products. They may even believe in fairy tales, including the one about how, one day, some desperate customer will walk in and buy all of the dust-covered stuff in the warehouse. The occasional sale of a piece of dead inventory perpetuates many sales managers belief in this myth. But these infrequent sales cannot come close to economically justifying maintaining all of the products that should be removed. In the movie Wall Street, Michael Douglas character, Gordon Gecko, said, "Dont get emotional about stock, it clouds your judgment." He was referring to securities.

The same advice applies to the material in your warehouse. Dont get emotional about stocked inventory!!! The goal of inventory liquidation is to dispose of unwanted inventory at the best possible price or the least possible expense. Here are some ways you can accomplish this task. Theyre presented in the general order of desirability: Transfer the excess stock to another company location where the inventory is needed. A product may be "dead" in one branch, but still active in another location. Why spend money to buy more of the product when youve already invested in inventory that is gathering dust at another company location? This option is particularly attractive if the cost of transporting the product between branches is a small fraction of the value of the item. Many distributors have instituted ongoing programs to move slow-moving inventory to locations where it is in greater demand. This process is called inventory balancing. "C" and "D" ranked products in one branch are candidates to be transferred to other branches where they are ranked as "A" items. Multi-branch distributors practicing successful inventory management balance their inventory between warehouses at least four times a year. Reduce the price to "move" the excess inventory. Department stores do it, why cant you? Offer your salespeople a monetary incentive to sell the product. This works especially well when a customer can choose between several products that will meet his or her needs. Sometimes it is almost miraculous how fast inventory can move when salespeople are provided with the proper incentive. Advertise the availability of this material to other suppliers. Consider placing ads in industry publications listing the products youre planning to liquidate. There are also Internet World Wide Web sites (such as www.industrymart.com) that maintain lists of available surplus stock. Industry Marts Larry Wise gives a good example of the value the Internet in inventory reduction. "I spoke to six industrial distributors recently. They we were all gearing up for a major reduction of excess inventory, and all of them said a major component in their reduction plans was to offer their lists of excess to the traditional surplus dealers. These dealers were buying inventory for pennies on the dollar and marking the products up 1000% to 3000%! Boy were those distributors about to get gypped!" These distributors didnt realize that at least some of their surplus inventory had value in someones eyes. And, the traditional surplus dealers may get rich because the distributors dont realize that theres still a strong market for some of their surplus stock. Internet sites that specialize in surplus material allow you to sell specific items in your excess stock at an amount close to your actual cost. And selling even part of your excess stock at cost is a lot better than selling the entire batch at 10 cents on the dollar!

Brainstorm and get creative. One distributor lost a customer contract to supply a certain, custom-made product. When the contract was canceled, there was a fourmonth supply of the item on the distributors shelf. And worse, the vendor wouldnt accept a return of the material. The stock of this item could be accurately termed "future dead inventory." Instead of taking the typical non-action of ignoring the situation, one salesman took assertive action. He called his competitor who won the contract, and sold his entire inventory of the product at 80% of cost. As there was no other use for the material, this was truly "found" money! Substitute the product for a less-expensive item. Suppose you sell water heaters. Your manufacturer replaced his model A345 with the model A365, which offers easier access to the heating element. You have three pieces of this discontinued 40gallon heater in stock. Naturally, contractors ordering a 40-gallon heater want the new model. But, when a customer orders a 20-gallon heater, why not offer them one of the discontinued 40-gallon heaters at the price of a 20-gallon unit? Donate the material to a non-profit organization. Can a school, church, or charity use some of your dead or slow-moving inventory? This alternative is especially attractive for sub-chapter "C" corporations. These companies can take a deduction of up to twice the cost of the inventory. Talk to your accountant or tax advisor for details and restrictions concerning material donations. Throw it away. The least agreeable alternative. But, at least your freeing up some shelf space in your warehouse, getting rid of an eyesore, and getting some value by being able to write off the cost of the material. But be sure you have tried all of the other possibilities before you implement this last resort.

Inventory Liquidation Is a Twelve-Month Job


Most firms worry about liquidating dead stock once a year that is, after they complete their physical inventory. The owner looks at the inventory valuation report. He clutches his chest as he views the list of type "X" items (i.e. stuff thats in your warehouse that you wish werent there). He makes one of several pronouncements: "We have too much stuff in our warehouse. Stop buying inventory." Great! Most of what is in your warehouse is dead or slow moving. The boss new policy prevents you from replenishing the inventory of the products that do sell on a regular basis. The result is all too common: You have a warehouse full of material, but you dont have the products necessary to meet your customers needs. "Were going to get rid of this stuff by next year." In many companies, this pronouncement is as predictable as the ball dropping on New Years Eve in New York Citys Times Square. Unfortunately, it is forgotten five days after the end of the fiscal year. And twelve months later, the warehouse is bulging with even more inventory.

"We need a new computer system (or new people) to straighten out this inventory mess." Without implementing the business policies necessary for effective inventory management, no person or computer system can bring a muddled inventory under control. Inventory liquidation must be an ongoing process that must be coordinated by a specific individual in your organization. We call this person the "dead stock coordinator." After receiving the list of discontinued products and items with excess inventory, this person must determine the best method of liquidation that is, the method which returns the most value to the company. They must go through the list, trying each method of liquidation in order of desirability, until they dispose of the material. But remember that dead inventory disposal isnt a one-person job. Every department must participate in the effort under the coordinators direction. The dead stock coordinator organizes everyones activities and makes sure that the effort to reduce dead stock and excess inventory continues throughout the year. Well, we hope youve gained some insight in how to deal with your non-moving inventory. Now, the biggest challenge you face is to start doing something about it. Because, as we all know, dead stock wont liquidate itself!
1998, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article may be distributed within a company or school for the benefit of its employees/students, but it may not be reprinted in a publication for sale, reproduced in a website, or be used in conjunction with consulting services without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Why Bar Code?


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Why Bar Code?


by Jon Schreibfeder

As you probably know by now, technology is expensive. Very expensive! And youve probably had the frustrating experience of investing in some new electronic gadget and not receiving the benefit you anticipated or were promised. Many people disagree with me, but I strongly suggest that you cautiously and skeptically evaluate every new technological tool. Ask, "How will this tool affect our companys bottom line?" If the new device wont improve profitability within a reasonable period of time, dont buy it.

This line of reasoning applies to bar coding. Bar coding can help your business by:
y y y

Providing value-added services to customers. Improving inventory accuracy. Making your employees more productive.

All of these benefits sound great! But, in order for the investment to be worthwhile, the benefits you receive must exceed the price you paid to implement the solution, in terms of both time and money. In this article well look at some of the benefits bar coding can provide, and discuss how to evaluate whether or not it is worth the cost. Value-Added Services for Customers: Many customers (especially OEM manufacturers) now require that distributors apply bar code labels to material shipped to them. This requires that the distributor has a bar code compatible printer and the necessary computer software to produce the labels required by the customer. This service is expensive. Consider not only the equipment and software, but also the labor necessary to affix the labels. It is normally offered only to high-volume, high-profit accounts. But keep in mind that if the customer requires UPC (Universal Product Code) or some other industry-standard labels, the costs associated with producing the labels can be applied to other tasks as well. Tasks such as supplying labels to other customers or preparing your warehouse for automated physical inventory counts (see below). If a customer requires special labeling, be sure to consider the cost of this custom value-added service when you consider the accounts profitability and salespeoples commissions. Improving Physical Inventory/Cycle Counting Speed and Accuracy: Physically counting your inventory is a boring, tedious, time-consuming task the is susceptible to many errors:
y y y

A product may be mistaken for a similar-looking item. A counter may record the quantity of one product in the space on a count sheet reserved for a different product. An operator, entering quantities of counted items, may make a keying error (i.e. enter 1,000 pieces instead of 100 pieces).

These errors are common and costly. For this reason, most distributors' first application of bar coding involves physical inventory. To prepare the warehouse for bar code physical inventory, a bar code label which identifies a product is printed and affixed to each stocking bin location. These labels are assigned to locations because it often is not practical to place a label on every piece of every product stocked in inventory. During the actual physical inventory process, the counter takes a hand-held bar code reader (with an attached storage device and numeric keypad), scans the label, and then enters the counted quantity using the numeric keypad. After a section is counted, the bar code reader is placed in a computer input device (often called a "wedge" or a "holster") and the product counts are automatically downloaded into the computer system, updating the on-hand quantities in the database.

Bar coded assisted physical inventories have several advantages over traditional counting methods:
y y

y y

Count "teams" are unnecessary as one person can scan the bar code label, count the product, and enter the count on the numeric keypad. Scanning and entering counts usually takes less time than writing down product numbers and counts and then manually entering the count information into the computer. Mistakes cant be made because the wrong product number is written down. Mistakes cant be made because the data entry operator enters the wrong quantity.

The costs involved in implementing bar coded inventories include:


y y y y y

The cost of printing bar code labels for all of your stocked products. Placing these labels in the appropriate bin locations. Buying or renting hand-held bar code readers. Buying or developing the necessary software for the bar code readers to read your bin labels and accept count quantities. Buying or developing the software for your computer system that will accept and process the information from the bar code readers.

Many computer companies offer a bar code package which includes a bar code printer for the labels, hand-held scanners, and the necessary software for both the scanners and your computer system. The savings realized from just the reduced labor cost often make physical inventory bar code implementations a worthwhile investment. But a word of caution: Because bar codes are assigned to bins, all of your products must be located in their proper locations. Dont attempt a bar code physical inventory unless your warehouse is in order! Shipping and Receiving: Bar coding is usually a cost-effective investment for assisting in the physical count of your inventory. Why not adapt bar coding to your other inventory-related transactions and have a completely automated warehouse? Imagine the time that would be saved if your receiving clerk could just scan products as they were received, rather than manually checking each item with paper and pencil. Or, picture the improvement in accuracy if your shipping clerk could verify that the right product was pulled to fill an order by scanning bar codes printed on both the pick ticket and bin. There are even radio frequency (RF) bar code units now available that will electronically transmit customer orders to warehouse personnel, avoiding the need for printed picking documents and resulting in paperless warehouses! As tempting as these capabilities are, dont jump into the implementation process without evaluating the associated costs (and concerns):
y

The bar code computer software necessary to process bar coded shipping and receiving transactions is usually far more complex (and expensive) than the software used to count on-hand quantities. Make sure that all of the "bugs" have been worked out of your software and procedures before you use bar coding to process your daily transactions.

y y

Bar coding implementation is expensive. Be sure that the benefit that you will receive from automating each specific task is greater than the cost. Implementing bar codes simultaneously in all of your internal processes can place a great strain on the people in your organization. It takes time for them to get used to new policies and procedures. Youve probably experienced the affect on customer service when a new system is "thrown" at employees.

It is far better to gradually implement bar coding. If youre experiencing "challenges" with your current physical inventory process, start there. After that function has been successfully implemented, determine if bar coding can be a money-making benefit in other inventory-related areas. Where do you get information about bar coding? Your computer vendor is probably your best source. You may also look at the distribution bar code sites on the World Wide Web. Just search on the words distribution bar code. Carefully evaluate the services that each company offers. But dont make a decision without checking their references and seeing, with your own eyes, their hardware and software performing the bar coding tasks youd like to implement.
1998, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article may be distributed within a company or school for the benefit of its employees/students, but it may not be reprinted in a publication for sale, reproduced in a website, or be used in conjunction with consulting services without the expressed written permission of Effective Inventory Management, Inc.

Next Article: The Cascading Effect of Effective Inventory Management


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The Cascading Effect of Effective Inventory Management


by Jon Schreibfeder

Doing one thing well often leads to doing other things well. This is true in many areas of business, including inventory management. Have you ever noticed that successful manufacturers and distributors have clean, organized warehouses? And companies in a perpetual "cash crunch" often stock material in filthy, disorganized, buildings?

How does running a "tight ship" lead to cascading profits? Well, imagine your companys gross sales dollars as a river. As sales grow, the current of the river increases. There is a waterfall downstream. The water that "cascades" over the waterfall represents your companys net profits. "Rocks" at the top of the waterfall represent your companys expenses. These rocks inhibit the flow of dollars over the waterfall and to your bottom line. Many of these rocks represent normal costs of doing business: cost of goods sold, payroll, rent, utilities, etc. Management of less-successful companies takes a fatalistic approach. They believe that all of these rocks (i.e. expenses) are large, permanent objects. There is no way these boulders can be moved or reduced in size. And, nothing can be done about new rocks that fall into the river. They dont realize that if the top of the waterfall is filled with rocks, no water can cascade down into the profit pool. Progressive companies look at these rocks from a different angle. They know that there will always be some rocks at the top of the waterfall. But with a little effort, they can chip away at some of the rocks and completely remove others. These companies know that as they decrease the mass of rocks at the top of the falls, they increase the amount of water cascading over the top. So the obvious question is, what rocks (i.e. expenses) can be removed or reduced in size without affecting customer service? Superior customer service must be maintained. It is directly responsible for your sales volume or, in our illustration, the flow of the river. Lets take a look at a few of these removable rocks: Lost and Damaged Material: Customers want what they pay for. If material is damaged while it is in your warehouse, it cant be sold, or at best it must be sold at a reduced price. And, while you must pay your vendor for inventory lost in your warehouse, it doesnt generate any sales revenue. As your mother probably told you over and over again while you were growing up, something put away in its proper place tends not to get broken. And, youll be able to find it again when you need it. In a neat, well organized warehouse, little material is lost or damaged. It isnt a big rock, inhibiting the flow of profits to the bottom line. The money the company saves by not having to buy replacement material can be used to expand the companys product offering, to increase salaries, or to be put to some other worthwhile use. Unnecessary Labor: When material is missing in a warehouse, a scavenger hunt usually begins to find the missing material. If you consider the cost of your of labor, it is a very expensive activity. Will the customer pay more just because it took two of your people four hours to find the missing item? No way. Therefore, this unnecessary cost increases the size of the labor "rock." In a properly maintained warehouse, material is usually in its proper location, and is easily accessible to order pickers. The result: more orders can be picked in less time. This means that a company with an organized warehouse needs fewer warehouse people @#150; and those individuals not only have a pleasant working environment, but they can receive better wages because of their high rate of productivity. A well-

run warehouse only increases the size of its "labor rock" if there is an increased flow of sales in the river to justify it. The Cost of Replacing Misplaced Material: Some companies believe in the old saying, "do it twice, or dont do it at all." Or at least it seems that way. Theyll claim that theyre too busy to verify that every order going out the door contains the correct quantities of the right items. But what happens when a customer complains that an error in shipping has cost them a lot of time and money? The too-busy company finds someone to drop everything and get a replacement shipment to the customer. And these replacement shipments are expensive. Each one ties up an employee for several hours, placing another large boulder at the top of your profit waterfall. Will a customer pay extra for this exclusive service? Again, no way! Theyre ticked off that they didnt get the right stuff in the first shipment. A company that is focused on the bottom line knows how much it costs (in both actual dollars and customer good will) and does everything they can to prevent these boulders from being placed in their revenue river. They dont view checking orders as an unnecessary expense. These companies consider completely checking every order a top priority! Every business wants to maximum its profits. Many companies see improving sales as the only way to attain this goal (that is, to increase the current in the river). But leading companies realize that there is a better way. They know that it is usually easier to control expenses (that is, to remove boulders) than to find new sources of sales to increase the amount of water cascading over the waterfall to the bottom line.
1998, Effective Inventory Management, Inc., 116 Spyglass Drive, Coppell TX 75019. All rights reserved. This article may be distributed within a company or school for the benefit of its employees/students, but it may not be reprinted in a publication for sale, reproduced in a website, or be used in conjunction with consulting services without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Does Your New Inventory Contribute to Dead Stock?


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Effective Inventory Management, Inc. 120 S Denton Tap Rd, Ste 450-200 Coppell, TX 75019 (972) 304-3325 Fax: (972) 393-1310 Email: info@effectiveinventory

Does Your New Inventory Contribute to Dead Stock?


by Jon Schreibfeder

Today, most companies that distribute products are adding more new products to inventory than every before. Not only do these new items allow distributors to meet their customers changing needs, they also present the opportunity to penetrate new markets. Adding new products often fills management's brains with thoughts of higher sales and profits. But you must have more than stars in your eyes and thoughts of glory when you decide to expand your product offerings. It's true that some new products will just generate new sales. They will have no effect on the sales of existing stocked products. In fact, they may even contribute to increasing the sales of these items. But most new items will have a negative effect the sales of existing stock. That is, you'll sell less of the existing product once the new product is introduced. This is the situation we want to look at. There are two strategies for introducing new products, an "immediate" replacement and a "partial" replacement. If not handled correctly, either strategy can result in dead or excess inventory of existing products. Let's examine why this happens and what you can do to prevent it.

