Core Principles of Inventory Management

"Junk in equals junk out when it comes to inventory management" - Kelsie Garrett

In yesterday’s post, I gave a brief overview of inventory management and the effects it has on a business.  Today we are going to focus on 5 core principles of inventory management and the role they play in your business.

1. Just-in-Time (JIT) Inventory:

The first principle we are going to look at is the principle of Just-in-Time (JIT) inventory. The JIT approach aims to increase efficiency and decrease waste by receiving goods only as they are needed in the production process. This results in lower inventory holding costs but requires precise demand forecasting and supplier reliability. This method can be applied to all areas of inventory management: from raw materials arriving at the door, to raw materials being sent to production lines, and even the finished goods inventory going out to the warehouse and final customers.

When managing your inventory, it is crucial to ensure that the inventory arrives at your warehouse just in time to be processed into your system and transferred to the production line. This minimizes the time it sits in your warehouse and the period during which the item is using your cash instead of being turned into a finished good and generating revenue for your business. Although this principle offers more advantages than disadvantages, there are some critical prerequisites for its success.

To utilize this system effectively, you need to have an accurate sales forecast. I always tell my team: "Junk in equals junk out" when it comes to inventory management systems. If your sales forecast is not accurate, then your Just-in-Time inventory will not be successful.

Advantages of JIT:

• Waste reduction

• Improved efficiency

• Greater productivity

• Smoother production flow

• Lower costs

• Improved quality

In the food and beverage industries, this principle is especially important as items have expiration dates, necessitating a system that minimizes waste and ensures freshness.

Disadvantages of JIT:

• Supply chain disruptions

• Overreliance on forecasts

• Order issues

• Supplier dependence

• Acts of nature

When you operate your inventory management system on a lean Just-in-Time basis, you may be at the mercy of factors beyond your control, such as natural disasters or supply chain issues. It is essential to conduct a cost-benefit analysis on your inventory to determine which items would be more costly to run out of stock versus keeping them on hand. Each item will have different considerations.

2. Economic Order Quantity (EOQ):

The second principle we are going to discuss today is the Economic Order Quantity, or EOQ for short. EOQ is a formula used to determine the optimal order quantity that minimizes total inventory costs, including both holding and ordering costs. The goal is to find the ideal balance where these combined costs are at their lowest. Every business, no matter the industry, can benefit from the EOQ method.

The three variables used to calculate EOQ are:

• D = Demand in units (annual)

• S = Order cost

• H = Holding costs (per unit, per year)

The formula is as follows:

This formula helps businesses make data-driven decisions on the ideal order size to maximize profitability. While many ERP systems have this functionality built-in, you can also calculate EOQ manually if you do not have an ERP system.

It's important to note that EOQ is not a "set it and forget it" process. As your business grows and changes, so will the demand for the items you sell. For instance, while widget A might be selling really well this quarter, widget B may outgrow widget A in the future. In such cases, you would need to reevaluate the EOQ for the raw materials that go into both widget A and widget B.

3. Safety Stock:

The third principle I am going to touch on today is Safety Stock. Keeping extra inventory just in case of unexpected demand spikes or supply chain disruptions is known as safety stock. It acts as a buffer against uncertainties in demand and lead time. Safety stock is not just keeping extra products in your warehouse and calling it safety stock. There is reasoning behind safety stock for every item you hold in your warehouse. Safety stock is a way to mitigate the risks associated with JIT inventory. It gives your system a buffer for unexpected hiccups in your supply chain.

Safety stock takes into account several factors including: supplier lead time, supplier volatility, minimum order quantities (MOQs), forecast accuracy, and risk.

Suppliers play a big role in safety stock. If you have a supplier with a short lead time and a track record of delivering on time, in full, and quality products, you would carry less safety stock on those items because the risk of them delivering late or wrong product is low. On the other hand, if you have a supplier with a long lead time and a history of not delivering in full or with quality issues, you want to mitigate that risk by carrying additional safety stock on those items. The total amount of safety stock you carry will depend on how much risk out-of-stocks on those items would pose to your business. Supplier MOQs are another significant piece of safety stock. You need to balance the supplier’s MOQ with your demand and safety stock needs.

