What is inventory optimization?
Inventory optimization refers to the process of using mathematical algorithms to know the accurate balance of demand and supply. This specifies the most profitable inventory mix and the level of inventory to be stocked for each products that allows you fulfill maximum number of orders with the least amount of stock on hand. This means, when you optimize your inventory, your supply management software helps you analyze how to make the most, with the least.
Analyze and break down data to optimize inventory levels
With detailed sales and inventory data in hand, you can conduct a variety of ratios and analyses to optimize inventory levels and improve cash flow. A perfunctory glance at your inventory data compared to your sales numbers will let you know if your inventory is properly accommodating your sales.
In order to thoroughly evaluate inventory practices, follow these inventory management analyses and ratios:
1 – Analyzing your average inventory investment period:
To know the amount of time needed to convert money used to purchase inventory into sales, divide your current inventory balance by average daily cost of goods sold.
Average Inventory Investment Period = Current Inventory Balance Amount % Average Daily Cost Of Goods Sold
Now, if you unaware about the average daily cost of good sold, then divide your annual cost of goods sold amount by the number of days you were open for business during the previous year.
For example your business was open all days, i.e. 365 days.
Average Daily Cost of Goods Sold = Annual Cost of Goods Sold Amount % 365
Therefore, using the annual cost of goods sold amount and inventory balance from a prior year’s balance sheet is usually accurate enough for analyzing and optimizing inventory levels.
2 – Analyze your inventory to sales ratio:
Analyzing inventory to sales ratio helps you identify increase in inventory. The inventory to sales ratio can offer a quick and easy way to look at recent changes in inventory levels, as it uses monthly sales and inventory information. This ratio will help predict early cash flow problems related to your business’s inventory. Divide your inventory balance by sales for the month to find your inventory-to-sales ratio. Perform this ratio every month to see if the ratio is increasing or decreasing.
Inventory to Sales ratio = Inventory Balance % Sales for the month
This way, an increasing inventory to sales ratio will let you know that you are investing too much in inventory or your sales have dropped. Vice versa, a decreasing inventory to sales ratio will let you know that your investment in inventory is decreasing in relation to sales or your sales are increasing.
3 – Analyze your Inventory investment vs turnover analysis:
This is the most useful inventory management software analysis where you can know if your investment in a particular product or group of products requires analysis. This way you inventory data will really pay off. To perform this analysis, you’ll need to know:
- Number of inventory products in stock.
- Number of inventory products sold during a set period.
- Number of inventory products remaining during the set period.
Let me explain you giving examples which will make it easier to understand in order to analyze your inventory investment vs turnover analysis:
Suppose your turnover analysis reveals you have 200 liters of milk in stock, out of which 180 liters of milk has been used in the last 30 days and 20 liters of milk remaining in that set period of 30 days. This way you milk inventory requires no adjustment as you have utilized majority, keeping enough in reserves.
Now, suppose your turnover analysis reveals you have 200 liters of milk in stock, out of which 50 liters of milk has been used in the last 30 days and 150 liters of milk remaining in that set period of 30 days. This way you understand that you are ordering 3 times more than your business uses in that set period of 30 days.
Always remember, the more inventory you have in stock, the less cash you have in hand.
Analyzing and evaluating your inventory on frequent basis will not only help you optimize your inventory as your business evolves but helps you cash flow remain positive in turn enhance your bottom line.