Immediate Replacement
In an immediate replacement, a new item replaces an existing product. That is, you do not plan to sell the existing product after the new product is introduced. Most distributors know enough to discontinue the old product and prevent their buyers from replenishing its stock. But they usually don't pay much attention to the remaining stock of the old item. You face a problem if any of the old product remains in inventory after you begin selling the new item. Who wants to buy the old item once the new product is available? Most likely, your remaining stock of the old item will remain on the shelf and gather dust. How can you prevent this from happening? Try to sell out your entire stock of the old item before introducing the new product. Yes, that means rotating your stock. This is common sense, but some distributors have problems convincing their warehouse people to pull the oldest stock first. Maybe it's because the new boxes are "prettier" than the old ones. If you continually fight this battle, consider transferring your company's entire stock of the old product to one or more specific branches. These branches will not receive the new product until their stock of the old item is depleted. Other locations will be stocked with the new

product. This way, your employees have the opportunity to sell the old product or the new product, not both. But what if your customers know that the new product is available? They may insist on receiving the new item. What do you do with your existing inventory of the old product? Follow the example of computer retailers and discount it! Offer your customers a special price for the material you're trying to clear out of stock. And make it a substantial discount! You want to convince your customers that they are getting a "deal." Don't be tempted to offer a small reduction at first, and if necessary follow it up with a more substantial discount. As time passes, the old item will probably be worth less to your customers, and will therefore be harder to sell. You may not have the opportunity to sell the old item after a few months (or even weeks). The result: you're stuck with a quantity of the old product that has become dead inventory! It's almost always in your best interest to liquidate the stock of the old product as soon as possible.

Partial Replacement
In a partial replacement, a new product will take some but not all of the sales away from an existing product. The existing item is not discontinued, but often contributes to excess inventory. Why does this happen? Let's look at an example: ABC Distributors is introducing a new item, the model #A234 widget, that can be used in about half of the applications of an existing product, the model #A100 widget. The model #A234 is more energy efficient, and is less expensive. It's not surprising that the new product will be used wherever possible. The result: it will capture about half of the previous demand for model #A100. Here's the potential problem: Most distributors base replenishment (at least in part) on past sales or demand history. What will happen if the buyer replenishes model #A100 based on its past sales, without considering the effect the new product will have on future sales? The distributor will order twice as much of the model #A100 as is needed. In other words, ABC Distributors will be ordering excess inventory of the model #A100 from the vendor! It is imperative that whenever a new product is introduced that will partially replace the sales of an existing product, the sales or demand history of the existing product must be adjusted to reflect the projected sales of the new item. More new items are being introduced to the market than ever before. Distributors must spread the money they have available to invest in inventory over a greater number of products. Carefully consider the effect new product sales will have on existing products. You cannot afford to waste money on dead and slow moving inventory!
1998, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article may be distributed within a company or school for the benefit of its employees/students, but it may not be reprinted in a publication for sale,

reproduced in a website, or be used in conjunction with consulting services without the expressed written permission of Effective Inventory Management, Inc.

Next Article: A New Look at Measuring Customer Service


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Effective Inventory Management, Inc. 120 S Denton Tap Rd, Ste 450-200 Coppell, TX 75019 (972) 304-3325 Fax: (972) 393-1310 Email: info@effectiveinventory.com

A New Look at Measuring Customer Service


by Jon Schreibfeder

A common measurement of the performance of your stocked inventory is the customer service level. It measures how often you have the items you've committed to stock when your customers want them. The customer service level is calculated with this formula: Number of line items for stocked products shipped complete by the promise date Total number of line items ordered Notice that we're measuring line items shipped complete that is, when the entire quantity is delivered on or before the promise date listed on the order. If the customer orders ten and we ship ten, we get credit toward the customer service level. But if the customer orders 25 and we only ship 24 before the promise date, we get no credit. Why no partial credit for shipping 24 out of 25 pieces? Well, if the customer the customer wanted 24, they would have ordered 24. They wanted 25! The customer service level measures how often we have the products we've committed to stock, when our customers want them. But does a high customer service level guarantee a satisfied customer? Not necessarily. Consider one of my recent experiences:

I ordered a small bookcase from a prestigious (i.e. expensive) mail order company. The phone clerk told me the item was in stock and that I would receive it in five to seven days. Three weeks went by and the bookcase didn't arrive. I called and was told that bookcases are shipped by moving van, and I should have been quoted three to four weeks delivery, not five to seven days. The bookcase eventually arrived, but it was badly damaged. The shipping box did not contain adequate packaging. I called and was told that another bookcase would be sent right out. Two days later, I didn't receive a replacement bookcase I got a box of file folders! I made more phone calls. Nine weeks after I placed the original order, I finally received what I ordered. I'm sure everyone reading this article has had similar experiences. Even though the item I wanted was in stock when I placed my order, the company did not deliver what I expected, and I was disappointed. Considering the manpower and freight expense necessary to correct the multiple errors, the company obviously lost money on the sale. And worse, they lost a customer! Do you think I'll ever order another product from that company? Not unless I need more examples of poor customer service for future articles. What bothered me more than anything else was the "band aid" approach the company took toward solving the problems I encountered. Each time I called, I felt their representative was trying to get me off the phone as quickly as possible. They made no attempt to ensure that these problems would not reoccur in the future. How do I know?
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Two weeks after the promise date, when I called to check on delivery, I was told "those guys quote five to seven day delivery for all items, no matter how long it actually takes to get there." When I reported the original bookcase as damaged, they didn't ask what was wrong, the clerk just said in an exasperated tone, "we'll get another unit out to you." When I called to say that I got file folders rather than the bookcase, the first words I heard were, "you know you'll have to return those folders or pay for them." Only after a strong letter to the president of the company did I receive a note from a customer service supervisor saying that, as a concession for my inconvenience, they wouldn't bill the shipping charges for all of the shipments.

Sure, this is funny. You're probably laughing. But how often have you disappointed one of your customers? Could they tell the same type of story about their dealings with your company? To remain competitive today, you need to expand your definition of customer service. Just having the material they want available in your warehouse is not enough. You must measure how often a customer is not satisfied with the products or services you deliver and the reason for their displeasure. Unfortunately, your customers won't always tell you when they're disappointed. So when they do report problems, you must treat the information they give you as valuable data. Capture this information and dissect it! Determine what went wrong, how you can correct the situation to the customer's satisfaction, and what you can do to prevent the same problem from reoccurring in the future.

To record and analyze reports of customer service failures, enter every customerreported problem in a Customer Service Failure spreadsheet. Here is an example of the spreadsheet used by one of our clients: Date/Order Customer Type 6/21/98 10987 6/23/98 11021 Jones Mfg. Atlas Co. 2 Problem Description Picker Bob A234 ordered A236 pulled Sales Sally Listed wrong address on order Sales Bob Negotiated prices not reported to inside sales Resolution Sent special shipment 6/22/98 Sent replacement shipment 6/24/98 Sent revised invoice 6/27/98 Verification 6/23/98

6/25/98

6/26/98 11435

Smith Industries

6/28/98

Problem types fall into eight categories: Type 1 Type 2 Type 3 Type 4 Type 5 Type 6 Type 7 Type 8 A reasonable quantity of a stocked product is not available from warehouse inventory. The wrong quantity is pulled off the shelf and delivered to the customer. The customer receives the wrong product. The material is sent to the wrong address. The material isn't delivered when promised. The product arrives damaged, or for some other reason cannot be used by the customer. Necessary documentation does not accompany the shipment. Billing is incomplete, inaccurate, or confusing.

Problems typically are reported by a customer to your customer service, accounts receivable, inside sales, or outside sales department. It is imperative that each problem and its resolution are accurately logged. The verification column lists when the customer was contacted to ensure that the problem was resolved to their satisfaction. Are we recording problems just looking for people to blame? No. We are trying to identify employees who need additional training as well as ways in which our current systems can be improved. If a malfunctioning system isn't improved, the same problem will occur over and over again. To fix a problem, we need to identify the

actual reason a problem occurred. For example, type 2 problems (customer receiving the wrong product) might be caused by:
y y y

The picker pulling the wrong product. The inside salesperson listing the wrong product on the order. A misprint in your catalog.

If we just yell at the picker every time a product is shipped in error, we probably won't correct the actual cause of the problem. Our goal is to continually reduce the number of failures reported each month as a percentage of the total number of orders received and filled. How successful can your company become? One company using this type of measurement now records three problems per 10,000 orders (.03%), which translates into a customer service success percentage of 99.97%! And they continue to try to improve! You can't improve the service you provide customers unless you carefully analyze your failures. Review each customer service problem with the appropriate individuals and departments. Disappointing a customer is bad. Not taking corrective action to ensure that similar disappointments don't reoccur threatens your company's future.
1998, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article may not be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Does Every Item Have To Be Stocked in Every Branch?


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Does Every Item Have To Be Stocked in Every Branch?


by Jon Schreibfeder

In deciding what products to stock, remember our goal: "Effective inventory management allows a distributor to meet or exceed his (or her) customers' expectations of product availability with the amount of each item that will maximize the distributor's net profits." Sure, there are some items your customers expect you to have on the shelf, in every location, so they can be picked up or delivered within an hour or two. But are customers always this demanding? Are there products now stocked in every branch location that could be delivered within 24 or 48 hours without negatively affecting customer service? Let's look at an example: Each of ABC Distributor's six branches sells an average of one Hayward 1396 pump (cost = $78.00 each) per year. There is usually one pump on the shelf at every warehouse. If you ask the branch managers, they'll say maintaining inventory of the pump in every location is necessary to provide good customer service. But in reality, customers are usually willing to wait a day or two to get the part after they place an order. As a matter of fact, several customers are shocked to learn that this item is usually available for immediate delivery. So why is the part on everyone's shelf?
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It allows each branch manager to control all phases of the order fulfillment process. They won't be "messed up" by the lack of performance on the part of another company branch. Like a squirrel gazing at a hollow tree full of acorns in November, many branch managers feel good looking at full shelves. They're confident that they can handle almost any emergency, except maybe a nuclear attack, if the warehouse shelves are loaded and their delivery trucks have full tanks of gas. It's a wonderful sales strategy to be able to say to a customer, "anything you will ever need can be delivered in 30 minutes or less."

None of these is a valid reason for stocking the product in all warehouses. If ABC Distributors stocked two of the pumps in a central location and transferred them to other branches as they were ordered, overall company inventory would be reduced by 10 pumps, or $780. If they could do this with several hundred or even several thousand products, they would enjoy a significant decrease in their cost of maintaining stock inventory. What about your customers? Will your customer service suffer as a result of a new stocking policy? Let's look at the question from a different angle: Are your customers willing to pay premium prices to help support your bloated inventory? Wouldn't they prefer to pay lower prices and get non-critical parts in 24-48 hours? But keep in mind that for this system to work, the warehouse that stocks the pump has to be a very, very, reliable supplier. It has to treat the receiving branches as preferred customers and provide consistent, accurate delivery of the parts ordered by the receiving warehouses.

1998, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article may be distributed within a company or school for the benefit of its employees/students, but it cannot be reproduced in a publication for sale, in a website, or in conjunction with consulting services without the consent of Effective Inventory Management, Inc.

Next Article: Are You Making Money?


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Are You Making Money?


by Jon Schreibfeder
In this article, we revisit the concept of adjusted margin and show how you can determine whether specific inventory contributes to your company's profitability using the "Adjusted Margin NIREP" comparison.

I'm going to begin this article with two assumptions which should be true for all manufacturers (who maintain stock inventory), distributors, and retailers:
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You stock material to meet your customers' expectations of product availability. You are in business to make money.

In this article we're going to look at how the material you have in stock relates to these goals that is, how it is helping you meet your customers' expectations of availability while contributing positively to your company's bottom line.

The Three Types of Stocked Inventory

Whether you are a manufacturer, distributor, or retailer, each piece of each item in your stocked inventory can fall into one of three categories: The Good: The inventory that you stock that provides a positive return on your investment that is, you make money when you sell the product. The Bad: Inventory that doesn't provide a return on your investment, but contributes to other profitable sales. For example, you might have to stock a line of slow-moving repair parts to support the sales of other, hopefully very profitable, products. "Bad" inventory is a necessary evil. It is not an investment, but an expense that is, it is an expense of doing business. The Ugly: Inventory that doesn't provide a return on your investment, and doesn't contribute to profitable sales. If you're in business to make money, there is no reason for this stuff to be in your warehouse. Refer to some of our other articles for advice on liquidating your inventory of this material. Your first step in analyzing the profitability of your inventory investment is to place each item you stock into one of these three categories. But to do this, we must determine when a product contributes to corporate profitability that is, what inventory falls into the "good" category.

Defining Profitability
How does the typical distributor, manufacturer, or retailer define profit? Well, if you ask someone in the sales department, they'll probably talk to you about his or her company's gross margin: Annual Sales Dollars Annual Cost of Goods Sold Annual Sales Dollars The higher gross margin, the better. Under most circumstances salespeople would rather sell a product with a 24% margin than an item with a 20% margin. Why? Because most salespeople are paid based on gross margin. But does the company get a better return on investment on the product with a 24% margin? Maybe, maybe not. It depends on the average value of inventory the company must maintain to generate the sales of the item. The average inventory investment will depend on such factors as:
y y y y

Cost of the item. Variations in customer demand. Reliability of the vendor and method of transport. Quantities that must be purchased in order to sell the item at a competitive price.

The higher the average inventory investment, the more it costs you to maintain or "carry" the inventory in your warehouse. What expenses do incur in carrying inventory?
y y y y y

Approximately 40% of the material handling expense. Sixty percent of material handling expense is typically associated with filling customer orders. Approximately 40% of rent and utilities. Again, the remaining sixty percent of warehouse activity is normally associated with filling customer orders. Insurance and taxes on inventory. If it's in your warehouse you have to insure it, and it may be subject to tax. Physical inventory and cycle counting. The more material in your warehouse, the longer it takes to count. Inventory shrinkage and obsolescence. The more material in your warehouse, the higher the possibility of shrinkage and obsolescence. After all, it's hard to steal something that isn't there! Opportunity cost of the money invested in inventory. How much could you make if you were to take the money you're investing in inventory and invest it in a more traditional investment (such as treasury bills)?

Typically the carrying cost of finished goods inventory is 25%-35% per year of the average inventory value. With this fact in mind, does a product with a gross margin of 24% contribute more to a company's bottom line than another product with a gross margin of only 20%? Let's look at an example: Product "A": Annual Sales = $12,500 Cost of Goods Sold = $9,500 $12,500 $9,500 Gross Margin = = 24% $12,500 Product "B": Annual Sales = $12,500 Cost of Goods Sold = $10,000 $12,500 $10,000 Gross Margin = = 20% $12,500 At first look, item "A" contributes more to the company's profitability. But what the gross margin doesn't reflect is that we have to maintain an average inventory of $5,000 of item "A" and $2,500 of item "B." If we subtract the yearly cost of maintaining this average inventory investment from the annual profit dollars (i.e. sales cost), the result is a new measure of profitability, the adjusted margin:
Annual Sales Dollars Annual Cost of Goods Sold (Average Inventory Value x Carrying Cost%) Annual Sales Dollars

Let's look at the adjusted margin of our two products: Product "A": Annual Sales = $12,500 Cost of Goods Sold = $9,500 Average Inventory Value = $5,000

Carrying Cost Adjusted Margin

= 25% $12,500 $9,500 ($5,000 x .25) = = 14% $12,500

Product "B": Annual Sales = $12,500 Cost of Goods Sold = $10,000 Average Inventory Value = $2,500 Carrying Cost = 25% $12,500 $10,000 ($2,500 x .25) Adjusted Margin = = 15% $12,500 Even though product "B" has a lower gross margin, its adjusted margin shows that it contributes more to the company's profitability. You may be asking yourself, "But how do we know if the company is making money?" The answer is actually fairly simple. You compare the adjusted margin to percentage of "non-inventory related expenses," or NIREP. The NIREP is calculated with this formula: Annual Non-Inventory Related Expenses Total Annual Sales Annual non-inventory related expenses include all of the expenses you incur other than what was included in the carrying cost. This includes all selling, marketing, and administrative costs. Every expense from your profit and loss statement should be included in either the carrying cost or NIREP. If your adjusted margin is 14% and your NIREP is 10%, you're making money. If your NIREP is higher than your adjusted margin, you're looking at either "bad" or "ugly" inventory. Please don't confuse the NIREP with the operating expense as a percentage of sales. That measurement includes the expenses that make up the carrying cost of inventory. You can use the Adjusted Margin NIREP comparison to gauge profitability throughout your organization. For example:
y y y

The profitability of a branch. Compare the adjusted margin for the branch to the NIREP calculated for that branch. The profitability of a product line. Compare the adjusted margin for the product line to the NIREP calculated for the company. The profitability of a customer for whom you maintain consigned inventory. Compare the adjusted margin for the customer (profit for the customer and the cost of maintaining the consigned inventory) to the NIREP for the company.

If an item or product line's adjusted margin doesn't exceed the NIREP for the company, someone had better be able to prove that, even though the material doesn't directly contribute to the bottom line, it contributes to other profitable sales. The Adjusted Margin NIREP comparison is a great tool for separating your good bad and ugly inventory. Start using it today!

1998, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article cannot be reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: EDI and the Internet... What's the Difference?


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EDI and the Internet... What's the Difference?


by Jon Schreibfeder

You've probably heard that electronic commerce (that is, sending information directly from computer to computer) can increase your company's sales and lower its costs. Indeed, you have probably been overwhelmed by advertisements, written in "technospeak," that promise fantastic improvements after implementing a particular electronic solution. But if you're like most business executives, you haven't had the time to explore the multitude of available electronic products and services. You have your hands full just making sure that your normal business is completed in a timely fashion. Well, if you have five minutes, we'd like to give you a basic understanding of the options available today. With this knowledge, you can decide if any of these solutions are worth exploring or implementing.

