Cost of Over and Under Stocking

The Over Stocked Problem  

If you are overstocked, you face a number of other costly issues.  Stock on hand surplus to requirements has a number of associated expenses including the following:

• The investment made in the production of a product which is equivalent to the variable costs of components of the product plus the labour, energy and other resources that are necessary to produce it.
• If you are a retailer and purchase product for resale, you have to pay the wholesaler’s invoice, which can often be in advance of receiving the income from selling a product if it’s a slow moving line. You might need a loan or overdraft to fund the invoice payment incurring interest.

• Losses from life expiry with products, like foodstuffs that have a short life and are then valueless, and have to be written off at a loss.
• Obsolescence where the product has to be written off or sharply discounted in order to move it e.g. women’s fashions.
• Storage costs either in a warehouse or a shop. In both instances the excess stock needs either more shelf space or displaces stock that might sell. In a retail environment with finite shelf space, any space taken up with slow moving lines displaces space that could be used for fast moving lines reducing the amount of them presented and therefore sold.

• The economic cost of excess inventory is both the direct cash tied up in the production and holding of the inventory and any interest on loan or overdraft funds borrowed to cover the inventory.  Economists call this the “opportunity cost”  of the money  tied up as it represents the cost of using it for some other opportunity that is more profitable.

Therefore any reduction that you can make in inventory is likely to reduce this cost of funding the surplus inventory.

Ironically, excess inventory sits on the company balance sheet as an asset of the company giving the somewhat misleading impression that it is contributing in some way.  Cash in your bank account also sits as an asset on the balance sheet and, given that cash increases in value through compound interest, it is better than excess inventory which diminishes in value over time and costs money to hold.

You could estimate the amount of money unnecessarily tied up in your inventory in the following example:

• 20 slow moving inventory lines out of a total of 100 lines.
  
• Each of the slow moving lines have 100 units in stock.
  20 x 100 = 2,000 slow moving items in total.
• Each item has either a wholesale purchase price (retailers) or a production cost (for manufacturers) of $50.
  $50 x 2,000 slow moving items = $100,000 cost
• The business is paying 5% per annum in interest
  $100,000 x 5% = $5,000 per annum in interest
• The cost for holding this stock for 100 days is:
  $5,000 divided by 365 days = $13.70 per day
  Multiply x 100 days = $1,370

The cost of over stocking in this case is:

$100,000 initial outlay in purchasing the items
Plus
$1,370 interest payment on the stock over the 100 days.

Solutions to Over Stocking

If we convert to the concept of “pull” inventory management, then we need a system for predicting quantity of either production or purchases from a wholesaler through the system. A technique that has developed to permit this is known as a Kanban. Because this tool is a large subject, it has an article of its own.

You can explore faster de-stocking by garage sales, heavy discounts and similar actions to move the slow stock more rapidly and get it down to manageable levels.  Be Careful if you sell this stock to your normal customers because they may slow down their purchases of your other products while they clear the discounted stock purchase meaning you get a double hit; a discount on excess stocks and a reduction in “normal” sales.  

Metrics

Metrics are important for you to see where your business has been and is going. You need a way to measure the speed your Inventory is moving so that you can see a positive or negative trend.

One metric is:

Inventory Dollar Days (IDD)

This is simply the acquisition cost of the product from the wholesaler, or from your production, times the number of days to date it has been held in inventory.  

The IDD will go up if more expensive inventory items enter the inventory system and/or if the length of time taken to clear the items out goes up. Either reason is one for concern.

Inventory Turnover Ratio

This measures the number of times a year you are selling the equivalent of your entire inventory.  A higher figure is better as it indicates you have less slow moving lines that are costing you money to hold.

Is is calculated as Sales/average inventory.  If you have Sales of $1 million and average inventory valuation is $200,000, your turnover is 5 times.

“Good” figures will be somewhat industry dependent so we can’t provide the “right” figures here.

Many techniques like Lean make huge improvements into these figures as part of their tuning process.

Go to the article at Investopedia: Inventory Turnover

Go to the article: Importance of Metrics for Profit

Practical Inventory management systems

Given the attention paid to the costs of over and under stocking, it is apparent that you can benefit from a good inventory management system.
Some small business accounting software has inventory modules that might be worth exploring.

A spreadsheet might also work. Search “spreadsheet inventory management” in Google.

A checklist, when you are looking for such a system, needs to be able to:

1. Identify fast moving items and
2. Calculate the lead time for replenishment from production (if you’re a manufacturer) or resupply from a wholesaler (if you are a retailer) so that you don’t run out.
3. Identify slow moving items.
4. Calculate the amount of “safety” stock required to avoid running out of an item, also known as a “buffer” (Buffer Management)
5. Take into account any life expiry issues.
6. Calculate the lost income from stock outs and the increased expense from overstocks and discarded products.
7. Provide useful metrics to monitor the state of the inventory.

In a small business, this ‘software’ can largely be covered by the owners and staff ‘gut feel’ for what is moving or not.  The trick is to be alert to these costs and to take steps to reduce them.

Homework

To see if the topics in this article are relevant your business, carry out the following steps.

1. Check your software system or ask your staff if you have any lines that are regularly out of stock and which you could sell if you had more of them.  These are your fast moving lines and probably your best sellers.  If so, try to estimate the cost of these shortages using the maths above.
2. Repeat the process by inspecting the surplus stock that you have and place a cost on that surplus stock using the method above.
3. If either, or both of these, are significant numbers in your mind:
   
   1. Design the outline of a project to improve the availability of these products.
   2. Rank the profit impact of this project against others your are, or planning to, work on (see The Amazing 80/20 Rule) to see what projects are more important to work through before this one.
      This is detailed further in the Skills Module: SM2.0 80/20 Sales Growth; Double Sales, Triple Profits
   3. If you decide this is a priority project, consider the human and other resources necessary to work on this project and plan to start the project when those resources finish doing what they are now. This avoids inefficient Multitasking. 
      Go to the article: Why Multitasking is Not Your Friend
4. If there was significant profit / value loss in your inventory system, give thought to how to prevent it happening again in the future.
   
   1. Consider a new or better inventory software system.  
   2. Introduce or tweak useful metrics to warn you when it reoccurs.

Resources

Links to other resources for more learning:

Wikipedia: Inventory information from definitions through examples, terminology, accounting, management, rotation and analysis – link

YouTube: Inventory Management – An Introduction by Rob O’Byrne – link

Books:

EIM – Effective Inventory Management – EIM allows an organisation to meet or exceed customers’ expectations of product availability while maximising net profits. A website with links to resources, seminars and articles – link

Eli Goldratt’s business novel “Isn’t it Obvious”  makes leaning about inventory management entertaining.  Eli developed the concept of the Theory of Constraints.

Go to the Skills Module: SM5.0 Find and Remove Bottleneck with Theory of Constraints (TOC)