# Most small businesses use an ERP system from companies like SAP, NetSuite and Microsoft. But they fall short of providing inventory optimization and rationalization. Achieving a well-balanced, efficient inventory is no small task as supply chain complexity is ever increasing. How do you get there? How do you know when you have arrived? Understanding and using some basic financial and accounting methods with an advanced inventory optimization solution will help get you there. It will also help keep you there.

Inventory planning uses a wide range of variables and metrics, which generally include:

· Storage efficiency (Inventory turnover rate, Inventory Levels, Space Utilization)

· Process effectiveness (Item Count Accuracy, Days of Supply, Lead time, Obsolescence and Deterioration)

· Other analyses like Pilferage and spoilage, Quality-Percentage Defect, etc.

· Customer satisfaction level - Return rate, Cancellation rate, etc.

· Financial perspective metrics - Insurance, Gross margin Return on Investment (GMROI), Average Cost per Order, Lost Sales Analysis, etc.

The cost of carrying excess and obsolete stock, as well as not having sufficient saleable inventory to meet demand is enormously high. It is common to find excess and obsolete stock representing 30% - 60% of inventory and to find that 5% - 40% of the time, customer demand cannot be met. The latter often results in expediting vendor orders at a premium cost that cannot be passed through (based on Valogix’ research and experience). On a $10M inventory that means potentially $4M - $6M is not being spent properly, a high price to pay for any size company.

According to industry research, companies that forecast, plan, and optimize more accurately generally have 15% less inventory, 17% better "perfect order" ratings, and 35% shorter cash-to-cash cycle times. While there are clearly many factors that affect bottom-line financial performance, most research shows that companies that do a superior job of fulfilling customers' needs This is evidenced by the perfect order, which tend to have higher earnings per share (EPS), better return on assets (ROA), and higher profit margins.

So, if you agree that your inventory is a valuable asset, what tools and processes do to use to manage it? Are you doing everything you can to insure the best results and best return on your inventory investment? Are you using advanced inventory planning and optimization software?

Inventory that is moving through a manufacturing process or that is being picked, packed, etc. in a warehouse is potentially earning money.

Here are some of the many metrics to gauge your inventory performance:

The Carrying Cost of Inventory measures how much it costs to store inventory over a given period of time. Use the following formula when calculating carrying cost of inventory.

Inventory Carrying Rate x Average Inventory Value

Every piece of inventory that you purchase and store in your inventory has some sort of cost associated with it, such as labor, risk/insurance, storage, and freight. This metric is used to figure out how much profit can be made on your current inventory, and it may also be used to help your suppliers map out their production cycles.

Two basic measurements for managing inventory are on-hand accuracy and velocity/demand (turnover). Location accuracy is defined as: the part number and actual physical count in a location match the data stated in the computer. The best way to develop and maintain location accuracy is a cycle count program.

Inventory Turns (Inventory Turnover):

The number of times that your inventory cycles or turns over per year. It is one of the most commonly used Supply Chain Metrics.

Calculation:

A frequently used method is to divide the Annual Cost of Sales by the Average Inventory Level.

or …

Inventory Turns can be a moving number.

Example: Rolling 12 Month Cost of Sales = $16,000,000. Current Inventory = $4,000,000

$16,000,000 / $4,000,000 = 4 Inventory Turns

A. Inventory Carrying Rate:

This can best be explained by the example below....

1. Add up your annual Inventory Costs:

Example:

$800,000 = Storage

$400,000 = Handling

$600,000 = Obsolescence

$800,000 = Damage

$600,000 = Administrative

$200,000 = Loss (pilferage etc.)

$3,400,000 Total

2. Divide the Inventory Costs by the Average Inventory Value:

Example:

$3,400,000 / $34,000k = 10%

3. Then, Add up your costs:

· 9% = Opportunity Cost of Capital (the return you could reasonably expect if you used the money elsewhere)

· 4% = Insurance

· 6% = Taxes

19% Total

4. Add your percentages: 10% (inventory costs) + 19% (other costs above) = 29%

Your Inventory Carrying Rate = 29%

B. Fill Rate definitions

Fill rates and calculations can vary greatly. In the broadest sense, Fill Rate calculates the service level between 2 parties. It is usually a measure of shipping performance expressed as a percentage of the total order.

Sample Fill Rate Metrics:

· Line Count Fill Rate:

The amount of order lines shipped on the initial shipment versus the amount of lines ordered. This measure may or may not take into consideration the requested delivery date. Example ABC Company orders 10 products (one order line each) on its Purchase Order #1234. The manufacturer ships out seven-line items on March 1 and the remaining three items on March 10. The Fill Rate for this Purchase Order is 70%. It is calculated once the initial shipment takes place.

Calculation: Number of Order Lines Shipped on the Initial Order* / Total Number of Order Lines Ordered (7/10 = 70%)

· SKU Fill Rate: The number of SKU's (Stock Keeping Units) ordered and shipped is taken into consideration. Above, we consider each Order Line to have an equal value (1 ). Here, we count the SKU's per Order Line.

Example: If on Line 1, the order was for 30 SKUs of product "AB" and on line 2, they ordered 10 SKUs of item "AC". If Line 1 ships on April 1 and line 2 on April 20, then the SKU Fill Rate is 75%.

Calculation: Number of SKUs Shipped on the Initial Shipment / Total Number of SKUs Ordered (30/40 = 75%).

· On-Time Shipping Performance is a calculation of the number of Order Lines shipped on or before the Requested Ship Date versus the total number of Order Lines. Throughout the following text, I refer to "shipped" on-time. But if actual "delivery" data is available, it may be substituted and compared to the Requested Delivery Date.

*On Time: Shipped on or before the requested ship date (except if the receiving party does not accept early shipments).

Inventory Months of Supply calculation:

· Inventory On-Hand / Avg Monthly Usage

· (the Avg Monthly Usage is typically the yearly forecast divided by12)

You can spend as much as you like or can afford or leverage on credit or loans for your inventory. What does matter is how you make that inventory work for you. In other words, what is your return on that investment now and in the future. Work to balance your inventory using today’s inventory planning and optimization solutions like those offered by Valogix. See next month’s Blog, Part 2 of inventory financial metrics.