Cost of Over and Under StockingScott Williams
In a manufacturing or retail environment, inventory levels are critical. Having too much inventory of products your customers don’t want and/or too little inventory on hand of what products your customers do want will cost you money and, consequently, profit. Many service businesses also have inventory even if it is items like stationary incidental to their main operation. This article shows you why under and over stocking costs and how to reduce the damage.
Table of Contents
The Understocked Problem
If you’re a manufacturer and you run out of a stock item it’s quite likely the lines that you run out of are your best selling ones. Because they are your best selling lines, they move most rapidly and you have trouble keeping up the supply through your production system or your wholesaler.
Try this simple exercise to see the cost of stock shortages:
- Your profit margin on a particular item is $10.
- You have 50 items in your product line and that at any point in time 5 of them are out of stock.
- For each of the 5 out of stock items, you could sell 100 units per week.
- You are out of stock of the items for 15 weeks of the year in your prime selling season.
The cost to you of being out of stock is:
5 out of stock items x 100 missed sales = 500 missed sales per week
500 missed sales x 15 weeks of the year = 7,500 missed sales per year
$10 profit margin x 7,500 missed sales = $75,000 missed profit for the year
Did you think that the cost would be as great as it was? When you look at the individual numbers involved they seem quite small but they can add up to a significant sum.
If you are a retailer, you face the opposite side of the same problem.
The customer enters your store with a view to buying a particular item and you don’t have it in stock. It’s quite likely to be a sale that you miss because they may not buy an alternative product from your store. Even worse, they may go to another shop to buy that item and then continue to shop in the other shop in future. Therefore, not only have you not sold the original item that they came in for, but you may have lost the customer entirely!
You can use the same mathematics as above to estimate the cost of understocked items to you as a retailer.
Solutions to Under Stocking
A first step to finding a remedy for under stocked lines is to be aware that you have a problem at all!
Many manufacturers and retailers don’t have the sort of record keeping that will tell them when they run out of a product on a regular basis. One of your early steps should be to set up some method of flagging your attention when a product is regularly out of stock.
Further reading on this topic at the article: Kanban
Very often, your best intentions for maintaining good inventory control will rapidly fall apart because it’s very difficult to estimate what products will be in fashion or demand at any particular point in time.
Any production system that produces all products on a best guess basis of what the customers will want will very quickly find shortages in the fast running lines and surpluses in slow running lines. This best guess approach can be thought of as a “push” model of inventory management; you are pushing the inventory that you think will sell out to the customer.
Alternatively, you can adopt a “pull” inventory model. This means that you stock your inventory according to what your customers are buying at any point in time. If they buy 10 units of a product then you replace it with 10 units. That way, you should be tracking customer demand fairly well. This is often known as “small batches”.
To manufacturers, this may seem very inefficient. It means that small quantities are required to be manufactured when the conventional wisdom is that you need large production batches to get “economies of scale”. On the face of it this is probably quite true for manufacturing as it’s widely known but, there’s also a great deal of business knowledge on how to convert your production line to small batches and therefore make it much more responsive to customer demand and therefore improve your income from having more fast selling lines in stock to sell.
For a retailer, buying from a wholesaler in small batches and having the overhead cost of shipping those batches to you may seem very expensive. However, there is the lost income cost of being out of a fast running product and the risk of losing a customer for life to offset the additional cost. With modern day courier systems, the cost may not be as bad as you expect.
You might need to convince your wholesaler of the benefit of this because it may make more handling work for them. For this reason, they may have a policy of minimum lot sizes. However, they face the same ‘feast and famine’ inventory problem that you do and you might find that they also find shipping small batches allows them to balance out their inventory as well; a “win win” situation.
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
$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 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:
- Identify fast moving items and
- 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.
- Identify slow moving items.
- Calculate the amount of “safety” stock required to avoid running out of an item, also known as a “buffer” (Buffer Management)
- Take into account any life expiry issues.
- Calculate the lost income from stock outs and the increased expense from overstocks and discarded products.
- 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.
To see if the topics in this article are relevant your business, carry out the following steps.
- 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.
- Repeat the process by inspecting the surplus stock that you have and place a cost on that surplus stock using the method above.
- If either, or both of these, are significant numbers in your mind:
- Design the outline of a project to improve the availability of these products.
- 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
- 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
- If there was significant profit / value loss in your inventory system, give thought to how to prevent it happening again in the future.
- Consider a new or better inventory software system.
- Introduce or tweak useful metrics to warn you when it reoccurs.
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
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)