How to Approach Inventory Analysis for Proper Working Capital Management
Governance, analysis, and control of working capital has always been important for distribution companies because it directly reflects the operational performance and financial health of an organization. Now, as businesses across the globe are trying to keep warehouse doors open through the downturn of the economy, proper working capital management is more critical than ever.
In its most basic form, working capital management is a trifecta of inventory, accounts receivable, and accounts payable. While there are other metrics to look at around working capital, like turnover ratio and collection ratio, the most common key performance indicator (KPI) distribution companies will focus on is their working capital ratio; simply the current assets divided by current liabilities. This all ties back to a core accounting objective: minimizing costs, maximizing return, and keeping operation cycles efficient and running.
This article is going to focus on one of the most significant components of working capital for distribution and manufacturing companies – inventory analysis.
Determining how much of a company’s dollars are tied up in inventory is a pivotal piece to accurate and proper working capital management. Inventory analysis should be a strong focus for organizations proactively arming themselves in a retracting market – both for survival in a downturn and to maximize revenue when (not if) the economy rebounds.
Inventory analysis is a thorough evaluation of your inventory to determine the optimum amount to keep on hand. There is not one single calculation that determines inventory levels. Instead, there are several metrics and measurements involved to be able to answer that question confidently.
Types of Inventory: The Good, the Bad, and the Ugly
Before considering inventory optimization, the first thing you need to find out is how much inventory you have on hand. It may seem rudimentary, but inventory can be roughly grouped into three categories:
- Good Inventory
Inventory that will sell/turn in an expected replenishment time period. You make money when this product is sold.
- Bad Inventory
Inventory that will sell/turn at some point in the future. This inventory won’t expire and become obsolete because customers need it – but it’s going to sit in your warehouse for a while.
- Ugly Inventory
This inventory doesn’t have a target customer. It is considered obsolete, expired, or just cannot be sold. If the product is sold, you lose money, and it often doesn’t lead to any other profitable sales. That means it’s taking up valuable space in your warehouse – which should be filled with good inventory.
While safety stock or “bad inventory” can protect you against unexpected product demand, additional inventory or “ugly inventory” can hurt profitability. When Clients First first met Wexco, a distributor of windshield wipers, blades, motors, and linkage components for a variety of consumers and automobile manufacturers, they were hitting a growth stall. They had millions of dollars tied up in bad inventory. That inventory would eventually be sold or saleable, but without a customer order – it was taking up room and tying up cash flow. During an inventory analysis, we discovered that Wexco had established significant safety stock levels that were causing the over-ordering of inventory reserves. The goal then was to help optimize their inventory replenishment and planning settings to avoid this overstock situation.
To measure how much good, bad, and ugly inventory you have available, you are going to need more than an inventory valuation report. You are going to need a solution that allows you to pull many reports and calculations. For starters, you need an “Inventory Aging Report” to show you how many weeks of inventory you have on hand – in units and dollars. Not only do you need to know what the cost of carrying that inventory is, but you must also know what the effective Economic Order Quantity (EOQ), otherwise known as the order quantity that minimizes the total holding costs and ordering costs. And, if you have multiple warehouses, you need to measure surplus inventory.
Metrics and Calculations for Your Inventory Analysis
Once you have an understanding of the types and quantity of inventory you have available, you can start to get a picture of how well you are managing inventory and maximizing your net profits. While there are many methods used to analyze a company’s inventory, we are going to share two vital measurements to keep in mind moving forward.
Customer Service Level
As a group of technology enthusiasts and experts who are continually learning, we came across a valuable blog series from Jon Schreibfeder, an author of several books on achieving effective inventory management. While he discusses several key metrics that help you analyze inventory, he highlights the most significant metric as “Customer Service Level.”
Your customer service level tells you how often you have inventory available when your customers want to buy it. Achieving a very high customer service level can be cost-prohibitive, depending on the value and carrying costs to meet those levels. Here is the calculation for reference:
# of Line Items Stocked X Promise Date / Total # of Line Items Ordered
Let’s look at an example. If you distributed 950 order line items last week, on time and complete, and you had orders for 1000 items, you have hit a 95% customer service level. When calculating this measure, you only include sales of stocked items that are filled using warehouse inventory – no non-stock items, special order items, drop ship, or direct ship items. Measuring your customer service level regularly will show you top products, vendor performance, buyer performance – everything you need to make improvements and optimize your inventory.
Another key measurement in optimizing inventory is demand planning and inventory forecasting. Your sales team complains that you don’t have enough inventory on hand while your accountants say that you have too much! Demand planning incorporates vital forecasting and replenishment to give you an accurate picture of what inventory you need to have on hand to meet your customer’s needs.
Twinings Tea was one of the first clients that Clients First helped to deploy the advanced demand planning solution for Dynamics NAV (now Dynamics 365 Business Central). At the time, Twinings needed a solution to manage the manufacturing material requirements for the K-Cups that they manufacture. When we were going through the forecasting elements of the tool, one employee asked, “Do you have to like math?” Fortunately, the software takes the complexity out of forecasting calculations and provides decision support for purchasing recommendations. The demand planning solution helped Twinings Tea improve efficiencies while avoiding stockouts on critical components.
Reducing inventory carrying costs and increasing margins can have a huge impact on your bottom line. With a demand planning solution, you get total access to your data to perform valuable forecasting and replenishment calculations that will shed insight into your inventory, from stocking levels to lead time to unanticipated demand. Demand planning software works to provide the most accurate forecast and replenishment plans available today. The net result is a reduction in inventory while maintaining or improving customer service levels. When surplus inventory is reduced and dead stock is identified for elimination, it frees up cash to fund future growth.
Inventory Analysis Made Easy with Clients First
Accurate inventory analysis requires the right integrated distribution ERP software to help you collect and consolidate data, improve collaboration with customers and distributors, and tightly track inventory operations. As your partner in technology, that’s where we can help. At Clients First, we offer a selection of flexible, reliable ERP solutions specifically built to fit the diverse requirements of distributors.
Improving your inventory position and replenishment methodology can free up highly valued cash and increase your customer service levels at the same time. If you have to get your inventory under control, we’re here to help. Using a variety of tools, reports that we’ve already built, extensions, and, exceptional inventory management know-how, we can configure your software so you can start measuring and analyzing inventory immediately. Book a meeting with our ERP and distribution industry experts so we can show you how we can help you overcome inefficiencies, optimize your inventory, and gain more insight into your working capital.