EDI
Electronic Data Interchange (EDI) is the process of electronically sending business documents from one company's computer to another company's system. Let's look at

the document flow for a typical EDI transaction between a customer and his/her supplier:
y

y y

A purchase order, entered in a customer's computer system, is electronically sent to the supplier's computer where it is automatically entered as a sales order. As the supplier's computer creates the sales order, it sends an order acknowledgment back to the customer's computer system. The customer's computer updates its purchase order with the promise dates for each item. When the material is shipped, the supplier's computer system sends a shipment notification to the customer's computer. The customer's computer again updates the purchase order, noting that the material is in transit. When the material is received and the stock receipt entered, the customer's computer sends a receipt acknowledgment to the supplier's system. The supplier's system creates an invoice and electronically sends a copy to the customer's computer. The customer's computer enters the invoice into its accounts payable system.

The transfer of documents is facilitated and controlled by an EDI Value Added Network (VAN) provider. The VAN provider knows how to contact each trading partner's computer, when to receive documents from each partner, and when to send documents to each partner. There are many VAN providers offering services including Harbinger (www.Harbinger.com) and GE Information Services (www.GEIS.com). Note that two trading partners (i.e. a customer and supplier) do not have to use the same VAN provider, as one provider will forward documents to another. What are the advantages of EDI?
y

y y y

A significant saving of labor, since transactions do not have to be entered at both the customer and vendor. For example, when the customer's purchase order was sent to the vendor, a sales order was automatically created in the vendor's computer system. A saving of time, as EDI is usually faster than placing an order by phone, fax, or mail. Fewer errors, as each transaction is keyed in only once, at the point of origin. Because a formal relationship is established between each set of trading partners (along with the VAN provider), EDI transactions are highly reliable and security is rarely an issue.

The savings are so significant that some large companies will only do business with suppliers that can accept and process EDI transactions. What are the costs and challenges associated with implementing EDI? Your computer system must be able to translate the transactions it creates into a standard form that can be received and understood by your trading partner's computer. This used to be a major problem, as the EDI "X.12" standard was written in general terms. As a result, one company's version of the EDI purchase order was not necessarily the same as another firm's EDI purchase order. Companies incurred significant expense modifying their EDI software (or "maps") for each trading

partner. Recently a new specific standard, EDIPro, has ensured that a company can trade transactions with nearly any partner with standard EDI software. Though originally developed for electrical distributors, EDIPro is quickly being adopted by other industries to facilitate EDI implementation.

The Internet
The Internet, also known as the "electronic highway," has been promoted as the information source of the 21st century. Where EDI establishes a relationship between two companies, the Internet provides a company or individual access to anyone else in the world that has an Internet address. All anyone needs to get on the highway is a personal computer, a phone line or cable TV access, and some very inexpensive Internet access software. How can your company use the Internet? To send and receive electronic mail You can send an electronic ("email") message to anyone in the world, at anytime, day or night. And that message is delivered to the recipient's mailbox within one or two minutes. For example, if you think of a question for one of your suppliers at 11:30 at night, you can send her an email message, and it will be waiting for her when she arrives at the office in the morning. If that supplier is located overseas, your response may be waiting for you when you wake up. If necessary, you can send documents, drawings, or pictures along with your email message. Email is not only quicker than conventional mail (also called "snail-mail"), it is usually less expensive. Consider the time and materials involved in typing a letter, printing it, putting it in an envelope, affixing the right postage, and delivering the letter to the mail room or post office. In fact, if the same message has to be sent to several people, email allows you to broadcast the letter to all of the recipients at one time! To provide information about your company You can inexpensively develop a "website" to tell the world of the products and services your company offers. Material in a website can include catalogs, new product information, lists of customer contacts, and general company information. Customers can access this information at their convenience. And because this material can be organized and indexed, you can include specific information that is only applicable to certain groups of customers. To accept orders and inquiries Customers can key in orders through special programs in your website. Or they can check on the status of existing orders. Using this Internet capability, your customers become your order-entry operators! You can even accept their credit card payments through your website! But some challenges (i.e. problems) accompany these capabilities:

Email Because email is so easy to send, you tend to receive a lot of it. A lot of this is junk mail (also known as "spam"). Some is from people and firms you really have no interest in communicating with (like all of those lonely people who want to show you their pictures). You have to spend a significant amount of time deleting unwanted mail. And there is a strong possibility that some of the mail you send may be accidentally deleted by the user before it is read. Also keep in mind that people that send email know how quickly it is delivered. They usually expect an immediate response. Information about your company Website information is available to anyone with a personal computer and Internet access. Even people with whom you won't do business. Like your competitors or students doing research. Do you want to broadcast your products and prices to everyone? And because the information is always accessible, you must constantly update it with current information. How would it look if a prospective customer accessed your website and saw you advertising a two-year old product as the latest and greatest model? Orders and inquires Website order-entry programs must be easy to use, fast, and secure. Customers must be able to find what they want to order, enter the billing, shipping and payment information, and complete the transaction faster than they could by talking to a sales representative. And they want to be sure that their credit card numbers and other personal information is kept confidential and is not lost in "cyberspace." Even though Internet credit card fraud occurs less than half as often as phone credit card fraud (as a percentage of transactions), many people are unwilling to send personal information over the Internet. Last December, I spent 45 minutes trying to enter an order for some gifts on a popular website only to find that the company's easy-to-use software had more "bugs" than Florida has during the summertime. It is very expensive to develop and maintain good website order-entry programs. Very few companies (other than travel agents and pornography sellers) have found website order entry to be profitable. This situation will probably change as the percentage of business people who regularly use the Internet continues to grow.

EDI and the Internet


EDI is a very reliable and secure method of electronically sending business documents from one company's computer directly to another company's system. But even with EDIPro and other new developments, it is relatively expensive. The cost is the primary reason why less than 1% of businesses in the United States have EDI capabilities. The Internet is relatively inexpensive to access, but because of its open structure it provides limited security for your information. To address this problem, EDI and Internet Service Providers have introduced "EDI over the Internet" and Intranet (i.e. limited access Internet sites) capabilities.

In any case, if you are considering implementing an EDI relationship, be sure the profit or savings you receive from introducing the service exceeds the cost of implementation.

Some Suggestions
Electronic commerce and the Internet are here to stay. Get on board by getting online! Call an Internet Service Provider (you can find a list in the yellow pages of your phone book, or just call America OnLine) and get an email address. The software is easy to use. Use the browser and search capabilities of the software to look at websites for other companies in your industry. See what they're doing, and determine whether it's time for your company to have a presence on the information highway. If you decide to take the plunge, contact a local web developer to help you develop a simple site, with pertinent information of value to your customers. Then advertise your site to your current customers by placing its address (also known as a "URL") on your letterhead and other publications. Your web developer can help get your site properly listed on popular search engines, so prospective customers can easily find you. Over time, expand the contents of your site and the features you offer your customers.
EDIPro is a trademark of the National Association of Electrical Distributors.

Jon Schreibfeder is president of Effective Inventory Management, a company specializing in helping distributors get the most from their inventory investment.
1998, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article cannot be reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: How Much Is Free Freight Worth?


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How Much Is Free Freight Worth?


by Jon Schreibfeder

Many vendors offer to pay freight charges if an order exceeds a certain minimum requirement. Many buyers are "brainwashed" into thinking that they must always place an order that meets the free-freight minimum, even if it means bringing more inventory than can be used or sold in a reasonable amount of time. But is placing a free-freight order always a good idea? In this article, we're going to examine a process that will let you determine whether or not placing a free-freight order is a good buy. As you will see, sometimes you can maximize your profitability by paying the freight. How much is free freight worth? That's easy. It's the dollar amount on the freight bill. This amount is an additional discount offered by the vendor. Using the process described below, you can determine whether this discount exceeds the cost of carrying the additional inventory necessary to meet the freight prepaid requirement. Suppose you have a vendor who has a $500 minimum order, but offers free freight for a $2,500 order: 1. Determine the how much it costs (per dollar) for the vendor to send you a shipment. This can be done by dividing the total freight charges on the last five vendor shipments by the dollar amount for the merchandise on those shipments. If you do not have this information: a. Determine the total weight and/or volume for each of the last five shipments from the vendor b. Contact a freight company to find what the freight charges would have been for each shipment c. Divide the total amount of the freight charges for these shipments by the total dollar amount for merchandise on those shipment 2. A $2,500 pre-paid freight order offers a discount equal to 2500 times the average freight cost per dollar of material determined in step #1. For example, if the freight cost was $.20 per dollar of material, a freight-paid $2,500 order provides you with a discount of $500 ($2500 x $.20). 3. Add the cost of the freight you must pay for a minimum order to the cost of the material on that order. For example, the minimum order the vendor will accept is $500. If freight costs $.20 per pound, you will have to pay an additional $100 in freight. So you will pay $600 for $500 in material. For a prepaid order, you will pay $2,500 for $2,500 worth of material. That is, you won't pay freight on the larger order. 4. Calculate the month's supply of the vendor's products that each purchase amount represents. Assume that total demand for all of the stocked products in the vendor line is $500 per month: $500 $500/month = 1 month's supply $2,500 $500/month = 5 month's supply

5. Calculate the inventory holding cost that would be experienced at each discount level. The holding cost is the amount of money necessary to maintain the balance of a vendor shipment in your warehouse during the time it takes to sell the entire shipment. It is calculated using the inventory carrying cost percentage, a measurement that reflects who much it costs to maintain a dollar's worth of stock inventory in your warehouse for an entire year. How to determine the inventory carrying cost percentage is discussed in some of our other articles. The company in this example has an annual inventory carrying cost of 30%. That is, it costs 30 cents to maintain a dollar's worth of inventory in the warehouse for an entire year. a. Multiply the net value of material purchased at each discount level by one-half. This is the average amount of the inventory purchased that will be on-hand during the time it takes to sell the entire shipment. For example, if it takes 20 days to sell the entire shipment, the average amount you will have on-hand is a 10-day supply. Half the time you'll have more than a 10-day supply, half the time you'll have less than a 10-day supply. Note that freight charges, which are part of the net investment, are not considered in the average inventory investment! Invty Level Invest Avg. Invty 500 2,500 500 2,500 250.00 1,125.00

b. Calculate the holding cost percentage for the time period you will have the shipment by dividing the annual holding cost by 12 (to determine the holding cost per month) and then multiplying it by the month's supply determined in step #4. The annual carrying cost for this example is 30%. Thirty percent divided by 12 is 2.5%. Level Month's Supply CC% per Month Total Hold Cost % 500 2,500 1.00 5.00 2.5% 2.5% 2.50% 12.50%

c. Multiply the total holding cost percentage from step b by the average inventory investment that was calculated in step a. The result is your "holding cost dollars": Level Total Hold Cost % Avg Invty Holding Cost $ 500 2,500 2.50% 12.50% 250.00 1,125.00 6.25 140.63

6. Your total cost of inventory (including all of the costs you will incur) is the net investment plus the holding cost dollars: Level Net Invest Holding Cost Total Cost 500 2,500 $600 $2,500 6.25 140.63 606.25 2,640.63

7. Finally, calculate the cost per dollar of inventory. The cost per dollar of inventory relates the total cost of inventory at each purchase level to the amount of inventory you will receive. This is calculated by dividing the total cost of inventory determined in step #6 by the stock dollars required for each purchase amount. Level Total Cost Cost per Dollar of Inventory 500 2,500 606.25 2,640.63 1.2125 1.0563

The cost per dollar for the $2,500 order is $1.0563, or 12.9% lower than the level at which you have to pay freight. Even considering the cost of carrying the additional inventory, the freight savings realized with a $2,500 order make the larger purchase worthwhile. But if the freight expense were less than $.20 per pound, it might not be a good idea to purchase a five month supply just to avoid freight costs. This analysis gives what was previously a very subjective decision a definitive dollars-and-cents answer. And keep in mind that you cannot place a $2,500 order every week. In order to reap the savings of the free-freight offer, you must place larger purchase orders, less frequently. If you place a $2,500 whenever you need one or two items, you will increase the amount of inventory in your warehouse. It will take longer to sell this stock, resulting in much higher carrying costs. It won't take long for these carrying costs to exceed the discount provided by the free-freight offer, no matter how costly the shipping charges. So, if you plan to take advantage of free-freight offers, perform the analysis described above. And only purchase these quantities when it's time to place a normal target with the vendor. You'll always know when your vendor is offering you a good deal!
1998, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article cannot be reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Forecasting Items with Long Lead Times


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Forecasting Items with Long Lead Times


by Jon Schreibfeder

A demand forecast (also referred to as a usage rate) is a prediction of the amount of each product that will be sold, transferred, used in an assembly, or otherwise consumed in the future. It's easy to see that inaccurate forecasts can cause major problems for your company. When forecasted demand is far below actual demand for a product, you risk running out of products and disappointing your customers. If forecasted demand exceeds actual usage, you'll probably be faced with large quantities of dead stock and slow-moving inventory. For your company to be successful, your demand forecasts for products must be as accurate as possible. Most software packages offer some demand forecasting tools. Most do a fairly good job of predicting future usage. But some of them include attributes that prevent them from doing the best possible job of predicting future demand in every situation. In this article we'll look at one situation that few software packages handle well: items with long lead times. These may be products that are made to order or are imported from overseas. When most packages recalculate purchasing parameters, they forecast demand for the upcoming month. For example, at the end of December, the system will forecast demand of products for January. Replenishment decisions are made based on this new forecast. This works well if your products have short lead times, say a week or ten days. But what if some of your products have extended lead times? For example, an item may have a twelve-week lead time. If you order the product at the end of December, you'll receive the shipment sometime around April 1st. At the end of December, predicting how much you will sell in January doesn't help the buyer at all. He or she needs to know what April's demand for the product will be. Fortunately, it's fairly easy to consider extended lead times in forecasting the future demand of products. The process is best illustrated with an example:

1. Add the current predicted lead time (expressed in days) for the product being forecast to the current date. The resulting date falls within the period for which to forecast demand. We'll call this the "forecast period." Depending on your system, the forecast period can be a week, a month, an entire season, or a certain number of days. In this example we'll consider the forecast period to be one month. 2. Once you determine the proper forecast period, you need to calculate a demand forecast for that period. This demand forecast should be determined by three elements: o Historical usage. o Changing trends. o Known changes in demand that are not reflected in past history or trends.

Historical Usage
There are many formulas that use past usage to forecast demand. In fact, EIM now uses 29 different formulas to forecast demand customers' finished goods inventory. Each formula is appropriate in different circumstances. As we discussed previously, a formula designed to forecast demand for the upcoming month is not appropriate for products with long lead times. We've found that in most cases the best way to forecast usage for products with long lead times is to look at the usage surrounding the same forecast period, last year. For example, if we're forecasting demand for April, 1999, we'll determine an average usage per month by averaging the usage recorded in March, April, and May, 1998.

Trends
There is a problem with forecasting demand with history that is a year old: Usage of a particular item may have dramatically increased or decreased during the past 12 months. For this reason, a "trend factor" is applied to reflect the changes in your volume of business. There are many ways to calculate a trend factor. An accurate trend factor can usually be calculated by comparing total usage (expressed in units) during the three months prior to the date you are calculating the forecast to the total usage recorded during same three months in the previous year. In our example we are calculating our forecast in December, 1998. So, we'll compare the total usage in October, November, and December, 1997 to the total usage in October, November, and December, 1998. If the usage has increased by 10%, we'll increase the average usage determined above by 10%. If total usage during the three-month period has decreased by 20% compared to the same period last year, we'll decrease the average usage by 20%.

Known Changes in Future Demand


What if you know that, because of a new customer, usage of a specific item will increase by approximately 50 pieces per month? Or what if a new product is introduced and you predict it will replace about 50% of the sales of an existing stocked item? Neither of these circumstances is reflected by either usage history or trends. A mechanism must be provided for a buyer to manually enter these known changes in demand. The demand forecast for April is determined by adding the calculated average usage (adjusted by a trend factor) to these known changes in future demand for the forecast period. This month we've looked at forecasting items with long, relatively consistent lead times. It's obvious that many of the traditional methods for forecasting lead times don't apply to this situation. In future articles we'll look at other "special" forecasting circumstances. For example:
y y y y

Setting up an import schedule designed to keep inventory levels to a minimum while avoiding stock outs. Buying for several months or an entire season. Dealing with long, irregular lead times. Replenishment orders that fill tractor-trailers, containers, or rail cars that don't create dead stock and slow-moving inventory.

Our goal is to determine the best forecasting model for each stocked product, because the more accurate the forecast, the better you'll be able to maximize both customer service and the return on your inventory investment. Please let us know if you have questions or comments.
1999, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article cannot be reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: When the Price Goes Down, How Much Do You Buy?
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When the Price Goes Down, How Much Do You Buy?


by Jon Schreibfeder

Sometimes the cost of an item will be dependent on how much is purchased. For example, Foyt's Racing Supplies offers the following discount schedule for the #AJ 3000 Brake Pads: Quantity 100 500 1000 Unit Cost 10.00 10.00 10.00 Discount 5% 7.5% 10% Net Unit Cost 9.50 9.25 9.00

The current usage rate for the item is 100 pieces per month. Which of the three quantities on the screen above represents the best buy? Your salespeople will tell you that's an easy question... the best buy is the quantity of 1000 that provides the biggest discount and the lowest unit cost. But in coming up with this answer, the salespeople are ignoring the fact that it costs your company something to maintain inventory in your warehouse. We refer to this amount as the inventory carrying cost. The inventory carrying cost, also known as the "K" cost, is the accumulation of all of the expenses you incur maintaining stocked inventory in your warehouse. These costs include:
y y y

y y y

Moving material to the proper bin location and shifting it to other warehouse locations as necessary. Insurance and taxes on the inventory. Approximately 40% of your warehouse rent and utilities. The balance of these warehouse expenses is considered as part of the cost of filling customer orders. Physical inventory and cycle counting. Inventory shrinkage and obsolescence. Opportunity cost of the money invested in inventory. That is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment.

