Inventory management is a set of practices followed by firms, retailers and other business entities to fulfill anticipated demand for goods and services across a predefined period of time to maximize sales volume and profits.
The retailer needs to have the right amount of stock in their warehouse to fulfill maximum number of orders for a month to run an efficient inventory management process.
The retailer should avoid understocking or overstocking items. If he understocks, not only would he sell less, but would also earn dissatisfied customers who would go empty handed.
At the same time, if he overstocks, he would incur charges. This is because the excess inventory would occupy warehouse space and various other charges for its upkeep. This is what we call as Inventory carrying cost.
Hence, the prime goal of Inventory management is to help stock an optimal level of inventory in your warehouse to fulfill maximum number of orders while keeping the carrying costs as low as possible.
You may want to go through the general inventory terminologies before we go deeper.
Difference between Stock and Inventory:
Theoretically, inventory for a business combines FINISHED PRODUCTS along with all the RAW MATERIALS that are used to produce them.
On the other hand, the term ‘STOCK’ particularly refers to RETAIL UNITS.
Example- A smartphone manufacturer that also manufactures all the components and accessories required to build the Smartphone, would consider the SMARTPHONE UNITS, COMPONENTS, and ACCESSORIES as INVENTORY.
On the other hand, a distributor of that smartphone brand selling units of SMARTPHONES and its accessories such as Headphones, Charger etc., would consider them as STOCKS.
However, Please understand that both the terms are often used INTERCHANGEABLY. Online sellers who can be distributors of a particular brand, often use the term INVENTORY.
We do not recommend using one term over another. However, due to a myriad of information over the web, it is better to clear the confusion.
If you are selling online, you can use any of the terms as long as you’re able to avoid confusion and smoothly navigate your business.
An efficient inventory management process revolves around a couple of things-
Higher Profit Margin for sellers-
- Ordering a minimum qty from the supplier to get more discounts. Lesser Cost price means a greater margin for the seller.
- Tracking dispatch and shipping of goods to customers to ascertain returns. The sooner the quantity is updated, the faster it can sold again.
Reduce Inventory Carrying costs for sellers-
- Ordering at the right time to reduce inventory carrying cost.
- Tracking sales on storefronts and marketplaces in real-time to push purchase order at the right time. This prevents early or late arrival of goods at the warehouse.
The process begins with the Supplier who stocks the inventory in a warehouse. The inventory is stocked according to specific labels within the warehouse.
The inventory makes way to the seller’s warehouse at a predetermined time once the purchase order is generated from the seller.
As discussed, the date and time is crucial for the sellers to avoid inventory carrying cost, excess inventory or a stock out situation.
The inventory is then sorted and a unique SKU, or stock keeping unit is allocated to each sellable unit by the seller.
The unique SKUs for each product helps your inventory management system to track its sales across marketplaces and storefronts. This keeps the seller updated and enables him to forecast and put the next purchase order at the RIGHT TIME.
Returned items are put back into the inventory management system by the seller for reselling.
By accurately timing the events within the entire supply chain, the seller can reduce inventory carrying costs and maximize his sales.
How to go about Inventory Management-The Science:
One of the goals of an efficient inventory management workflow is to ascertain the perfect time for the seller to put a Purchase order.
The timing has to be perfect because once the purchased stocks make their way to the seller’s warehouse, it has to reach at a time when he is just about to go empty¹. If it reaches too early, he will incur carrying costs in order to store it, if it reaches late, he would be sitting without stocks and unfulfilled orders.
This particular time in the month when your inventory reaches a certain minimum and you push the purchase order, is called the REORDER POINT.
Finding the reorder point is the foremost task of inventory management because it helps you to-
- Reduce Carrying Costs
- Prevents Overstocking or Understocking
- Fulfill the maximum number of orders, more profits
How to calculate the Reorder point?
Reorder Point is the sum of Lead Time Demand and the Safety Stock. It is expressed as-
ROP= Lead Time Demand + Safety Stock
Lets calculate the Safety Stock first-
Imagine you start with a certain amount of stock/Inventory at the first day of the month for a particular product/SKU.