Forecast accuracy plays a big role in safety stock as well. If you have an item with a steady forecast that you have run for a long time, you can carry less safety stock because the forecast is unlikely to fluctuate enough to cause out-of-stocks. Conversely, if you are launching a new product, the likelihood of the forecast being accurate is low. You will want to increase the raw material safety stock or finished good safety stock until you can more accurately forecast the new item.

Using the factors above, you can calculate safety stock for each item. From there, you will determine a minimum, maximum, and reorder point for each item. For example, if you determined that widget A needs to have 15 days on hand, the demand for the item is 15,000 units a month, the supplier’s lead time is 10 days, and the risk is low on the forecast, you would put together an estimated safety stock of:

- Minimum: (15,000 units / 30 days) * 15 days = 7,500 units

- Reorder Point: (15,000 units / 30 days) * (10 days / 2) + Minimum 7,500 units = 10,000 units

- Maximum: (15,000 units / 30 days) * 20 days = 10,000 units

If you are concerned about the volatility of the forecast, you can increase your minimum and maximum to account for fluctuations in demand. The formulas above will not necessarily work for all industries, and having a functional ERP system will help you determine these values.

4. ABC Analysis:

The fourth principle of inventory management is the ABC Analysis. This principle involves categorizing inventory into three categories (A, B, and C) based on their importance. ‘A’ items are highly valuable but less in number, while ‘C’ items are numerous but less valuable. This helps prioritize management efforts and resource allocation.

A grade inventory would be your best performing inventory.  This would be the smallest amount of inventory that accounts for 80 percent of your revenue.  Due to impact these items have on your revenue, these need to be your priority.

B grade inventory would be the inventory that accounts for 15% of your revenue.  These items can fluctuate between A and C grade during their lifetime.  While they do serve a purpose in your business, they are not as impactful as the A grade inventory and should be treated accordingly.

C grade inventory would be the inventory that is in the bottom 5% of your revenue.  This may consist of custom items that are slow moving items or items that demand has slowed and the item is dying off.  Stockouts on these items bring very little impact to the bottom line of your business.

According to a Supermarket News article, supply issues account for nearly $350 billion dollars in lost revenue for US and Canadian businesses.  This is why it is important to manage your inventory to minimize stockouts.

Once you identify your A grade inventory, you can focus a majority of your time on managing those items.  You want to build a strong relationship with the suppliers that supply your A grade inventory to ensure consistent supply of those items.  While you may have a good relationship with your suppliers and feel confident in what they can do, it is always good to mitigate risk by finding multiple sources for your inventory.  If a natural disaster happens and destroys the supplier’s plant, will they still be able to supply you?

5. FIFO and LIFO:

The last principle of inventory management we will discuss today is FIFO and LIFO. These are inventory valuation methods that businesses use to manage their stock efficiently.

First-In, First-Out (FIFO)

FIFO assumes the oldest inventory items are sold first, making it ideal for perishable goods. Since I worked mostly in the food and beverage industry, we always used the FIFO method. To minimize loss due to expired products, the first product in the door would be the first product used. In this method, it is essential that your ERP system tracks expiration dates.

A previous client I worked with didn't track their expiration dates in the system, instead using receipt dates or manually calculating expiration dates based on the Julian date. This caused a lot of inventory to be shipped and used out of order, leading to products expiring without the team realizing it. Once they corrected the system and started focusing on the FIFO method, their expired products were drastically reduced.

Last-In, First-Out (LIFO)

LIFO assumes the most recently produced items are sold first, which can be useful in scenarios of cost fluctuation. However, the LIFO method is not ideal for the food and beverage industry but can be beneficial for other sectors. This method uses the newest inventory first and can be helpful during periods of inflation, resulting in higher Cost of Goods Sold (COGS) and lower tax liabilities.

Depending on your industry and financial goals, the choice between FIFO and LIFO will vary. Each method has its unique advantages, and the appropriate choice depends on your specific business needs.

Mastering core inventory management principles is crucial for maintaining operational efficiency, reducing costs, and enhancing customer satisfaction. By implementing accurate tracking, managing inventory turnover, maintaining optimal stock levels, and using technology wisely, businesses can achieve seamless operations and sustained growth.

Is there a specific aspect of these principles you’re excited to implement in your business?

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