The total cost of carrying inventory, in dollars, grows as the investment in inventory grows. If you have more inventory, you have more money tied up in your warehouse stock. Inventory taxes and insurance increase. You probably also experience more inventory shrinkage (lost, damaged, or stolen material) and product obsolescence. Even apparently fixed expenses such as warehouse rent and utilities can vary with the amount of inventory maintained in your warehouse. Suppose you could eliminate 40% of your current inventory. Would you still need all of the warehouse space you now occupy? Could you lease or sub-lease part of the building? Remember that even if you own your warehouse building, you still have a rent expense. But instead of the rent being the amount of money you pay to the owners of the building, it is the amount of income you give up by not being able to lease the building to another business. Because of the direct relationship between the total value of inventory and the cost of maintaining that warehouse stock, the inventory carrying cost is expressed as a percentage of the average value of stocked inventory. As a general rule, the annual inventory carrying cost will be between 25% and 35% of the average value of stocked inventory. For example, if a distributor has an average inventory investment of $1,000,000, the annual carrying cost will be between $250,000 and $350,000. Firms with lower operating costs, such as those that own their own building, should use a number close to 25%. Distributors with higher operating costs, such as those whose warehouse space is limited and very expensive, should use a higher carrying cost percentage. In determining the quantity that results in the lowest total cost of inventory, we need to compare the net savings received at each discount level to the cost of carrying larger quantities of the product in your warehouse. We follow these steps in making this comparison: 1. Calculate the total incoming cost (i.e. what you pay the vendor plus freight and other miscellaneous expenses) at each discount level. This is done by multiplying each purchase quantity by the corresponding unit cost: Purchase Quantity 1 100 500 1000 Net Unit Cost 10.00 9.50 9.25 9.00 Total Incoming Cost 10.00 950.00 4,625.00 9,000.00

2. Calculate the net carrying cost we will incur if we purchase each quantity: A. Calculate the average value we will have on-hand during the time it takes to sell the entire purchase quantity. We do this by dividing the Total Incoming Cost in half. After all, half the time we'll have more than this amount, and half the time we'll have less than this amount.

Purchase Quantity 100 500 1000

Total Incoming Cost 950.00 4,625.00 9,000.00

Average Value of Inventory 475.00 2,312.50 4,500.00

B. Calculate the amount of time it will take to sell each purchase quantity. Remember that the usage rate for the item is 100 pieces per month: Purchase Quantity 100 500 1000 Monthly Usage Rate 100 100 100 Month's Supply 1.0 5.0 10.0

C. Determine the net carrying cost for each purchase quantity. For this example, the annual carrying cost is 30%, or 2.5% per month. This is done by multiplying the average value of inventory by the appropriate holding cost percentage: Average Value of Inventory 475.00 2,312.50 4,500.00 Net Holding Cost 11.88 289.06 1,125.00

Purchase Quantity 100 500 1000

Holding Cost % 2.5% x 1 mnth = 2.5% 2.5% x 5 mnth = 12.5% 2.5% x 10 mnth = 25%

3. Add the Net Carrying Cost to the Incoming Cost to equal your Total Cost for the material. Purchase Quantity 100 500 Incoming Cost 950.00 4,625.00 Net Holding Cost 11.88 289.06 Total Cost 961.88 4,914.06

1000

9,000.00

1,125.00

10,125.00

4. Divide the Total Cost of each Purchase Quantity by the total value of the material (Purchase Quantity x Unit Cost) to determine your net cost for each dollar's worth of material purchased. Purchase Quantity 100 500 1000 Purchase Quantity x Unit Cost 1,000.00 5,000.00 10,000.00 Net Cost for $1 Worth of Material $0.962 $0.983 $1.013

Total Cost 961.88 4,914.06 10,125.00

You achieve the lowest total cost by purchasing 100 pieces at a time. In fact, the total cost for the 1,000-piece bracket is higher than the non-discounted unit cost. That's paying more than a dollar for a dollar's worth of material! Carefully examine discounts for buying larger quantities of an item. A lower price doesn't always result in the best value!!
1999, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article cannot be reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Forecasting Future Demand of Products


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Forecasting Future Demand of Products


(Part One)

by Jon Schreibfeder

This is a continuation of a series we started several months back. Now, in addition to theory, we're going to get into actual effective forecast formulas. In 1987, Gordon Graham wrote a book, Distribution Inventory Management for the 1990s. In this book, Graham described what he considered to be the best method for forecasting the future demand for both seasonal and non-seasonal products. Let's take a quick look at these formulas: Non-Seasonal Products: Calculate demand for the upcoming month by averaging the usage recorded in the past six months. Seasonal Products: Calculate demand for the upcoming month by averaging the usage recorded in the upcoming six months, last year, and then applying a "seasonal trend factor" that expresses the anticipated increase or decrease in business experienced over the past year. These are simple formulas. And at the time Gordon wrote the book, simple formulas were necessary for distributors to successfully manage their inventory:
y

Many buyers could not effectively deal with mathematical formulas or computers. Ten-key calculators were considered "state-of-the-art" technology. In fact, most purchasing decisions at the time were based on "SWAG" (silly, wild-ass guessing). Any formula (including Graham's) introduced to provide consistency in ordering had to be fairly simple and easily replicated on a calculator. Computers did not have the power to perform comprehensive forecasting formulas for thousands of parts within a reasonable period of time. Calculating Graham's simple average for thousands of items stretched the physical capabilities of most computer systems.

The demand forecasts produced by the Graham formulas were generally more accurate than the predictions of the guy with the dull pencil and clipboard out in the warehouse. But there was still a considerable difference between Graham-based predictions and what was actually sold. At the time, these deviations were considered "unavoidable," and there was no way around them. Now consider how market conditions have changed since 1987:
y

Technology has allowed distributors to expand and increase their market areas. The result: You face more competition than ever. This competition has created more pressure on distributors to consistently have the products their customers want, when and where they want them. Increased competition has also put pressures on profit margins. Distributors have to offer lower prices in order to retain current business and attract new customers.

The number of new products introduced to the market continues to increase at a rapid rate.

These conditions present some unique challenges:


y y y

Decreased margins tend to limit the amount of money a distributor has available to invest in inventory. Distributors must spread the money available to invest in inventory over a greater number of products. Customers are less tolerant if product availability does not meet their expectations.

You're obviously in trouble if you don't have the inventory your customers expect you to have. And if you've bought too much of an item, your money is tied up and can't be invested in the other products that allow you to take advantage of new sales opportunities. These challenges require the best possible product forecasting. You can no longer accept as "inevitable" great deviations between forecasts and actual sales. Formulas developed just to be "easy to understand" and "better than a guy with a clipboard" have to be replaced with more comprehensive methods. Products with different patterns of usage, and different replenishment methods require different forecasting formulas. We need more than one formula for non-seasonal products, and one formula for seasonal products. For example, a product whose sales mirror local economic conditions requires a different formula than a product with steady, fairly predictable sales. And just as important, each formula needs to be easy to understand. During the next several months, we'll look at some of the 29 different forecast demand formulas developed by EIM. We're going to start with a formula for nonseasonal products with fairly consistent usage. These are items that sell regularly and whose volume has increased or decreased less than 20% per month during the last several months. When forecasting the usage of non-seasonal products with fairly consistent usage, we want to average the usage that was recorded during the past several inventory periods. But we also want to "weight," or place more emphasis on, the most recent month. Why? 1. There are often trends in a product's usage as it becomes more or less popular over time. For non-seasonal products, demand in the upcoming inventory period will more likely be similar to the usage recorded in the past several inventory periods than what happened six, eight, or twelve months ago. 2. At the same time, there is usually a certain amount of random variation in a product's usage from one inventory period to another. Notice how the usage of the item in the first example below has fluctuated over the past five months. This "up-and-down" pattern of usage is common for inventory items with moderate-to-high sales. If we were to use just the most recently completed one or two inventory periods in our calculations, the random fluctuations in usage

would probably have too great an influence on the forecasted demand. We want to include enough history to ensure that random fluctuations do not have a significant impact on a product's forecast. Here is a common set of weights to use in calculating demand for a non-seasonal item with moderate-to-high sales:
y y y y y

Place a weight of 3.0 on the usage recorded in the most recent period. Place a weight of 2.5 on the usage recorded in the next previous period. Place a weight of 2.0 on the usage recorded in the next previous period. Place a weight of 1.5 on the usage recorded in the next previous period. Place a weight of 1.0 on the usage recorded in the next previous period.

Let's see how the forecast for an item is calculated with the following usage history. Usage is the quantity of a product sold, transferred, used in assemblies or repair orders, or otherwise taken from stock. Number of Business Usage per Days in Month Business Day

Month

Total Usage

June May April March February

148 133 126 110 104

20 19 18 22 20

7.4 7.0 7.0 5.0 5.2

Note that we've specified the number of business days in each month, and determined the usage per business day. Utilizing usage per business day provides more accurate forecasting than traditional forecasting methods that rely on total monthly usage or usage per calendar day. After all, if a company is closed for several days during a month (remember the Christmas holidays?), considering that month's lower usage equally with the usage recorded in other months tends to underestimate future forecasted demand. For example, in the chart displayed above, total usage recorded in May (133 pieces) is about 5.5% higher than total recorded in April (126 pieces), but the demand per business day is the same. We will apply the weights of the demand calculating formula to the usage per business day for the five preceding months to determine the forecast demand for July: Usage per Weight Business Day Extension

Month

June May

3.0 2.5

7.4 7.0

22.2 17.5

April March February Total

2.0 1.5 1.0 10.0

7.0 5.0 5.2

14.0 7.5 5.2 66.4

The extension (66.4) is divided by the total weight (10.0) to determine our prediction of the demand per business day for July (6.64 pieces per day). And this demand per day is multiplied by the number of business days in July (21) to predict the demand of 139.4 pieces for the inventory period. Compare the results of this calculation to the demand predictions provided by other forecast formulas and methods. We think you'll be impressed with the results. Next month we'll look at non-seasonal products with significant increasing or decreasing usage. In the meantime, if you have any specific questions, please let us know.
1999, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article cannot be reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Part Two


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Forecasting Future Demand of Products


(Part Two)
by Jon Schreibfeder

This is a continuation of a series we started several months back. Last month we looked at forecasting the future demand of non-seasonal products. This month we'll look at demand forecasts for products whose usage varies from season to season throughout the year. If necessary please review Part One for the background necessary to understand the concepts we'll explore this month. Some items, like beach umbrellas, are more popular in summer than in winter. On the other hand, portable heaters enjoy much higher sales when the weather gets cold. These are seasonal items. But the weather is not the only factor that determines whether or not an item is seasonal. If a product's usage is controlled by an event (such as Christmas or the start of school) or an annual activity (like yard clean up in the fall), the item is also considered to be seasonal. The usage of a seasonal product rises and falls throughout the year. Look at this seasonal item's usage history: Jun May Apr Mar Feb Jan 1999 1999 1999 1999 1999 1999 Usage 1999 ? 300 150 80 50 30

Dec Nov Oct Sep Aug Jul Jun 1998 1998 1998 1998 1998 1998 1998 Usage 1998 50 100 150 300 520 460 400

Usage of the product is very low during the winter months. But in early spring, sales begin a gradual increase and peak during the summer months of June, July and August. If we forecast demand for June 1999 by using the formula for non-seasonal products with consistent usage (described in Part One), we get the following result: Number of Business Usage per Days in Month Business Day

Month

Total Usage

May April March February January


Month

300 150 80 50 30

19 18 22 20 22

15.8 8.3 3.6 2.5 1.4

Usage per Weight Business Day Extension

May April

3.0 2.5

15.8 8.3

47.4 20.8

March February January Total

2.0 1.5 1.0 10.0

3.6 2.5 1.4

7.2 3.8 1.4 80.6

The extension (80.6) is divided by the total weight (10.0) to determine our prediction of the demand per business day for June of 8.06 pieces. Because June has 20 business days, demand for the inventory period is 161.2 pieces (20 days x 8.06 pieces per day). Remember that demand is defined as a prediction of the usage of a product during the upcoming inventory period. Is 161 pieces a good forecast of June's usage? Probably not. After all, usage in June 1998 was nearly three times this amount (460 pieces). It is obvious that we need different formulas for calculating the demand for seasonal items. We've found that one of the best indicators of what demand will be for a seasonal item next month is the usage recorded during the upcoming several months, last year. For example, one formula for forecasting demand for seasonal items considers the usage for the upcoming month and the following month last year, applying the following weights:
y y

Place weight of 2.0 on the usage recorded in the month being forecast, last year. Place weight of 1.0 on the usage recorded in the month following the month being forecast, last year. Number of Business Usage per Days in Month Business Day

Month Total Usage

June 1998 July 1998

400 460

19 18

21.1 25.6

Usage per Month Weight Business Day Extension

June 1998 July 1998 Total

2.0 1.0 3.0

21.1 25.6

42.2 25.6 67.8

The extension (67.8) is divided by the total weight (3.0) to determine our prediction of the demand per business day for June of 22.6 pieces. Because June, 1999 has 20 business days, demand for the inventory period is 453 pieces (20 days x 22.6 pieces per day). But there is a problem with forecasting demand with history that is a year old. Business in the branch where the item is located, or in its particular line of products, may have increased or decreased during the past 12 months. For this reason, a "trend factor" can be applied to the results of the weighted average formula to reflect overall changes in your volume of business. Many systems will allow you to manually maintain trend factors. Say, for example, you determine that the sales volume in our item's product line increased 20% over the past year. To determine the actual demand forecast for the product, we'd increase the result of the seasonal weighted average formula by 20% to determine the actual demand forecast for June, 1999: 22.6 pieces/day + 20% = 27.1 pieces/day More advanced systems calculate a suggested trend factor by comparing the total usage in the last three completed months (before the forecast demand calculation) to the total usage in the same three months in the previous year: Total Usage March,1999 - May, 1999 = 530 pieces Total Usage March 1998 - May, 1998 = 462 pieces (530 - 462) 462 = 14.7% Business in the past three months was 14.7% greater than the same period last year. This percentage is added to the results of the weighted average formula: 22.6 pieces/day + 14.7% = 25.9 pieces/day Whether specified manually or calculated automatically by the system, trend factors must be applied whenever seasonal forecast formulas are utilized to compensate for the change in business experienced over the past 12 months. Next month, we'll continue our examination of various methods of forecasting the future demand of products. Please check back with us as we continue this analysis. Remember, accurate forecasts will substantially contribute to the profitability of your company!
1999, Effective Inventory Management, Inc., 120 S Denton Tap Rd, Ste 450-200, Coppell TX 75019. All rights reserved. This article cannot be reprinted, or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Can You Predict if Inventory Will Die in Your Warehouse?

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Can You Predict if Inventory Will Die in Your Warehouse?


by Jon Schreibfeder

This month, I'd like to revisit one of my favorite topics. It's one of the greatest causes of dead inventory: leftover quantities of new stock products. You know what I mean. You buy 100 pieces from the vendor, sell 25 to customers, and the remaining 75 pieces rot on a shelf in your warehouse. Remember that any stock inventory that is not eventually sold to customers represents a loss to your company a loss that must be paid for with net profits! In a previous article, we explored how considering the effect a new item will have on existing inventory can help prevent the remaining stock of the existing products from becoming dead inventory. But what else can you do to prevent material from dying in your warehouse? Well, a good place to start is to follow a four-step plan whenever you're considering adding an item to stock: 1. Carefully consider each new investment in inventory. 2. Set sales goals for the new products. 3. Negotiate the return of unsold material with the vendor before the purchase order is signed. 4. Monitor progress towards achieving sales goals each month. This month, we'll explore the first step: carefully considering the addition of each new product to inventory. We'll examine the other three steps in upcoming articles.

The Inventory Actuarial Table


Most distributors carefully consider each new purchase of capital equipment. Every truck, desk, and computer purchased must have the potential for increasing profitability of the company. After all, money doesn't grow on trees, and management knows that the limited funds available for new capital equipment must contribute to the company's profits. Unfortunately, new inventory items don't always receive the same careful consideration. Why? Because introducing new inventory items is often an emotional decision. You have a "hunch" that something will sell, and you act on that hunch by investing in some of the product for stock. Unfortunately, often these hunches are wrong, and the result is dead inventory. Is there a better way than simply relying on hunches? We think so. After working with many distributors, we've found there are some common characteristics of those new products that usually meet or exceed sales projections. There are also common attributes of new items that often become dead inventory. We call the result of our research the "Inventory Actuarial Table." In the insurance industry, actuarial tables assess the risk involved in insuring a car, a person's life, or something else for which an insurance policy is issued. Our actuarial table looks at the risk of a new stock item becoming dead inventory. Our inventory actuarial table is divided into three sections:
y y y

Items presenting the least risk of becoming dead inventory. Items presenting a moderate risk of becoming dead inventory. Items presenting a substantial risk of becoming dead inventory.