Let’s assume the sales volume and replenishment cycle for successive weeks as given below. We will use this data to calculate the Safety Stock, Lead Time Demand and the Reorder Point.
You can do the same with your own data.
Now, suppose that you replenish your stock every week on an average. So you may have 4-5 replenishment cycles every month as given below. Consider the following replenishment cycle given below.
|Replenishment||Expected (days)||Actual (days)||Variation (days)|
|1||6 (Lead Time)||10 (Max Lead Time)||+4|
Please understand that you may replenish your inventory many times a month. However, for calculations, you need to find a monthly average of your replenishment time or lead time. This is what we call the Average Lead Time.
Here, we have taken 5 instances in the above example.
Now, calculating the Safety Stock,
Safety Stock is expressed as-
(Maximum Daily Demand * Maximum Lead time in Days)- (Average Daily Demand * Average Lead time in Days)
Average Daily Demand =(5000+6000+6500+7000)/20= 1225
We are considering 20 days instead of 30 due to 5 working days across 4 weeks.
Average Lead Time = expected days ∓ Variation
= 6 + 3 = 9 (Variation= +4+3+1-2-3=3)
Maximum Lead Time in Days = 10
Maximum Daily Demand = 1300 (assumed)
Thus, Safety Stock = (1300*10)-(1225*9)= 13000-11025 = 1975
Lead Time Demand-
Lead Time Demand = Average Demand * Lead Time
= 1225*6= 7350
Thus, Reorder Point = 7350+1975 = 9325
Free Reorder Point Calculator:
The entire math can be programmed into a spreadsheet as well. You can find ROP for each and every SKU. We made this calculator to help you calculate ROP for 10 SKUs. Click to download.
Further Cost Saving using Price Break- The Annual Cycle:
Apart from saving by minimizing the carrying costs, sellers are also tempted to save on Price Breaks. Price breaks are offered in bulk quantities. The more you order, the lesser average unit price you incur.
Online selling these days come with frequent spikes in demands. Average order quantity for relatively a normal day compared to the ones on Black Friday or Cyber Monday can be many times your usual demand.
This is when Price Break on volumes can save a lot of money and add to your profitability. And as you might have guessed, ascertaining the right order quantity will do the trick.
Obviously, it is tempting to purchase higher volumes to earn maximum discounts but an optimal purchase order quantity would only have enough to fulfill all the orders. This prevents incurring additional Carrying Costs.
To optimize this, we bring in the Economic Order Quantity or EOQ.
Definition of Economic Order Quantity:
The quantity of purchase order that minimizes all the costs associated with inventory management is called the Economic Order Quantity.
It is expressed by the Mathematical Formula as given below-
EOQ = √(2*Annual Demand*Fixed Cost/Annual Carrying Cost)
Unlike the Reorder Point, Economic Order Quantity is often calculated taking the entire year into consideration. Larger firms that manufacture and sell items through brick and mortar stores often employ EOQ to ascertain their annual needs.
Often, it is advisable to keep an eye on your Inventory Turnover ratio and Sales ratio too.
How do you go about inventory management for your online business?
You can easily manage your inventory online if you are selling on multiple channels. A number of small business inventory software can do that for you. Online inventory management has become a norm these days and this is what we are doing at Orderhive.
Orderhive syncs your inventory across all your selling channels automatically so that, neither you have to update your inventory quantity manually nor you end up selling more than you actually have in the warehouse.
You can put your excel sheets to rest. Let Orderhive manage your inventory online while you streamline your focus on the stuff that really matters.
1- The inventory does not actually go to Zero. Sellers usually have something called as Safety Stock from where they fulfill the demand until the next inventory lot reaches the warehouse.
Arup works as Content Marketing Manager for Orderhive. Apart from running Orderhive's digital strategy, Arup likes to write deep and incisive articles on topics across a wide spectrum.
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