January 14, 2019

How to Maintain the Right Inventory Levels

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A serious problem facing many manufacturers is tying up cash reserves by keeping too much inventory or too many raw materials on hand. Finished products don’t move as quickly as you thought, or you made more than you needed “just in case,” or you bought a lot of raw materials because you got a bigger discount if you ordered more.

Regardless of why you did it, the problem remains: you disrupted your cash flow and you’re not quite sure how you’re going to move this stuff quickly.

While I can’t tell you how to move all that product quickly (I mean, I can, but that’s something we should do over on phone call or face-to-face meeting).

But I can tell you how to avoid running into this problem in the future, and to make sure you operate at the right inventory levels.

The first thing you need to do is to truly understand your business. Not just your mission statement, or a description of “this is what we make;” you need to know what your company is known and valued for.

The best way to do that is to run a Pareto analysis (also called the 80/20 rule) and/or an ABC analysis on the products you sell.

The Pareto principle says that 20 percent of your products will drive 80 percent of your revenue. And the reverse is true: 80 percent of your products will drive 20 percent of your revenue.

The ABC analysis breaks down the Pareto analysis even further: the top 10% of your products are the A performers, the second 10% are the B performers, and that remaining 80% are your C performers.

We used to run something called an E&O report (Excess & Obsolete Inventory), and made our decisions based on criteria like:

  • Sales in last 60 days.
  • No sales.
  • Excess above the demand.
  • True obsolete.
  • Specials which could skew the numbers.

(You can apply this same principle to your staff, but that’s for another article.)

Then, you have to make business decisions about which products you no longer want to carry, like cutting the bottom 10% of your products. Not the bottom 80%, because there are probably some that are still generating significant revenue, but the bottom 10% could make a huge difference in your profitability, efficiency, and your cash flow.

Here’s a hypothetical;: If you carry and/or make 100 different products, I’m willing to bet that the bottom 10% of them aren’t doing anything. But you’re still paying for manufacturing costs, administration costs, storage costs, and even the cost of putting them in your catalogs and on your website.

I’m further willing to bet that if you were to look at your administrative costs for that bottom 10% versus the revenue they’re generating, your costs are far outstripping the sales. And if you were to cut that bottom 10%, you could eliminate all those costs without having a negative effect on your bottom line. (If anything, profits should increase.)

Second, plan your stock based on how much you move in a month. If you sell 10 motors per month, keep 10 in stock. If you sell 30 hammers a month, keep 30 hammers in stock. Don’t stock 300 hammers or 50 motors. Just make or order the exact number of units you need. This is called the Economic Order Quantity. According to investopedia.com, it “is the ideal order quantity a company should purchase for its inventory given a set cost of production, demand rate and other variables.

This way, you can offer very good service, but keep a low inventory, because you make your high volume items to a forecast, rather than waiting for an order. You know you’re going to get the order, but you don’t know how many. Therein lies the business and the guesswork — the science and the art, the tarot and the telescope — of forecasting.

Third, this also means you should review your build forecast every 30 days.

You forecast your sales and say “we’re going to sell 1 million units per month.” So you build 1 million units and you measure it. If you’ve underestimated it, you can increase your build quantity, and if you’ve overestimated, you can reduce your build quantity.

So if you build 1 million units, but only sell 800,000, then you should build 800,000 the next time. (Actually, only build 600,000 the next month, but then ramp it back up to 800,000 the following month.)

But don’t build 1 million again. A lot of businesses will keep building 1 million units each month, sell 800,000 each month, and then wonder why they have 2 million units in stock at the end of six months.

Conversely, you could have a demand of 1.2 million units per month, which means you’ve got a backlog of 200,000. That means you need to increase your production to 1.2 million units because you’ve underestimated what your demand will be. (Again, make 1.4 million in the next month to catch up with the backlogged orders, but from there on out, make 1.2 million.)

That’s the benefit of continually reviewing your forecast. You don’t have to do it on every item, but you should at least do it on your most popular items.

If you want to avoid having too much or too little inventory on hand, make sure you’re always measuring and assessing your sales and production. Drop the bottom 10% of poorest-performing products, know your Economic Order Quantity, and review your build forecast every 30 days.

Comments? You can contact me directly via my AdvisoryCloud profile.

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