Let's look at some common characteristics of the products in each category, as well as looking at some things you can do to minimize your risk of each type of product "dying" in your warehouse without being sold.

Least Risk
These items are almost sure to sell. For example: New Items with a Firm Customer Commitment that is, a signed customer purchase order to buy the entire quantity that you must bring into inventory. Yes, there is a chance that the customer will go out of business, cancel the order, or return the material for credit, but most customers who are willing to sign a purchase order are intent on using the product. Non-Stock Products with Recurring Sales. These are non-stock products that are continually sold to one or more customers. After you've ordered them several times in one year to fill existing customer orders, you may decide that it would be more economical for you, and more convenient for your customer, to keep several pieces in stock.

To reduce the chance of these items becoming dead inventory, sales should be analyzed at least twice a year to ensure that your customers are continuing to buy these products. If you notice a drop in usage one month, immediately contact the customer to determine the reason for the decrease in demand. Perhaps they are experiencing a temporary drop in usage or, for some reason they've determined that your service is unsatisfactory, or their needs have changed. Quickly identifying the reason for the decrease in sales allows you to fix the problem or to liquidate your remaining inventory before it becomes dead stock.

Moderate Risk
There is a greater chance that these new stock items will eventually become dead inventory. Salesperson and customer "suggestions" represent the most common type of moderate risk item. Has a salesperson ever burst into your office and exclaimed, "these would sell like hotcakes if we only had them on the shelf"? This salesperson's excitement is reflected in a common sales pattern for new stock items:

Notice that sales spike shortly after the item is introduced to inventory. This is probably due to the fact that salespeople are featuring this product in their sales calls. As time goes on, salespeople don't talk about this product as often. In fact, their attention may be centered on more recent additions to inventory! They forget to remind the customers who asked that the product be stocked why they aren't buying more of the item. To reduce the chance of these items becoming dead inventory, you must continually remind the salespeople of the sales and current stock position of all new stock items. Print and distribute a report containing the following new product information to each salesperson each week, or at a minimum each month, until the product has been in inventory for five to six months:
y y y

Product number and description. Current month sales (in units). Sales projection for the current month (provided by the salesperson before the item was added to inventory).

y y y y y y y

Total sales (in units) of the item to date. Total sales projection to date (provided by the salesperson before the item was added to inventory). Current on-hand quantity. Manually set minimum stock level of the item. Manually set maximum stock level of the item. Name of salesperson who requested that the item be stocked. Reason why the item was added to stock.

Note that because we don't have enough usage history to accurately forecast future demand of new products, they are normally maintained with manually set minimum and maximum stock quantities. By continually reminding salespeople of the existence (as well as the sales volume) of new stock items, we hope that they will continue to enthusiastically promote the product.

Substantial Risk
What type of new stock item is often at the greatest risk of becoming dead inventory? Products that your vendor suggests you carry! Your vendor's salesperson arrives at your office carrying an armload of glossy brochures. He shows you sales projections showing that a new item will take off and provide you with a wonderful opportunity to increase your profits or market share. Unfortunately, the new inventory may not be the panacea portrayed in the fancy graphs. Recent surveys have shown that only a small fraction of customers who have said in a survey that they would buy a new item eventually purchase any of the item. This means that the vendor's survey (which was probably biased towards purchasing the product) probably does not accurately reflect the eventual actual sales of the item. The best way to reduce the chance of vendor-recommended items becoming dead inventory is to negotiate the return, at no charge, of any unsold portion of the initial stock shipment of the product six or nine months after the date of receipt. If the vendor is unwilling to take back this unsold material, carefully reconsider stocking the product. Can you obtain a small quantity of the item from another source, even if you have to buy it at a higher cost? This "test quantity" will help you determine whether or not the new item will be a profitable addition to your inventory. Sure, the high cost will mean that you won't make a lot of money from the item during the test period. But losing money for a month or two on sales of an item is usually preferable to writing off a large unsold portion of the initial shipment. When you add new items to inventory, you're investing part of your company's limited assets in the hope of gaining new sales and increasing profitability. Each new product addition should be made only after careful analysis, and the performance of every item should be reviewed on a regular basis.
1999, Effective Inventory Management, Inc. All rights reserved. This article may be distributed within a company or school for the benefit of its employees/students, but it cannot

be reproduced in a publication for sale, in a website, or in conjunction with consulting services without the consent of Effective Inventory Management, Inc.

Next Article: A New Look at Safety Stock


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A New Look at Safety Stock


by Jon Schreibfeder

Theoretically, it should be easy to determine when to reorder a stocked item from a supplier. If you know that customers will order ten pieces of the product each day, and you know that it will take seven days to get the shipment from the vendor, you should reorder the product when there are seventy pieces on the shelf:

Demand per Day Lead Time Usage During Lead Time 10 pieces 7 days 70 pieces

This quantity is appropriately called the "order point." But the order point formula contains one more element: safety stock. Safety stock provides protection against running out of stock during the time it takes to replenish inventory. Why is this protection necessary?
y

Demand is a prediction based on past history, trend factor(s), and/or known future usage of a product. The item's actual usage will probably be more or less than this quantity. Safety stock is needed for those occasions when actual usage exceeds forecasted demand. It is "insurance" to help ensure that you can fulfill customer requests for a product during the time necessary to replenish inventory.

The anticipated lead time is also a prediction, usually based on the lead times from the last several stock receipts. Sometimes the actual lead time will be greater than what was projected. Safety stock provides protection from stock outs when the time it takes to receive a replenishment shipment exceeds the projected lead time.

The following diagrams illustrate how safety stock is used:

Projected Lead Time = 8 Days Demand = 1 piece/day On Order with Vendor = 0 The dotted line in the graph represents the available quantity (On-Hand Committed) of the item. A replenishment order is placed on the first of the month as the available quantity available reaches the order point ("A" in the graph). In this example, there is none of the product currently on incoming replenishment orders. Therefore, at point "A," the item's available quantity equals its replenishment position. The actual usage of eight pieces during the lead time is consistent with projected demand. The shipment arrives on the 9th of the month. As the stock receipt is processed, the available quantity on the shelf is equal to the safety stock quantity. The protection provided by the safety stock was not needed. The product again reaches the order point on the 11th of the following month ("B" in the following graph):

Projected Lead Time = 8 Days Demand = 1 piece/day On Order with Vendor = 0

Another order is placed with the supplier. But the vendor is temporarily experiencing manufacturing problems and the shipment arrives two days late ("C" in the graph). If it weren't for the safety stock, we would have run out of the product. Shortly after the shipment arrives, a customer orders 10 pieces of the product. You experience more than a week's usage in just one day. The available quantity falls to "D" in the following graph. A replenishment order is issued that day, but the available quantity is already below the order point.

The safety stock quantity allows you to satisfy customer demand for the product until the replenishment shipment arrives from the supplier on the 29th of the month ("E" in the graph). Again, safety stock prevented a stock out.

How Much Safety Stock Do You Need?


Take a look at this graph:

When a replenishment shipment arrives, the available quantity is usually somewhere in the shaded area of the graph. Notice that the safety stock quantity is in the middle of the shaded area. Half the time you will use some or all of the safety stock before the replenishment shipment arrives. The other 50% of stock receipts will arrive before you use any of the safety stock. On average, the full safety stock quantity is always on the shelf when the replenishment shipment arrives. It is, on average, "non-moving" inventory. A distributor puts inventory in her warehouse to sell it to customers. Profits from these sales are necessary to pay the distributor's expenses and provide a return on her investment. With this thought in mind, it seems as though it would not be a good idea for a distributor to intentionally have non-moving inventory in stock. On the other hand, keep in mind the goal of effective inventory management: "Effective inventory management allows a distributor to meet or exceed his (or her) customers' expectations of product availability with the amount of each item that will maximize the distributor's net profits." Safety stock is, in reality, an expense of doing business. But it is necessary to ensure good customer service. To maximize profits, we must carefully control all expenses, including safety stock. Therefore, we want to achieve our customer service goals with the least possible amount of safety stock.

The Conventional Ways of Calculating Safety Stock


There are two common conventional methods for calculating the safety stock quantity for a product:
y y

Percentage of Lead Time Demand Days Supply

As we discuss the various methods for calculating safety stock quantities, we'll refer to two variables, "forecast demand" and "usage." Forecast demand is a prediction of how much of a product will be sold or otherwise used in a particular month, and usage is the quantity that was actually sold or used.

Percentage of Lead Time Demand


Retired inventory consultant Gordon Graham long advocated that, for most items, 50% of lead time demand provides an adequate safety stock quantity. Let's look at an example: Demand/Day = (390/30) = 13 pieces Projected Lead Time = 8 days Demand During the Lead Time = (8 x 13) = 104 pieces Safety Stock = (104 x 50%) = 52 pieces

The thirteen pieces per day is multiplied by the projected lead time of eight days resulting in a lead time demand of 104 pieces. Safety stock is half this amount, or 52 pieces. This quantity represents a four day (4 days x 13 pieces/day) reserve. This method is easy to understand but it tends to maintain too much or too little safety stock for many items. For example: Products with long but very reliable lead times and with fairly consistent demand. If we use this method for an imported product with a 12-week lead time, we'll keep six weeks stock in reserve as safety stock. If we usually receive the shipment on time and demand doesn't vary substantially from month to month, we'll have too much safety stock in other words, too much money tied up in non-productive inventory. Products with very short lead times and significant variations in demand from month to month. If a product had a one-week lead time, this method will keep a three or day supply of the item in reserve as safety stock. If usage tends to vary significantly from month to month, there probably won't be enough safety stock available to consistently fill customer demand and the company will experience stock outs.

Days Supply
The days supply method allows a buyer to manually specify a number of days supply of a product to hold in reserve as safety stock. Because a buyer usually does not have the time to review the safety stock parameters for every item each month, he or she will probably set the days supply to provide more than enough safety stock. After all, in the eyes of most buyers, excess inventory is usually preferable to stock outs. As a result, the days supply method often results in the accumulation of non-producing inventory.

A Better Way of Maintaining Safety Stock


Remember that the purpose of safety stock is to protect customer service from unusual customer demand during the lead time or delays in receiving a replenishment shipment. Why not base the amount of safety stock maintained for each item on the variations in demand and lead time? The greater the variation in demand and/or lead time, the more safety stock will be maintained for the item. This is referred to as the "average deviation method." Let's look at an example. We'll consider the variation or deviation in demand as the difference between the forecast demand of a product in a month and the actual usage in the past three months (it is common to use three to six month's history in this calculation). Consider an item with the following forecast demand and usage history:

Forecast Actual Deviation

Demand Usage January February March 50 76 80 60 80 70 10 4 -10

In January, the demand forecast was 50 pieces and actual usage was 60 pieces, resulting in a deviation or difference of 10 pieces. In February, the demand forecast was 76 pieces and actual usage was 80 pieces, which produced a deviation of four pieces. The average deviation is: (10 + 4) 2 = 7 pieces per month Note that the deviation for March, in which demand exceeded usage, is not considered in our calculation of safety stock. Why? Because if our prediction of what customers want exceeds actual sales, we certainly don't want to add more safety stock to inventory. We probably have more than enough on the shelf already. Next we have to calculate the average deviation of the product's lead time. In calculating this amount, we'll just look at the last three stock receipts from the primary source of supply. Why so few? Well, a lot of things can occur over extended periods of time that will affect the lead time for an item. For example:
y y y

Your vendor can add or shut down production lines. Freight carriers can use different routes. The availability of the raw materials needed to make the product may change.

Here are the three most recent stock receipts for the item along with the anticipated lead time for the product when the purchase order associated with the stock receipt was entered:

Anticipated Actual Date of Receipt Lead Time Lead Time Deviation June 15th April 20th February 2nd 10 days 8 days 8 days 17 days 13 days 6 days 7 days 5 days -2 days

As with our analysis of demand and usage, we will not consider any stock receipt whose actual lead time was less than its anticipated lead time in other words, any time we received the item early. The average lead time deviation of the remaining two stock receipts is six days: (7 + 5) 2 = 6 days

The six days is multiplied by the current anticipated demand per day to determine the anticipated usage during the six-day period. Demand per day is calculated by dividing the current monthly demand by the number of work days in the month. For example, say the current monthly demand is 90 pieces and the current month has 18 work days. The demand per day is five pieces; multiplied by the six-day deviation equals 30 pieces. The 30 pieces is added to the demand deviation to determine the total safety stock for the item: 30 + 7 = 37 pieces As a final step in determining the safety stock quantity, we'll multiply the average deviation by a deviation multiple. The deviation multiple used is dependent on the customer service level we want to provide to our customers. Customer service level is defined as the percentage of line items for stocked products shipped complete by the promise date. The higher the multiple, the more safety stock we'll maintain, and the higher the customer service level. Please refer to our other articles for a complete discussion of the customer service level. Generally we've found that the following multiples provide the corresponding level of customer service:

Deviation Multiple Resulting Customer Service Level 2 3 4 95% 97% 99%

If our goal is a 95% customer service level, we'll multiply the average deviation by a multiple of two (37 x 2 = 74 pieces). Be careful! Using a higher deviation increases the amount of non-moving inventory on your shelf. In our example, the difference between a safety stock quantity derived using a deviation multiple of two or three is an additional 37 pieces! Yes, this is a more involved way of calculating safety stock than the conventional methods previously discussed. But it reflects the variations in market conditions, and therefore better predicts if a particular product needs more or less safety stock. And, if your computer system calculates your replenishment parameters, you won't have to worry about performing the calculations. However, you will have to properly assign deviation multiples to each item, in each warehouse, in order to meet your overall customer service level goals. We'll discuss that process next month.
1999, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Another Look at Inventory Turnover

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Another Look at Inventory Turnover


by Jon Schreibfeder

A few months ago, we published an article entitled, "Why Is Inventory Turnover Important?" You can find this article, along with more than 25 other informationpacked documents in the articles section of this website. Recently, we've had quite a few questions on how turnover should be calculated. So this month we're going to try to clarify the proper method for calculating inventory turnover. First, let's define "inventory turnover." Turnover is the number of times you sell your average investment in inventory each year. Turnover is calculated with the following formula:
Cost of Goods Sold from Stock Sales during the Past 12 Months Average Inventory Investment during the Past 12 Months

For example, if a company has total annual sales (at cost) of $12,000,000 and its average inventory value is $3,000,000, its inventory turnover is four turns per year (12,000,000 $3,000,000). If the results of the inventory turnover equation are to accurately reflect the performance of a firm's investment in stock inventory, we must take great care in determining the values for both cost of goods sold and the average inventory value. Let's look at these two components.

Cost of Goods Sold


The value appearing in the numerator of the equation should reflect the cost of goods sold from stock over the previous 12 months. For example, if we are calculating

turnover at the end of August, 1999, turnover should be based on the total cost of goods sold from September, 1998 through August, 1999. Direct and drop shipments (i.e. sales of material sent directly from a vendor to a customer) are not included because the material never passes through your warehouse, and as a result is not reflected in the average inventory value appearing in the denominator of the equation that is, we have not made an investment in inventory in order to generate these sales. Special order items (i.e. products ordered for a specific customer order that are not normal inventory items) are also not included in turnover calculations because they do not remain in inventory for a significant period of time. They normally are shipped to customers within several days of their receipt from the supplier. Including the cost of special order items in the cost of goods sold used in the equation tends to exaggerate turnover. The cost of goods sold figure is not always accurately calculated. For example, some companies compute turnover by considering year-to-date cost of goods sold, and compute an annual figure based on this amount. For example, August is the eighth month of the year. At the end of this month, we're two-thirds the way through the year. If a company's cost of goods sold through the end of August is $8,000,000, that company may feel that this will be two-thirds of the annual cost of goods sold ($12,000,000). But this method assumes that sales are consistent throughout the year. If a company experiences any seasonal fluctuations (e.g. a slowdown during the Christmas season) this method will not result in an accurate cost of goods sold amount. As a result, the calculated turnover will not reflect actual inventory performance. If you are considering turnover for the company, you should only include the cost of goods sold of items delivered to customers. This would include amounts sold to customers as well as quantities used for repairs and in assemblies. Including transfers in the calculation of overall corporate inventory turnover produces exaggerated results. After all, a company could continually transfer material from one location to another without ever selling it to a customer. If we were to include transfers in turnover, the company would have incredibly high inventory turnover, but no sales! However, if you are calculating the inventory turnover for a central warehouse, you should include transfers in the calculation of inventory turnover. Central warehouses are facilities that serve as the normal source of supply for other company locations. These branches are customers of the central warehouse. If we don't consider transfers in the inventory turnover of a central warehouse, the results of the calculation will fall short of actual turnover for that facility. Most companies use average cost in the calculation of the cost of goods sold. You may use another cost basis (e.g. last cost, FIFO, LIFO, etc.) as long as you are consistent from month to month. Also, be sure that the cost basis used for the cost of goods sold in the numerator is the same cost basis used for the average inventory value in the denominator of the equation.

