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Importance of Inventory Management

January 28, 2015

This video discusses how having an effective inventory management system can impact your entire organization.  Find out more about the variety of inventory measurements, statistics and why they matter, the role of inventory management on the supply chain and the impact of inventory management on business performance.

Transcript:

"Hello. Thank you for joining me. My name is Brandon Cumby, and Today I will be presenting the importance of inventory management. Not only will I drill into the nuts and bolts of an effective inventory management system, but also how inventory management is an essential business practice that has a profound impact on all functions in an organization.

This presentation will be divided into four main topics. One,a variety inventory measurements. Two, statistics and why they matter. Three,the role of inventory management in a supply chain, and four the impact of inventory management on business performance. There will also be some asides to present and discuss key observations of significant researchers regarding analytics and supply chains. I'm going to explore these topics by posing an assortment of questions along the way. The purpose of this is so the viewer can begin to think about the topics in regard to their own organization.

First, please allow me to introduce myself. I'm an application consultant here in our ERP practice at CS3. I have somewhat of an unconventional background for a CPA. In that instead of going straight into the accounting profession, I spent the first part of my career in the telecommunications industry in a variety of roles. Inventory and inventory management was a vital component of my day to day experience during this time.

During a downturn in the industry. I made a career change by earning a degree in accounting—doing well enough to earn a position in the Big Four where I spent a large portion of my client engagement hours heavily involved in the valuation and measurement of inventories, as well as extensive examination of design and implementation of inventory control procedure.

Before we can discuss inventory management. I would like to make sure I hit on some framework. The concept of a stock keeping unit or askew. The definition is straightforward, but the concept is fundamental and crucially important. For every unique item, there is a unique skew. For every skew, it references one and only one item. There's a one to one relationship between unique items and skews.

Now we can agree upon that. The first basic question, I would like to pose is, where's my inventory? This may seem like an odd question, but if you really think about it, this can get very granular, depending on the size and complexity of an organization. This becomes especially important in fast-paced industries or in organizations where rapid growth is status quo. Let's look at the details. Being able to answer questions at this level of detail in the affirmative is a positive step in inventory management. If the answers to these questions are nebulous, that begs the question, 'why not?'

Is it organized and segregated by item and product, in which warehouse is it located, and on which shelf or racks and on. The next key question is 'how much inventory do I have on hand?' In an environment with high dollar value low quantity transactions, this is less likely to be a problem.But in businesses with a vast quantity of relatively low to medium dollar value transactions. This is a critical control point, and on-hand quantity can get out of hand rather quickly with sometimes disastrous results. See what I did there? Okay, okay, that's a CPA's poor attempt at humor. We're gonna have to move on from that. So the granular questions for how much inventory do I have on hand are, can I run?—'can I rely on my on-hand quantities?' This results from controlling inventory movement. We say inventory movement; we have to define what that is. Inventory movement is the transfer received shipment or return of items. What we want to ensure is that it's properly documented. Furthermore, 'are the controls in place to prevent shrink or in documented usage?' Shrink is a term that refers to employee theft, pilferage. And finally, the account in me are a lot are serialized items properly identified. Lastly, once you know where the inventory is located in the on-hand quantities. The final basic question is, 'what is the value of my inventory?' How do we really know that the appropriate cost is assigned to each item? The financial impact from properly controlling this vector can result in everything from financial misstatement,pricing errors, severe negative impact on gross margin, and in turn, the bottom line. Further, for a lot in serialized items that need to be properly identified by cost layer. So far, I've talked about an inventory management system without discussing the components. So I'd like to take a quick break and discuss that they must exist in a symbiotic relationship.

And they're as follows, a system of how it organized and well-documented business processes that drive human behavior related to inventory. That's the first component. And the second major component is a structured and computerized record-keeping system that collects and organizes the inventory data. So as you can see, an effective inventory management system is not just a computer system. There are business processes that drive the proper usage of the computer system that records the inventory transactions.The key component here is consistency. Consistency drives all business practice in relation to inventory management systems.

I would like to switch gears for a moment and talk about statistics and value. I know I know this is probably a snooze fest, but it's very important. So, what are statistics, and why do we care, what's the value? The measurements of on-hand quantities and inventory value are one-dimensional statistics. They are directly measured, and they require no special expertise. They involve such concepts as how many, how much does it cost me to buy or make the product, but without these measurements, all perspective and physical inventories lost. I'll pose a rhetorical question; what do you value?

This is different for every organization and likely to be specific to an industry, but the answer should be contemplated before we delve into more advanced concepts. In general, the consensus among the heavy hitters from law, government, big data, research, and business iconoclast is the measurement and value are correlated—so it should be considered. In researching this topic for myself, the aphorism 'we value what we measure' was a common theme. In practice, people in organizations tend to measure and evaluate what is easy to measure—not necessarily what adds value. This alone makes a powerful case for the importance of an inventory management system, in so far that it makes it easy to value and control inventory. Just the word statistics makes most people cringe—even me a little bit—usually for the same reason, lack of understanding.

Although the topics have on-hand quantities and item value are simple one-dimensional statistics, in fact, we casually use statistics in many facets of everyday life. I'll give some anecdotal evidence here, some simple statistics that are used in everyday conversations when discussing professional sports, talking about the weather, when discussing whether to buy one car over another, you evaluate the fuel efficiency by looking at miles per gallon. Now I'm going to give you a little bit more backstory myself my personal hobby is endurance running—the marathon distance specifically. The entire sport, in fact, when I really thought about it is statistically driven.How far, how fast, overall time runners rank these things to compare performances. Another statistic that runners keep track of is minutes per mile,which is referred to as pace. So in my hobby, this is crucially important to understand. These are just some examples, with which almost everyone has some level of familiarity. See, statistics are not so scary once you think about these examples. Inventory, and statistics so what, so far, I presented inventory fundamentals as well as a few talking points about statistics. But now, I want to hit on some of the potential negative effects of ineffective inventory management.

