Most entrepreneurs are so busy focusing on profit, sales, revenues, and costs, that they often neglect one important part of their business – inventory. Inventory can play a substantial role in the health of your business. Having a great inventory management system helps avoid spoilage. It helps you save money and increases your productivity and efficiency. Most of all, it helps you keep your customers. You want to make sure that you have what your customers are looking for when they want it. This is why you should pay attention to inventory management metrics.
Why Isn’t Overstocking Warehouses An Effective Solution For A Problem of Low Availability?
Having too little inventory can lead to decreased customer satisfaction and missed sales. Low product availability can decrease your customer’s trust and loyalty. Most of all, it can reduce your sale and revenue. So, the most logical thing to do is to overstock your warehouse, right?
Well, not really. Overstocking your warehouse is not the solution to low availability. Why? Well, having too much inventory can lead to a lot of problems including increased holding costs and product spoilage. It can potentially lead to losses.
So, you’d ask, how much inventory should I carry? Well, the goal is to reach optimal inventory levels. You have to strategically plan your inventory to make sure that you avoid having too much or too little items in your warehouse. The best way to achieve this is to really look at your inventory management metrics.
TOP 9 INVENTORY METRICS
To keep your inventory balanced at all times, here’s a list of key inventory metrics that you should pay attention to:
1. Inventory Turnover
This is an important metric to look at because this helps maximize your revenue. If you’re a retailer, your goal is to move your inventory off the shelves. The faster you can move the inventory out, the bigger your revenue.
You should pay attention to your inventory turnover, especially if you have a low profit margin. So, increasing your inventory turnover is critical to increasing your profit. That’s the only way your business can survive.
Inventory turnover is calculated as:
Cost of Goods Sold (COGS) ÷ Average Inventory
Let’s say that your inventory at the start of the year is $2000 and your ending inventory is valued at $3000. You add both numbers and then divide the sum by 2 to compute your average inventory. So, your average inventory is at $2500. Let’s say that your COGS or cost of goods sold is valued at $15,000.
So, to compute your inventory turnover, you need to divide 15,000 by 2500. So, your inventory turnover is 6. So, what does this mean? This means that you replace the product inventory 6 times a year.
This is how this metric becomes helpful. There’s 365 days a year, right? So, you have to divide 365 by 6, your inventory turnover. When you do that, you get the number 60.33. This number is called Average Days to Sell, which we will discuss later on. But, what does this number mean? Well, this means that you sell your product every 60 days. Is this number good or bad? It depends on what you’re selling. But, this number means that you’re not moving your inventory out fast enough.
Having a low inventory turnover may mean that you’re overstocking your product. It may mean that you have poor marketing strategies or that your product is just not in demand.
Having an overly high product turnover means that your inventory level is too low and you’re not meeting the demands of your customers.
A lot of web retailers would tell you that the ideal inventory turnover for online businesses should be around 4 to 6. But, if you want to maximize your profit and earnings, you have to increase your inventory turnover to around 10 or 11.
Having a high inventory turnover reduces your holding costs like warehouse rent and insurance. It also reduces the likelihood of theft. Plus, having an above-average inventory turnover increases your revenue.
2. Demand Forecast Accuracy
The key to successful inventory management is to have an in-depth understanding of the law of supply and demand.
To take advantage of the countless market opportunities, you must accurately forecast the demand for your product.
To accurately forecast demand, you have to look at market trends. You can also check how your competitors are doing. You can also tap an industry expert to help you make an accurate forecast.
There are various forecasting methods that you can use, including qualitative forecasting, time series analysis, causal analysis, and simulation forecasting.
Here are a few forecasting tips that you can use:
Establish a baseline. You can pull your last year’s sales and use it as a baseline data.
You must get to know your customers closely. You must know their buying patterns and dispensable income.
3. Gross Margin Percentage
Gross margin is an important metric, not only in inventory management, but in the business as a whole. This metric is also called ‘income’, ‘revenue’ and ‘profit’. The gross margin is calculated as:
(Sales – Cost of Goods Sold) ÷ Sales
So, let’s say that you’re selling a bag for $100. Your cost of producing the bag is $30. This means that your gross margin percentage is 70 percent. This means that your profit is 70 percent of your sales. Not bad, right?
Now, how is this metric important in inventory management. Well, if you have a high gross margin, you don’t have to worry about having a high inventory turnover. But, if you have a low gross margin percentage, you would want to increase your inventory turnover. This is the only way your retail business can survive.
4. Cost of Carrying
This metric is calculated as:
Carrying costs ÷ Overall costs
So, let’s say, your overall business cost is ten thousand dollars a month and your carrying cost (storage, warehouse rental, salary of warehouse personnel, etc) is valued at $1000. This means that your cost of carrying is 10 percent. This is a pretty huge number.
To maximize your profit, you want your carrying costs to be as low as possible.
5. Average Inventory
As previously mentioned, average inventory is calculated as:
(Beginning Inventory + Ending Inventory) ÷ 2
It’s important to look at this number so you could avoid unexpected drops or spikes in your inventory.
6. Holding Cost
The holding cost is the total cost of storing unsold inventory. This includes labor, storage space, maintenance, and insurance. It also includes damaged or spoiled goods. You would want to keep this number as low as possible. To do this, you need to follow these tips:
Reduce your supplier lead time. Make sure that your suppliers deliver the goods promptly.
Get rid of your obsolete items. Put them on sale if you have to.
Choose a supplier with low minimum order quantity to prevent overstocking.
7. Average Days to Sell
This metric measures how often you sell your product. Do you sell an item per day or do you get just one sale every thirty days? As previously mentioned in this article, “average days to sell” is computed as:
(Average Inventory + Cost of Goods Sold) ÷ 365
You want to keep this number as low as possible. If you sell slow moving product, 30 is a good number. But, if you’re selling low profit perishable products, you’d want to move your products out as fast as you can. Keep your average days in inventory low.
8. Return on Investment or Gross Margin Return on Investment (GMROI)
This is one of the most important inventory performance metrics. It is calculated as:
(Sales ÷ Average Cost of Inventory) x Gross Margin
Then GMROI measures how much you’re earning for every dollar you spend on your inventory.
If your GMROI is higher than 1, it means that you’re earning a profit. It means that you are selling your product more than what you’ve paid for them. If your GMROI is lower than 1, it means that you’re losing money.
But, how do you use this in inventory management? If your inventory is not moving, your product might be priced too high. You can mark it down, to increase your inventory turnover. But, you have to be careful. You don’t want to lose a huge amount of gross margin. After all, the goal of running a business is to earn profit.
9. Item Fill Rate
Item fill rate is basically the rate at which the order is fulfilled compared to its demand.
This is calculated as:
Received Quantity ÷ Ordered Quantity
So, let’s say that you have a total order of 300 for the month of January. But, you were only able to deliver 200 items. This means that you have an item fill rate of 67%.
Having a low item fill rate means that your inventory is too low. This means that your supply is lower than the customer demand. This could lead to low customer satisfaction.
To maximize your sales, revenue, and customer satisfaction, it’s best to keep your item fill rate at 100 percent.
Paying attention to inventory management metrics can help you figure out how much inventory you need. It helps you prevent shortages and avoid spoilage. It keeps you ahead of the demand curve, so you can keep your customers happy and satisfied all year long. It helps you save time and increase customer loyalty.
And lastly, don’t forget the cardinal rule in inventory management – keep a huge stock of “in demand” items and reduce the stock of obsolete products or items with low demand.