Average Inventory Value


This is the average value of stock inventory over the previous 12 months that is, the same 12 months used in determining the cost of goods sold previously discussed. It should include all material in your warehouse, even the dead stock. Companies that manufacture and assemble products may also have to consider factors other than the cost of raw materials (or components) in turnover calculations. If the cost of goods sold amount in the numerator includes any labor or other charges necessary for producing or assembling finished goods inventory, the average inventory value should include the same non-inventory charges for both the current work in progress (WIP) inventory as well as the finished goods inventory. If the cost of goods does not include any labor or non-material charges, the average inventory value should only include the actual cost of the components or raw material. Again, we're trying to use a consistent cost basis in the numerator and denominator of the equation. As we said at the beginning of the article, inventory turnover measures the number of times you sell your average investment in inventory each year. To put it another way, it is the number of opportunities you have to have to earn a profit on the money you have invested in stock inventory. It is a crucial measurement that must be calculated accurately.
1999, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Protect Yourself against Theft


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Protect Yourself against Theft


by Jon Schreibfeder

In a previous article, "Do Your Employees Understand the True Cost of Lost Material?" we discussed the fact that many employees don't realize the value of your stock inventory and may "borrow" products or take samples for their personal use. Unfortunately, there is another reason why material disappears: theft. Many distributors find it hard to believe that their employees or customers would steal. But unfortunately stealing, especially petty theft, is a very common reason for "inventory shrinkage." And a distributor who doesn't admit that theft is a problem, or a potential problem, is just burying his or her head in the sand. Employee theft is not a new phenomenon. Nearly a hundred years ago, my greatgrandfather owned a clothing store in Weston, West Virginia. He occasionally commented that he'd been in business for 30 years and had never sold a single handkerchief to an employee (these were the days before Kleenex). Did the employees think they were stealing? Probably not. These were good people who never would have thought of taking money out of the cash register. But they didn't appreciate the true value of inventory. They didn't see the direct relationship between the inventory in the store, turning that inventory into cash by selling it to customers, and using that cash to pay employees and other expenses. As we stressed in the article mentioned above, employees must see all inventory shrinkage as an expense that reduces the amount of money available to pay wages and benefits. It takes money out of their pockets. There are, of course, some people who are truly thieves. And sometimes a distributor inadvertently hires one. Thieves usually don't see their long-term security tied to the success of the firm that employs them. Most often these individuals have a short-term goal: that is, getting as much material as possible out of the warehouse (without being caught). Some distributors install security cameras and other theft-deterrent devices. While they are important tools in a retail environment, the effectiveness of these "hi-tech" solutions in a distribution warehouse is questionable. True, they may be a deterrent to some theft, but employees who are also thieves usually put considerable thought and effort into getting around these systems and continue to steal. At the same time, honest employees often feel intimidated and resentful as "big brother" continually watches their every move. These feelings often discourage good and loyal employees from giving their all for the company. A better way to discourage theft is for management to create an atmosphere that encourages effective inventory management. Here are several policies that will help to solve the inventory shrinkage problems faced by many distributors. Limit access to the warehouse. You cannot hold your warehouse employees responsible for the material in your warehouse if customers, truckers, salespeople, and other individuals can walk through the aisles, unescorted, at any time. Only the people receiving, moving, picking, and packing material should be allowed in the area where merchandise is stocked. After all, how many people are allowed to wander around the vault at your local bank?

Your salespeople may complain that they need to run out to the warehouse to check material availability because the stock balances in the computer are inaccurate. This may be true. Unfortunately, one of the major reasons why computer stock balances are inaccurate involves the number of people who have access to the warehouse. This is truly a "chicken and egg" situation: Your salespeople need access to the warehouse because your stock balances are inaccurate. Your stock balances are inaccurate because your salespeople (along with customers, vendors, truckers, and others) have access to the warehouse. This is a vicious cycle that won't be broken until you implement business policies that are designed to maintain accurate stock quantities. O.K., some distributors can't keep salespeople out of their warehouse. Maybe they don't have enough help, or maybe salespeople are responsible for providing afterhours service to customers. If your company is in this situation, be sure to implement a tool that allows salespeople to easily record any material they remove. In fact, many companies allow the salespeople themselves to develop the system to record the products they remove for emergencies, samples, or other valid reasons. This "system" is often just a clip-board hanging by the warehouse door. At one company, the following information is noted for each item taken (that's not listed on an actual pick ticket): Date 6-10-99 6-10-99 Quantity 1 12 Item # A-1234 Reason Taken By

Sample for Acme Construction Jeff Miller Karen Becker

M-2356 Emergency for Jensen Controls Will Bring Back P.O.

Every day, a clerical employee will update the computer for each item listed on the clipboard. Management reviews these material withdrawals on a regular basis. Be sure to keep this system simple. Don't give your salespeople any reason for not recording every piece of every item they remove from stock. In fact, let them design the procedures. Then they won't have any excuses not to follow them. In addition to controlling theft, there are several other reasons why limiting access to your warehouse is important:
y

y y

It takes time to run out to the warehouse to check stock. If a salesperson must run out to the warehouse every time she needs to check the availability of a product, how much time does she spend on her feet? How many fewer customer inquiries can she answer? Should you pay her by the mile rather than by the hour? If you check stock by physical inspection, you may commit material to one customer that was just promised, by another salesperson, to another customer. The person manually inspecting the on-hand quantity of an item may be unaware of additional quantities in other warehouse locations.

Pay your employees well. If you pay your employees more than they could earn at other distributors, and pay them based on how well they perform, you'll probably be able to get the best people available in the workforce. When employees can see a direct correlation between performance and their compensation, they usually tend to

work hard. And, if an employee doesn't meet your expectations, there are probably many people (often trained by your competitors) waiting to take their place. We've seen great results when the accuracy of on-hand quantities affects the compensation of all employees that have access to warehouse inventory. These employees are motivated to treat your inventory as if it was their own. It's like having management constantly watching over your warehouse operations. On the other hand, low-paid employees usually aren't motivated. They can't see a correlation between their performance and the compensation they receive. So why bother to put forth the extra effort necessary to do a good job? While at work, they tend to concentrate on what they must do "to get by" that is, what they can get away with (possibly including theft) and avoid getting fired. Their lack of motivation is contagious and can easily become part of your corporate culture. And, in any case, they'll be gone as soon as a better opportunity appears. If someone is caught stealing, get rid of him. While most people don't like big brother watching over their shoulder, they also don't like people getting away with criminal acts. If someone steals, they are stealing from everyone who works for your company. After all, the money used to buy replacement merchandise is money that could have been used to pay higher wages or provide additional benefits. If you overlook certain indiscretions or continually give people a "second chance," you are condoning behavior that is detrimental to the well-being of your company and your employees. Inventory accuracy is a necessary element in any effective replenishment system. If your buyers don't know how much of a product is in your warehouse and available for sale, there is no way they can accurately determine when to replenish stock and how much to order. You'll end up with a "lose-lose" inventory: shortages of products your customers expect you to have in stock, and excess quantities of slow-moving items.
1999, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: There's No Such Thing as Free Inventory


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There's No Such Thing as Free Inventory


by Jon Schreibfeder

A few weeks ago a Canadian distributor emailed me with a very interesting situation: "The vendor of one of our seasonal product lines has an interesting program to encourage us to stock a lot of their products. At the end of the popular season, they give us a full credit for all of our remaining stock on hand. They then re-bill us for this material next year, at the start of the popular season. Any obsolete material can be returned to the vendor and will be credited at full cost. Our salespeople are telling our buyers to stock tons of the material as unsold stock really doesn't cost us anything. How much should we buy?" There is an old expression that there is no such thing as a free lunch, and I firmly believe that there is no such thing as free inventory. Just because the vendor issues a credit for any unsold material at the end of a season doesn't mean that the distributor doesn't incur costs in carrying the stock in their warehouse for the remainder of the year. These are the costs the distributor will experience in carrying this stock:
y

y y

y y y

Moving material from the receiving dock to the proper bin location and shifting it to other warehouse locations as necessary (such as to bulk storage at the end of the season and back to the picking area at the start of the next season). Insurance on the inventory. If it is in your warehouse, you are probably responsible for it. Rent and utilities for the portion of your warehouse used to store material. The material takes up space that could be used to store other products, sublet to another business, or not rented in the first place. The cost of physical inventory and cycle counting. If you don't buy it, you don't have to count it. The cost of inventory shrinkage. If it is in your warehouse, someone may steal it or it may be broken. Opportunity cost of the money invested in inventory that is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment. Or, if you finance your inventory purchases, the amount of interest that you pay the bank. Note that the distributor will only experience the opportunity cost during the popular season, as they will get their money back for any unsold material when the season ends.

The one typical cost of carrying inventory that this firm won't experience is product obsolescence. They won't have to sell some of the material below cost, or throw it out, because it has exceeded its expiration date or fallen out of fashion. Because the company will only experience the opportunity cost for a few months, and they will have no cost of obsolescence, they will have a lower than normal cost of carrying inventory. How low? Well let's look at an example: Say the firm normally writes off two percent of the average inventory value each year because of obsolescence. If the normal annual carrying cost for the company is 28%, the annual carrying cost for this obsolescence-free inventory will be 26%. But this figure must be further reduced because the company's money is only invested during the popular season. Assume that the popular season is four months long, the annual opportunity cost is eight per cent, and $10,000 worth of inventory is purchased for the entire season. If the annual opportunity cost is 8%, the monthly opportunity cost is 0.67% (8% 12). If we multiply this amount by four months, the result is a carrying cost of 2.68% that is, a further reduction of 5.32% (8.00% - 2.68%) off of the annual carrying cost for the inventory of this product line. The result is a further reduction of the carrying cost to 20.68%. In fact, the actual carrying cost will be lower than this amount as the cost of any material sold during the four-month period will be immediately available for re-investment by the company, providing an opportunity for additional profit. The economic order quantity formula (EOQ) is often used to determine how much of each product to order from the vendor. This formula is discussed in several of our articles and books, as well as most purchasing and inventory textbooks. A common version of the EOQ formula is:

If we order products using this formula, the lower carrying cost will suggest that we order more of each of the products in the line. Here is the EOQ for an item with monthly demand of 100 pieces, a cost of ordering of $5 per purchase order line item, and a replacement cost per unit of $25. Here is the EOQ at the company's normal 28% carrying cost:

And here is the EOQ at the lower 20.68% carrying cost:

We will purchase 17% [(48 - 41)/41] more inventory at the lower carrying cost. Yes, because of the vendor's special credit policies, the distributor should purchase more inventory. But, they should be careful not to get carried away and fill up their warehouse with material that won't contribute to the company's bottom line. There is, after all, no such thing as free inventory.
2000, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Put Your Time to the Best Use: The Myth of Disposing of Dead Inventory
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Put Your Time to the Best Use


The Myth of Disposing of Dead Inventory
by Jon Schreibfeder

We all have 24 hours in our day. Most of us spend somewhere between 8 and 12 of these hours at work. It is vital that we are as productive as possible with this time that is, that we get the most benefit (i.e. corporate profit) out of each hour. In recent months, I've seen several articles concerning finding "gold" in your dead and excess inventory that is, your stocked products that haven't sold for a certain length of time (usually a year). These articles say that if you just use the Internet and other creative ways to find willing buyers, you will greatly enhance your company's net profit. Some have even gone so far to say that this process should be made a top priority for your company. Well, it's true that turning excess inventory into cash is good. But before you put considerable effort into a dead stock liquidation program, be sure that you are currently "buying right" that is, be sure you are ordering the right quantities, of the right items, at the right time. To show you how "buying right" does more for your profitability than liquidating dead stock, we'll look at an example. We ranked the items for one of our distributors. The ranking process identifies those products that provide the most opportunity for your company to earn a profit. We begin the process by sorting all stocked products in a warehouse in descending order, based on cost of goods sold (COGS) during the past 12 months. Those products that are responsible for 80% of sales are assigned to rank "A." The items responsible for the next 15% of inventory items receive a "B" rank. The next 4% of items are assigned a "C" rank, and those responsible for the last 1% of sales receive a "D" rank. Products with no sales (i.e. dead stock) receive the rank of "X." Here are the results (note: numbers rounded to provide clarity): Rank #Items %Total COGS$ %Total A B C D X 2,000 3,000 4,000 4,500 1,500 13% 20% 27% 30% 10% 100% 8.0 Mil 1.5 Mil 0.4 Mil 0.1 Mil No Sale 10.0 Mil 80% 15% 4% 1% 0% 100%

Total 15,000

Note that 13% of the products (the "A" ranked products) generate 80% of the warehouse's $10,000,000 in sales. The remaining 87% of products generate the remaining 20% of sales. Here is the inventory turnover the distributor experienced before implementing more effective replenishment methods: Rank COGS$ Avg Invty Turnover A 8.0 Mil 1,666,667 4.8

B C D X

1.5 Mil 0.4 Mil 0.1 Mil No Sale

500,000 222,222 166,667 163,121

3.0 1.8 0.6 0.0 3.7

Total 10.0 Mil 2,718,677

They were experiencing 3.7 annual inventory turns per year. Their average gross margin was 24%. Return on investment (ROI) is defined as annual turnover multiplied by gross margin percentage. This distributor was experiencing an ROI of 88.8 (3.7 turns x 24%). This is a return of approximately 89 cents for every dollar invested in inventory. We weren't satisfied with these results. We immediately scrutinized how the distributor purchased the 2,000 "A" ranked items. We found that, due to inaccurate demand forecasts and unusually high safety stock quantities, they were buying too much of these products at the wrong times. This meant that these items were often overstocked, but replenishment shipments weren't received until stock was entirely depleted. We implemented effective ordering controls and over a period of three months, and the value of "A" ranked items decreased from $1,666,667 to $1,333,333 (a reduction of $333,334): Rank COGS$ Avg Invty Turnover A B C D X 8.0 Mil 1.5 Mil 0.4 Mil 0.1 Mil No Sale 1,333,333 500,000 222,222 166,667 163,121 6.0 3.0 1.8 0.6 0.0 4.2

Total 10.0 Mil 2,385,343

Turnover for "A" items increased to six annual turns and overall turnover increased to 4.2 turns per year. As a result, return on investment increased from 89 cents to $1.01 (4.2 turns x 24% gross margin) for every dollar invested in inventory. Had we eliminated all of the dead stock instead of concentrating of increasing the turnover of "A" items, overall inventory would have only increased to 3.9 turns per year: Rank COGS$ Avg Invty Turnover A B 8.0 Mil 1.5 Mil 1,666,667 500,000 4.8 3.0

C D X

0.4 Mil 0.1 Mil No Sale

222,222 166,667 0

1.8 0.6 0.0 3.9

Total 10.0 Mil 2,555,556

The ROI would have only increased from 89 cents to 93.6 cents (3.9 x 24% margin). The result: We experienced a greater increase in profitability from paying more attention to the "A" ranked items than we would have in liquidating our dead stock. And there were other advantages to this action plan as well:
y

We freed up $333,334 (valued at full cost) in working capital. It is doubtful that we will receive our full cost for the dead stock ($163,121) when it is liquidated. Chances are good that we will dispose of a good deal of this dusty inventory for less than our cost. The customer service for "A" ranked items actually increased. Why? Because the distributor's buyers were giving extra attention to these critical items that comprise 80% of the total sales volume.

Sure, liquidating dead stock is important. But it probably won't contribute as much to your overall profitability as the process of ensuring that you are buying the right quantities of fast-moving products at the right time. This distributor has a long way to go to achieve his inventory-related goals, but he's off to a good start. See our other articles and our new book, "Achieving Effective Inventory Management," for ideas on how to optimally set the replenishment parameters for stock items.
2000, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Do You Monitor Your Residual Inventory?


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Do You Monitor Your Residual Inventory?


by Jon Schreibfeder

I visited a large manufacturer last week to review their inventory management polices and procedures. I was impressed with their knowledge and the systems they had in place. As I spoke with various department managers, one question was continually asked: "How does our inventory turnover compare to others in our industry?" Why did they ask this question? To judge the performance of their planners and buyers. I refused to answer. Not because I didn't know, but because there was no other company in their industry whose turnover could be equated to this firm's performance. Why? Because this company's supply chain was unique. It received many components and raw materials from an overseas subsidiary of its parent company. This source of supply was dictated by the parent company and could not be changed by local management. Therefore it was in a unique position for acquiring material. To compare its turnover to any other company, or to the industry at large, would be comparing apples to oranges. So we began looking for other measurements to judge their planners and buyers. One of those I suggested was to measure the day's supply of a product on-hand when a replenishment shipment is received. Our term for this "left on shelf" inventory is residual stock. This may seem like a strange measurement, but let's look at why it is important. There are two questions a buyer must answer in replenishing the stock of a product: when to place a replenishment order, and how much of a product should be reordered. Economic lots, price break analysis, and the economic order quantity formula provide the answer to how much to order that minimizes the company's cost of inventory. The new measurement, day's supply on-hand when a replenishment shipment is received (residual stock), helps to ensure that we are ordering at the right time. We don't want the replenishment position (ON-HAND - COMMITTED + ON ORDER) of an item to fall below the order point before we issue a replenishment order. There are three components to consider in calculating the order point: Demand Anticipated usage of the product. Anticipated Lead Time How long it will take to receive the replenishment shipment and prepare it for use or sale.

Safety Stock Safety stock is insurance against running out of an item because of unexpected demand during the anticipated lead time or vendor shipment delays. These three components are used to calculate the order point: Order Point = (Demand/Day x Anticipated Lead Time) + Safety Stock If the residual stock is greater than "x" day's supply at the time of the last three stock receipts, one or more of the following conditions probably exists:
y y y

Demand forecast predictions consistently exceed the actual usage and must be evaluated for accuracy. The anticipated lead time is greater than the actual experienced lead times. The maintained safety stock quantity exceeds the amount necessary to protect customer service that is, there are not great variations in lead time or demand from month to month.

To decrease the residual stock to its target of "x" days supply, we can reduce inventory levels by correcting demand or the anticipated lead time, or by maintaining less safety stock. If demand, anticipated lead time, and safety stock are properly maintained for the item, our target order from the vendor (i.e. free-freight amount, truckload, lot size, etc.) may be too large to optimize the company's turnover and net profitability. If the residual stock is less than "y" day's supply at the time of the last three stock receipts, one or more of the following conditions probably exists:
y y y

Demand forecast predictions are consistently less than actual usage and must be evaluated for accuracy. The anticipated lead time is less than the actual experienced lead times. The maintained safety stock quantity is not adequate to protect customer service that is, there are great variations in lead times and/or usage from month to month.

We need to correct demand or the anticipated lead time, or to maintain more safety stock. There are no fixed values for the "x" and "y" day's supply parameters. The target residual day's supply to for each item depends on such factors as the importance of the item to the company's sales or processes and its general availability. While residual stock analysis doesn't provide a measurement that can be compared to other company's results, it does bring to the attention of the buyer products that have the potential of turnover improvement or that may be hindering customer service that is, it is a valuable tool for the company to achieve its goal of effective inventory management.

2000, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: The Mysterious Cost of Carrying Inventory


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The Mysterious Cost of Carrying Inventory


by Jon Schreibfeder

The carrying cost of inventory is the cost of maintaining your average inventory investment of inventory in your warehouse, storeroom, stockroom, or other location where you stock raw materials or finished goods. What costs do you incur in carrying inventory?
y y y y y

Cost of putting away stock receipts and moving material within the warehouse. How much of your employees' time is spent in these activities? Rent and utilities for the portion of your warehouse used to store stock inventory. Insurance and taxes on inventory. If it's in your warehouse, you have to insure it, and it may be subject to tax. Physical inventory and cycle counting. The more material in your warehouse, the longer it takes to count. Inventory shrinkage and obsolescence. The more material in your warehouse, the higher the possibility of shrinkage and obsolescence. After all, it's hard to steal something that isn't there! Opportunity cost of the money invested in inventory. How much could you make if you were to take the money you're investing in inventory and invest it in a more traditional investment (such as treasury bills)? Or if you are

financing your inventory, how much interest are you currently paying the bank? The carrying cost percentage is calculated by dividing the sum of these expenses (along with the opportunity cost) by the average inventory value. It is the amount of money it takes to maintain one dollar's worth of inventory for an entire year. For years many industry consultants have maintained that determining your company's actual carrying cost is too difficult to calculate in a reasonable amount of time, and that you should use a rule of thumb such as "current prime rate plus 20%." One inventory "guru" recently suggested that you should adjust your carrying cost percentage so that the economic order quantity formula suggests "reasonable" reorder quantities. This is backwards thinking. The economic order quantity formula is designed to calculate the lowest total cost reorder quantity (i.e. your "best buy quantity") based, in part, on the cost of carrying inventory. If it costs you less to maintain inventory in your warehouse, you will tend to stock more. If your carrying costs are high, you will probably want to keep just enough inventory in your warehouse to protect customer service. Guessing at your carrying cost will not ensure that you are buying the quantity that will minimize your firm's total cost of inventory. Just as important, using an approximate carrying cost does not help you identify areas for potential improvement in your warehouse operations. In these days of increased competition, lower margins, and greater customer demand of product availability, it is important to lower operating costs and increase productivity wherever possible. By closely examining the specific components of the inventory carrying cost and comparing the numbers to other firms in your industry and region, you can identify areas that are candidates for improvement. With all of this in mind, EIM would like to help you calculate your cost of carrying inventory. If you will print and fill out the attached questionnaire and send it to us by email, mail, or fax, we will calculate your carrying cost and send you a comparison of your answers to each question to others in your region and industry. There is no charge for this service as long as you agree to let us add your information to our database. Please note that all responses are confidential. Data we present to other companies will not identify your company name or location. Even if you don't fill out the questionnaire, please review it, as it includes most (if not all) of the factors you must consider as you calculate your own inventory carrying cost.

Questionnaire for Calculating Carry Cost of Inventory


Complete for each stocking facility. Please contact us with any questions. Send the completed questionnaire to:

Effective Inventory Management, Inc. 120 S Denton Tap Rd, Ste 450-200 Coppell, TX 75019 USA Phone: (972) 304-3325 Fax: (972) 393-1310 Email: carrycost@effectiveinventory.com Your Name _____________________________________________________________ Company _______________________________________________________________ Address _______________________________________________________________ City _____________________ State/Prov ____________ Postal Code ______ Phone _____________________________ Fax ______________________________ Email _________________________________________________________________ Distributor/Manufacturer/Retailer ______________________________ Types of Products Sold _________________________________________

We will only contact you with the results, or if we have questions concerning your answers.

1. What was your average inventory value over the past 12 months (sum of month-ending inventory values divided by 12)? _______ 2. What was your total warehouse labor expense (wages, taxes, and benefits) during the past 12 months (including the expense of inspection, putting away stock, moving from bin to bin as necessary, assembling kits, and filling customer orders)? _______ 3. What percentage of warehouse activity is dedicated to filling customer orders and transfers? _______ 4. Is this warehouse owned or rented? _______ 5. If the warehouse is rented, what is the monthly rent? _______ 6. If the warehouse is owned, what is the rental cost of comparable warehouse space under a "triple net" lease (i.e. a lease where the tenant pays all utilities, maintenance, and property taxes)? _______ 7. How many square feet (or meters) is your facility? _______ 8. How many square feet (or meters) is your warehouse? _______ 9. What were the total warehouse utilities you paid last year? _______ 10. What were the total property taxes you paid last year? _______ 11. What was your total warehouse maintenance expense last year? _______ 12. What was your total warehouse supply expense, excluding shipping materials (that is, storage boxes and other supplies used in the process of receiving and stocking material)? _______ 13. What was the cost of warehouse equipment that was expensed (i.e. not capitalized) last year? _______ 14. What was your total depreciation expense for warehouse equipment last year? _______ 15. What was the value of written-off inventory last year? _______

16. What was the value of inventory shrinkage last year (not included in the written-off inventory value)? _______ 17. How much current inventory is in excess of a 12-month supply (a value equal to monthly demand x 12)? _______ 18. What was the cost of insuring your warehouse and equipment last year? _______ 19. What was the cost of insuring your inventory last year? _______ 20. What was the cost of any inventory taxes you paid last year? _______ 21. If additional labor was necessary to conduct physical counts of your inventory, what was the cost of this labor (including taxes and benefits)? _______ 22. If you borrow money to finance your inventory, what was the average outstanding balance over the past 12 months? _______ What is the annual interest rate? _______ 23. If you borrow money to finance warehouse equipment or improvements, what was the average outstanding balance over the past 12 months? _______ What is the annual interest rate? _______ 24. If you finance your own inventory purchases, what interest rate could you expect to receive if you invested that money in a relatively safe incomeproducing investment? _______

Please use this information to calculate an inventory carrying cost for our company. We agree to allow Effective Inventory Management, Inc. (EIM) to use this data for comparative purposes, but acknowledge that EIM will not reveal our company name or location to any other party without our expressed written permission.

______________________________________________________________ Signed by Company Representative ______________________________________________________________ Print Name, Title, and Date

Next Article: Consider if Some Inventory Will Need To Be Buried


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Consider if Some Inventory Will Need To Be Buried


by Jon Schreibfeder

Over the past 12 months, I've seen numerous articles on liquidating unwanted dead stock and excess inventory. In fact, we published an article several months ago exploring the advantages of using Internet websites (such as www.tradeout.com, www.surplusbin.com, and www.industrymart.com) to assist in the liquidation of unwanted stock. But liquidating unwanted stock using the Internet (or any other method) is not always successful. Why? For the simple reason that in order to sell something, a potential buyer must exist. Can't everything be sold at some price? Unfortunately, no. Last week, a distributor gave me an example of material that cannot be sold, at any reasonable price. He has an assortment of repair parts for obsolete equipment. This equipment is not in service anywhere! No one could use any of these items except maybe as a rather ugly door stop. Because the parts are made of a combination of glass, plastic, and steel, they cannot even be sold as scrap. The only practical thing he can do with this stuff is to throw it out in order to free up the warehouse space for other items. That is, bury it! His company will be out what they paid for this inventory as well as the expense incurred in buying, receiving, and maintaining the material in stock. Please avoid having to throw out inventory. Whenever you buy a new product, consider its "burial risk." Look at the following diagram:

Inventory's Risk of Burial

Products in the bottom left quadrant ("High Risk") have a very specific use and are just sold to one or two customers. You are taking a great risk stocking these products unless your customer has given you a firm commitment (e.g., a purchase order signed in blood) that he or she will buy whatever quantity of the item you must purchase from the vendor. If you don't have this commitment and the customer goes out of business, stops using the part, or begins buying it from your competitor, you will be forced to plan the burial ceremony for the remaining inventory. Items located in the upper left quadrant ("Moderate Chance") are less likely to need burial. Even though these items are only sold to a limited number of customers, they have multiple uses or applications. A good salesperson can monitor your customers' demand for these items so that you can adjust stock levels as usage increases or decreases over time. The bottom right quadrant also contains items with a moderate chance of needing burial. Even though these products are sold to many customers, they have a limited number of uses or applications. But even if one of these products was replaced by a new and improved model, at least some of your customers probably would be candidates to purchase your remaining inventory (though at a substantial discount). And, because of the wide appeal of these products, you also might find success liquidating them through an Internet site. This type of "remnant" inventory usually doesn't require burial. Finally, the products in the upper right quadrant have the least risk of needing burial. These items are commonly used, in many applications, by a large number of customers. Excess inventory of these products usually can be sold by reducing the price, offering salespeople an incentive to move the product, utilizing an Internet liquidation site, substituting the product for a less expensive model, or some other means. Whenever you analyze whether to stock a product or determine customer prices, consider the burial risk factor. Keep track of the percentage of products falling into each quadrant of the chart displayed above that cannot be sold at any price, and must be thrown out. This equation represents the percentage of inventory that must be buried: Quantity That Is Eventually Thrown Out x 100 Original Purchase Quantity

For example, you might normally have to throw out 10% of the purchased stock of items that fall into the bottom left "high risk" quadrant. This "scrap" factor should be included in gross margin and pricing decisions. Say you purchase one of these items for $10 and want to receive a 30% margin on sales of the item. Typically you would set the price at $14.29: Sales$ - Cost$ $14.29 - $10.00 = = 30% Sales$ $14.29

Gross Margin =

But the 10% of the original purchase quantity that, on average, will be thrown out must be paid for out of the amount of the item that actually sells. So, we'll calculate a gross margin based on a cost of $11.00 ($10.00 + 10%). We'll have to set a selling price of $15.72 to maintain the same 30% gross margin: Sales$ - Cost$ $15.72 - $11.00 = = 30% Sales$ $15.72

Gross Margin =

Always consider a new item's burial risk factor when setting customer prices. Fortunately, most products whose remnant stock will need to be thrown out tend to be less competitive and price-sensitive. Why? Because they are sold to a limited number of customers and have few uses. There isn't much of a market for them. You are much better off planning for the inevitable burial of inventory that cannot be sold than letting it take you by surprise. If competition does not allow you to include a burial risk factor in your pricing:
y y

Consider whether or not you need to really stock the product. After all, you are taking a significant chance on absorbing a loss. If you must stock the product, be sure that other profitable sales will compensate you for your probable losses.

After all, isn't our primary goal to be profitable?


2000, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Analyzing Inventory Adjustments


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Analyzing Inventory Adjustments

by Jon Schreibfeder

I just spent two great days working with a large food distributor. The company has begun a program to achieve effective inventory management. As part of the program, they are cycle counting products (see Cycle Counting Can Eliminate Your Annual Physical Inventory!) and entering inventory adjustments when they find discrepancies between the quantity of a product in their warehouse and the perpetual inventory maintained by their computer system. Though the company has implemented a system that corrects current inaccurate inventory balances, it still needs to adopt a system that will improve future inventory accuracy. That is, they need to improve their methods of handling stock to prevent additional stock discrepancies. How will they do this? By carefully analyzing the reasons for inventory adjustments. Why? Because most inventory adjustments are the result of problems encountered in the normal handling of material. Here are some common reasons for inventory adjustments:
y y y y y y

Material is missing from inventory. More of a product is in inventory (or in a bin location) than is recorded in the computer system. Some of the product in inventory is damaged and cannot be sold. Part of the quantity in inventory is outdated or cannot be sold because it has been in inventory for too long a period of time. The product is obsolete. The remaining inventory in stock is less than the quantity a customer would normally purchase.

Along with the quantity and item, this company will accurately record the reason for each adjustment. Every month, a summary of adjustments (by item and reason) will be reviewed to see if changes to policies and procedures can help prevent future discrepancies. Let's take a quick look at some of the underlying reasons for adjustments: Material Missing from Inventory:
y

Does a particular warehouse person have problems pulling the right quantity of this product for outgoing orders? Are they filling orders from the wrong bin location? Can this problem be solved with additional training or reassignment? Are pickers confusing this item with similar products? Can this problem be solved with additional training or by separating the stocking locations of the two items? Are employees substituting one product for another without recording what product is actually shipped? Can the procedure for noting substitutions be improved?

y y

Are sample quantities of the item being removed from inventory without being recorded? Is it feasible to establish sample accounts for each salesperson? Do you suspect that the product is being stolen? Can the inventory of the item be caged or secured by some other means?

More Material on the Shelf Than Expected:


y y

Are stock receipts being processed in a timely manner? Can you streamline paperwork to expedite the receiving process? Are pickers confusing this item with similar products? Can this problem be solved with additional training or by separating the stocking locations of the two items? Are employees substituting one product for another without recording what product is actually shipped?

Some of the Product in Inventory Is Damaged:


y

Are the receiving people failing to identify damaged material as it is received? Can retraining and specific corporate policies for receiving damaged material solve this problem? Is material being damaged in your warehouse? For example, are employees climbing on boxes (and crushing them) to retrieve material stored on a high shelf? Can more training or additional material-handling equipment help to protect inventory from damage? Is material broken in the process of being delivered to your customers? Should you consider using better packaging materials for outgoing shipments?

Some of the Product Is Outdated:


y y y

Do warehouse employees have a problem properly rotating stock? Can more training or gravity racks ensure that the oldest stock is always shipped first? Should you buy smaller quantities of these items, more often? Would it be effective to offer material that is about to be outdated and offer it at a substantially reduced price?

The Product Is Obsolete:


y y

As most dead inventory is the result of leftover quantities of new stock items, do you carefully monitor the accuracy of the projections of new product sales? Do you regularly identify obsolete products and try to liquidate this material as soon as possible?

Remaining (Remnant) Inventory:


y y

Can you limit sales of the item to the vendor package or to some other minimum quantity? Can remnant inventory be used as samples or consolidated and repackaged for sale?

Every inventory adjustment should be viewed as an opportunity for improvement that can lead to greater corporate profitability. If you use inventory adjustments merely to correct the on-hand balances in your computer, you will probably continue to correct the same items until the end of time. Things will only get better if your company decides to learn from its mistakes!
2000, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: How Much Does It Cost You To Buy?


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How Much Does It Cost You To Buy?


by Jon Schreibfeder

A few months ago, in an article entitled "The Mysterious Cost of Carrying Inventory," we published a questionnaire that you can fill out, return to us, and have us calculate your specific company's inventory carrying cost percentage that is, what it costs to maintain a dollar's worth of stocked inventory in your warehouse for an entire year. The carrying cost is used in many inventory analysis and planning formulas including the economic order quantity formula, the calculation that is designed to determine your "best buy" replenishment quantity. We published the questionnaire in response to the contention of many inventory consultants and "gurus" that it is too difficult to accurately calculate your company's inventory carrying cost and that a "rule of thumb" (e.g. the prime rate plus 20%) or default value (e.g. 25%-35%) should be used in all formulas requiring a carrying cost percentage. Based on your response in sending completed questionnaires back to us and the resulting carrying cost percentages, we have concluded that:

y y

It is fairly easy to calculate a distributor's or manufacturer's inventory carrying cost. There is no single accurate default value for the inventory carrying cost.

The carrying cost percentages we calculated from the questionnaires ranged from a low of 18% to a high of 42%. This is very significant, as the cost of carrying inventory is an integral part of many inventory analyses, including the economic order quantity (EOQ) formula: 24 x Cost of Ordering Stock x Forecast Monthly Demand Carrying Cost % x Unit Cost How much of an effect does the carrying cost percentage have on calculated replenishment quantities? Well, using a 25% carrying cost in the EOQ formula results in 20% greater replenishment quantities than a 35% carrying cost. Just think of what 20% more inventory would cost your company. Remember that the EOQ is supposed to be the quantity that provides you with the lowest total cost. Replenishing inventory with quantities other than this "best buy" quantity will cause your company to experience higher costs and/or excess inventory. There is no way to determine which order quantity represents the "best buy" without accurately calculating your company's specific carrying cost percentage and cost of ordering stock. The cost of ordering stock is the cost of issuing and processing a line item on replenishment order. I have read many articles stating that, as with the inventory carrying cost, this number is also too hard to calculate. Many analysts suggest that you should just pick a value between $5.00 and $6.00. As with using rules of thumb for the inventory carrying cost, if you just guess at your company's cost of ordering stock, the resulting economic order quantity will not represent your company's best buy quantity. In fact, utilizing "rules of thumb" for the carrying cost percentage and cost of ordering stock results in an economic order quantity formula that probably won't maximize your company's profits: 24 x Rule of Thumb Guess x Forecast Monthly Demand Another Rule of Thumb Guess x Unit Cost So this month we publish a questionnaire that allows us to calculate your company's cost of ordering a line item of stock material. As with the carrying cost questionnaire, if you will answer these questions and send your responses to us by email, mail, or fax, we will calculate your cost of ordering stock and send you the results. If we have relevant data in our files, we'll include a comparison of your answers on each question to others in your region and industry. There is no charge for this service as long as you agree to let us add your information to our database. Please note that all responses are confidential. Data we present to other companies will not identify your company name or location.

Questionnaire for Calculating the Cost of Replenishing Inventory


Complete the following for your company: 1. How many purchase order line items for stocked products were issued in the past 12 months (approximate by taking one month's total and multiplying by 12)? _______ 2. What percentage of all items purchased are stocked products as opposed to special order or catalog items? _______ 3. What percentage of all items purchased are consumed internally by the company and not resold or are used as components in products that are resold? _______ 4. What is your total purchasing and expediting department's labor expense (wages, taxes, and benefits) during the past 12 months? _______ 5. What is your total accounts payable labor expense (wages, taxes, and benefits) during the past 12 months? _______ 6. What is the total annual expense for supplies used by your purchasing department? _______ 7. What is the total annual expense for accounts payable supplies? _______ 8. What is your total annual data processing expense? _______ 9. How many line items are received in each warehouse each month? _______ 10. What is your total labor expense (wages, taxes, and benefits) per month for the person (or people) who verifies the accuracy of stock receipts? _______ 11. What percentage of this person (or these people's) time is spent verifying stock receipts? _______

Please use this information to calculate a cost of ordering stock inventory for our company. We agree to allow Effective Inventory Management, Inc. (EIM) to use this data for comparative purposes, but acknowledge that EIM will not reveal our company name or location to any other party without our expressed written permission.

______________________________________________________________ Signed by Company Representative ______________________________________________________________ Print Name, Title, and Date

2000, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: The Promise of Collaborative Forecasting

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Effective Inventory Management, Inc. 120 S Denton Tap Rd, Ste 450-200 Coppell, TX 75019 (972) 304-3325 Fax: (972) 393-1310 Email: info@effectiveinventory.com

The Promise of Collaborative Forecasting


by Jon Schreibfeder

When you hear the term "business to business (B2B) E-commerce" what comes to mind? Buyers looking through online catalogs and placing orders for needed products? Companies sending purchase orders via EDI (electronic data interchange) that are automatically transformed into sales orders in their suppliers' computer systems? Or, maybe the ability to pinpoint the exact position of a package being shipped to you from a vendor? There is another form of electronic commerce that promises to greatly increase the efficiency of the supply chain. It is called Collaborative Planning Forecasting & Replenishment (CPFR). CPFR involves a customer regularly notifying a supplier of his/her expected future needs of certain products. To see the value of CPFR, let's look at an example. Acme Manufacturing makes widgets. The number of widgets produced by Acme varies from 50 to 1,000 pieces per month depending on orders from its customers and forecasts from its sales force. Each widget requires two #B100 adapters, which are normally purchased from Smith Distribution. Previously Acme used minimum and maximum parameters to replenish their stock of the #B100 adapter: Acme Manufacturing's Minimum = 10 pieces Acme Manufacturing's Maximum = 110 pieces

When the on-hand quantity of the adapter fell below 10 pieces they would order a box of 100 adapters from Smith Distribution. Acme expects, and receives, same day delivery of the product. Smith Distribution's lead-time for the adapter is two weeks. Their buyer, Rick Sarner, previously based his replenishment decisions for the #B100 adapter on the usage history recorded for the item:

Smith Distribution's Minimum = 200 Smith Distribution's Maximum = 500 Rick thought that he was stocking the item conservatively by setting the minimum to 200 pieces or two of Acme's normal orders. He was in shock when he was chastised in August (when Acme required 900 pieces) for running out of the product and shutting down his customer's production line. To avoid future problems, Rick's first reaction was to significantly increase his minimum and maximum stock quantities. But he found there were two problems with this solution: 1. How large should he set the minimum and maximum quantities? Unless Rick bases the replenishment parameters based on Acme's capacity to produce the product, he will always run the risk of a stock out. 2. Because a large quantity isn't delivered to the customer every month, greatly increasing the minimum and maximum quantities would have a detrimental effect on Smith Distribution's inventory turnover and therefore its profitability. Rick determined that his stocking problems were the result of a lack of information. He was always forced to guess (based on past history or informal comments from his salespeople) his customer's future demand of the product. Collaborative Planning and Forecasting Requirements (CPFR) presents a better solution by facilitating communication between Smith Distribution and Acme Manufacturing. Acme doesn't wait until there are 10 pieces left on the shelf to call Smith and order another box of the product. Acme electronically communicates changes in its future needs for the #B100 adapter to Smith Distribution based on its widget production schedule:

Rick can base his purchases on what Acme expects to use in the future, not what they have used in the past. Changes in Acme's production schedule and the need of the #B100 adapter are electronically communicated to Smith Distribution. If Acme plans to increase production from 50 to 100 widgets during the week of October 23rd, it sends an electronic notice of the change to Smith Distribution's computer system. As a result, Rick will have ample time to get the necessary stock from the vendor. On the other hand, if Acme decides to decrease widget production, Rick can reduce his stocking levels. Of course Rick is not about to bet his job on the accuracy of Smith's forecast. He will retain a safety stock of 200 pieces to protect customer service just in case Acme has an unexpected emergency order from one of its customers, or a replenishment shipment from the vendor is delayed. In fact, Smith distribution will carefully monitor the accuracy of Acme's predictions of future product usage:

Because Acme's forecasts of future usage are very accurate, Rick can order the #B100 adapter to meet Acme's expected usage. The result: Smith Distribution can stock less of the product and still maintain a high level of customer service. In fact, they probably can reduce the 200 piece safety stock quantity. As an incentive to keep providing accurate forecasts, Smith Distribution bases Acme's discount for adapters, in part, on the accuracy of its product forecast. Smith Distribution can maintain less inventory. Acme gets the #B100 adapter at a lower price. Rick Sarner has fewer sleepless nights worrying about how much of the product to stock. CPFR truly provides a win-win-win situation. Even if your computer system does not currently support CPFR, you can institute a collaborative forecasting program: 1. Ask your good customers for product usage forecasts. Not every customer can provide this type of information, but offer an incentive to those that can provide accurate future usage information (e.g. actual purchases within 20% or 25% of their forecast). 2. Make sure that shipments to customers providing forecasts are not included in your normal usage history. After all, you may sell these products to other customers, too. Your total forecast demand quantity will be the sum of collaborative forecasts and a factor of past usage. If you add usage that is included in collaborative forecasts to usage history, you will be "double counting" these sales in determining much to buy from the vendor.

3. Encourage your salespeople to offer collaborative forecast programs to your best customers, especially original equipment manufacturers (OEM) companies. 4. If you can determine in advance what you will need from your vendors, work with them to develop a collaborative forecasting program in which you provide accurate estimates of your future needs in exchange for better terms or discounts. Collaborative forecasting works to solve two of the greatest challenges faced by buyers and inventory managers:
y y

Stock outs of critical products Unneeded safety stock sitting on the shelf gathering dust

Of course there are many instances in which customers cannot predict their future product needs but whenever they can, collaborative forecasting promises to increase productivity and profitability throughout the supply chain. Let's work to replace inventory with information.
2000, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Justly Judging Your Vendors


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Justly Judging Your Vendors


by Jon Schreibfeder

What do you expect from a vendor? Most distributors, manufacturers, and retailers expect to receive the products they order:
y y y y

At the lowest possible price. On time. In salable or usable condition. Packaged to minimize the cost of preparing the item for sale or use.

How do you measure a vendor's performance in meeting these expectations? Most companies judge vendors on "gut feelings" and anecdotal experiences. Few have any objective measurements. In this article we will discuss three ways you can determine how well your vendors are helping you achieve the goal of effective inventory management and which of these methods produces the best results.

The Customer Service Level


In a previous article we introduced the customer service level as a good method to determine how well you meet your customers' expectations of product availability. The customer service level measures the number of line items that are filled completely before the promise date. For example, if your customer orders 100 pieces of a product and you deliver 100 pieces on or before the promise date, you get credit towards the customer service level. Delivering anything less than 100 pieces on or before the promise date is viewed as a customer service failure. The customer service level can be adapted to determine the number of purchase order line items that are delivered on or before the promise date. After all, if this measurement is good enough for you to measure the service you provide to your customers, shouldn't it also be valuable in determining how well your vendors are servicing you?

Average Number of Days Late


The customer service level is a pass-fail test. If the vendor ships or delivers the entire quantity ordered by the promise date, they get credit. If they ship late or don't ship completely, they get no credit. But the customer service level treats a shipment that is two days old and one that is two months old equally. They're both considered failures. But aren't you more concerned with shipments that are long overdue? Isn't a shipment that is two weeks late usually a bigger problem than a shipment that is two days late? To better judge the performance of your vendors, we need a more comprehensive measurement. The average number of days late is calculated with the following formula: Total number of days late for all line items received this month Total number of line items received this month The total number of days late is the number of days between the promise date and the date the line item was completely received or the balance canceled. In dealing with

vendors, the average number of days late is usually a better measurement than the customer service level because it quantifies the vendor's inconsistency. Qualifying each vendor's inconsistency in lead times is very important. In order to maintain superior customer service, you must maintain more safety stock (i.e. reserve inventory) to compensate for greater inconsistencies in vendor lead times. This additional safety stock raises the average value of stock inventory and results in decreased corporate profitability.

Vendor Satisfaction Analysis


In addition to goods arriving on time, they must be in salable condition. Our third measurement, the vendor satisfaction analysis, tracks the number of line items ordered from a vendor that cannot be sold or used on the promise date. This analysis classifies each problem item by:
y y y

Vendor Item Problem preventing the item from being used

Typical problems include:


y y y y y y y

The product was not delivered on time. The product ordered was not the product received. The wrong quantity of the product was received. Necessary manuals or other documentation were not delivered with the shipment. The product arrived damaged. The wrong price was charged for the material. The packing slips and/or invoices were incorrect or incomplete.

Every month you should look at several measurements produced by the vendor satisfaction analysis for each of your key suppliers:
y y y

Percentage of line items delivered without any problem. The percentage of line items experiencing each type of problem. The number of occurrences of each problem experienced by a particular item during the previous 12 months.

Determine if the problems:


y y y

Had a negative effect on the service you provided to your customers. Caused you to maintain additional inventory to maintain a satisfactory customer service level. Increased your operating costs.

Share the results with your vendors. Can you help them reduce errors in the future?

y y

Collaborative forecasting Can you provide your vendors with better predictions of your future needs? Your vendors can probably better serve you if they know what you think you will order in the upcoming several months. Report damaged material Vendors can use this information to redesign packaging or shipping procedures to prevent future damage. Incomplete or missing paperwork The vendor may not realize that, if certain paperwork is missing, you will not be able to sell or use the material received. Include your warehouse bin locations on their packing slips This will expedite your put-away process.

The best way to improve your operations, reduce your operating costs, and improve customer service is to closely monitor the problems produced by your current operations. Applying the vendor satisfaction analysis to supplier shipments is a good way to identify ways to improve your replenishment process.
2000, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Do You Know Where Your Information Comes From?


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Do You Know Where Your Information Comes From?


by Jon Schreibfeder

Most computer systems provide a lot of information. Management and employees depend on the analysis provided by the computer software to make critical business decisions. But do you know how the numbers appearing on your reports and screens

were generated? Before you respond, "Of course I do, it's only common sense!", let me describe some surprises several of my customers have experienced in the last six months: Episode #1 An English food distributor was perplexed. Sales of a particular frozen food item had dropped off, but his computer system was maintaining a high level of inventory of the product. We investigated. Here is the usage history we found: Month December, 2000 November, 2000 October, 2000 September, 2000 August, 2000 July, 2000 Usage (Cases) 35 52 76 94 128 137

Notice how usage for the item decreased rapidly from July to December. Yet his system was predicting demand for January 2001 of 175 cases! The current purchasing parameters were based on this expected demand. We called the software support team of the computer company and asked what was going on. They responded that predictions of future demand were based on an average of what was sold in the past. Looking at usage over the previous six months, I still didn't understand how the system was predicting demand of 175 pieces. The support technician explained that average usage of the product was calculated over the entire time it had been in inventory. The item had been stocked for a little less than 10 years (3,554 days, or about 118 months). During that time the company had sold 20,650 cases of the product, or about 175 cases per month. I tried for half an hour to explain that considering average usage over a ten-year period was not a logical way to forecast future demand of a product. The support person continually repeated a phrase that has nearly caused me to commit murder several times over the past 21 years: "The system is performing as it was designed." Episode #2 An industrial distributor was looking at a ranking report produced by his computer. This is a report that lists items in descending order based on cost of goods sold. He was perplexed. He had actually sold $4,000 worth of a product (at cost) this year, but the report showed a value of $24,000 for the product in the cost of goods sold column. What happened? We called the support department of this computer company. The support person told us that: 1. The distributor had just completed the second month of his fiscal year. 2. In the first two months of the fiscal year he sold $4,000 worth of the product. 3. The system annualized sales over the first two months and projected that he would sell $24,000 for the entire year.

Unfortunately this was a seasonal item that was sold only in January and February. I explained to the support person that many products do not have consistent usage throughout the year. I further said that it was not logical to project sales over an entire year based on two months usage. Again, I was told that the system was functioning according to the design specifications and the documentation. Had the customer not carefully scrutinized the report, he would have treated the item as though it had greater than actual sales. Episode #3 A distributor called me and said that his computer system was projecting a 10% increase in demand for the items of in a certain product line this year. He said his system based the increase on a trend calculated by comparing sales recorded during the past several months this year to the sales recorded in the same months last year. The system's methodology sounded logical, but he too was perplexed. Neither he nor his sales department thought these products had been selling well in recent months. The distributor and I looked at the usage history and found that most products had experienced a 3% to 5% decrease in sales. Again we called the support department. The support technician explained that the system was designed to calculate trend factors based on the cost of goods sold of all items in the line. And this year there had been a 10% increase in cost of goods sold over the previous year. Unfortunately the cost of goods sold increase was due to a 13% price increase in the early part of the year. If we had followed the suggested trend factor and increased the stock quantity of each of these products, we would probably been faced with an overstock situation. These examples involve three very popular, widely used distribution software packages. In each case the customer did not understand how the system calculated some critical inventory-related information. information on which they relied to make important business decisions. There is a very good chance that you are unaware of some (though perhaps less dramatic) "quirks" in the information provided by your computer system. You need to be aware of them. This data confusion may be caused by a feature that was designed for a specific customer or industry, and your company may do business a different way. The other firms may experience different patterns of usage, cost their inventory differently, obtain material from different sources, process transactions differently, etc. Yes, there is a possibility that a feature was not well designed and is a "bug" that needs to be corrected. But keep in mind that every business is unique. Even companies in the same industry buy material and process transactions in very different ways. No single computer system can meet the precise needs of every business. Take the time to be sure you understand how your computer system derives the information it presents on inquiries and reports as well as the computations it follows in calculating replenishment parameters. Examine every critical field! Remember that even fields that seem to have a clear definition can be computed in several ways. For example: On-Hand Quantity Some systems reduce the on-hand quantity of a product when material is shipped. Other systems update this quantity when material is invoiced.

Cost of Goods Sold Is the cost used in your financial statements based on an actual cost, replacement cost, average cost, or some other cost? If it is an average cost, how is this amount calculated? We know of four different methods for calculating average cost. Demand/Usage Some systems consider customer requests in demand or usage. Other systems consider only actual sales. How does your system consider warehouse transfers in determining total demand or usage? Occasionally we find a customer being misled by a system providing incorrect information. But more often we find mistakes made because a customer incorrectly assumed they understood the meaning of a field. Don't fall into this trap. If you understand how your system derives information, you can interpret the data correctly, or you can determine how the system must be modified or enhanced to provide you with the information you need to run your business.
2001, Effective Inventory Management, Inc. All rights reserved. This article cannot be reprinted or reproduced, in whole or in part, without the expressed written permission of Effective Inventory Management, Inc.

Next Article: Dealing with Items That Experience Sporadic Sales


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Effective Inventory Management, Inc. 120 S Denton Tap Rd, Ste 450-200 Coppell, TX 75019 (972) 304-3325 Fax: (972) 393-1310 Email: info@effectiveinventory.com