What is often not talked about when discussing inventory and its management is the impact on business. The impact on a business overall with poor inventory management is widespread, and it ranges from several things such as loss sales, impacted bottom line, can also be susceptible to theft, or undocumented to use by employees, and ultimately, it can result in unhappy customers. And then its obvious that unhappy customers are detrimental long term to a business.

At this point, I'd like to tie all of this together by giving an overview of a widely respected study of systems dynamics in relation to supply chain management. This is not intended to be an exhaustive exposition on the topic, but merely an introduction. To me, it's the most logical way to tie these topics together so that we can really make a case for a strong inventory management system. I would hope that if this information is rung true,you would initiate further exploration into the details of inventory management systems. Here at CS3, we are equipped to help consult the design and documentation of the business process, as well as design and implementation of the software systems that support the processes.

We, as business people and mostly as a society, owe large debt to a fellow by the name of Jay Forster, who founded an entire field of study called system dynamics. You see, Jay Forster was an interesting guy. Raised on a farm with no electricity, he eventually made his way to a small little school that you may have heard of called MIT. Where he subsequently earned a master's, invented modern magnetic memory, worked on prototype radar systems,help design and build the ENIAC computer, and the Whirlwind computer, which is considered the underpinnings of modern connected IT systems.

Forster was classically trained as an engineer and a computer scientist. He was then asked to join the Sloan Business School at MIT to determine how his background in science and engineering can be brought to bear on the core issues that determines success or failure of corporations. This newly created position resulted in the development of system dynamics. One of the premises to Forster's development of this field is that systems, at some level, are closed, and they develop their own internal feedback loops, which then influence future behavior. System dynamics is currently being used throughout the public and private sector for framing and understanding and discussing complex issues and problems—including policy analysis and design.The main piece of his research that speaks specifically to our discussion of inventory management systems is the concept of the bullwhip effect. The bullwhip effect is an observed phenomenon in forecast driven distribution channels.

Throughout the next several minutes, I will explain fully what the difference between forecast driven versus demand-driven distribution means to a business, and the inventory management system. The bullwhip effect refers to a trend of larger and larger swings in inventory in response to changes in customer demand as one looks at firms further back in the supply chain to a customer. The concept first appeared in Forster's industrial dynamics in 61, and thus it also became known as the Forster effect. Since the oscillating demand magnification upstream of a customer is reminiscent of a cracking whip, it became known as the bullwhip effect.

Because customer demand is rarely perfectly stable,businesses must forecast demand properly positioned inventory, and other resources. Forecasts are based on statistics, and they're rarely perfectly accurate. Because forecast errors are given, companies often carry an inventory buffer called 'safety stock.' In periods of rising demand, downstream participants increase orders. In periods of falling demand, orders fall or stop altogether,thereby non reducing inventory. The effect is that variations are amplified as one moves further away from the customer. The causes can be divided into behavioral and operational causes. The behavioral causes are fairly simple:misuse of policy, misperceptions of feedback and delays, or panic ordering reactions from human beings after unmet demand. The operational causes are much more numerous, but also easier to control. Some operational causes in a traditional demand driven inventory system. The largest operational costs in a traditional demand-driven inventory management system is forecast error, as well as adjustment of inventory parameters with each observation. Lead time variability also has an impact on forecasting error and directly affects replenishment time. Different supplier problems also amplify the bullwhip effect through things like trade promotion and forward buying, as well as allocation, shortage gaming, and different kinds of lean policies implemented by suppliers.

In theory, the bullwhip effect does not occur if all orders exactly meet the demand of each period. Looking at this slide, we can see the differences between a traditional forecast driven and demand-driven distribution channel. In theory, the bullwhip effect does not occur if all orders exactly meet the demand of each period. However, we've already discussed that forecasting errors often lead to more oscillations. The conclusion of studying the bullwhip effect is that it is necessary to extend the visibility of customer demand as far as possible. Achievement of a demand-driven supply chain which reacts to actual customer orders is the way to mitigate the bullwhip effect. For example, this model has been successfully implemented in Walmart's distribution system. Individual stores transmit point of sale data from the cash register back to corporate headquarters several times a day. This demand information is used to cure shipments from the Walmart distribution center to the store and from the supplier to the distribution center. The result is near perfect visibility of customer demand and inventory movement throughout the entire supply chain. Better information leads to better inventory positioning and lower cost. We can clearly see the understanding of this problem affirms the need for a cogent, effective inventory management system at the very least. Even so, once an inventory management system is in place. What goal should be set simply beyond capturing cost and tracking inventory movement?

I'm going to propose three additional advanced measurements that should be calculated in use and decision making in relation to inventory management. These measurements add value and other cross-functional ways, as well. Since evidence has been presented, the inventory does not simply exist in a vacuum, and the degree to which does effectively manage whips throughout the organization. Know your carrying cost. Well, what is the carrying cost? Carrying cost is defined by the total additional costs associated with carrying inventory that is not related to the purchase or production of the actual goods to be sold. Some examples of carrying costs include, but are not limited to,storage space, such as warehouses trailers. Or temporary storage facilities, storage,and handling equipment such as racks forklift scanners and pallet Jacks. Inventory handling labor, such as warehouse personnel. Inventory insurance and risk cost such items that are not covered by insurance—such as obsolescence or carelessness—that results in damaged goods, or even theft. As well as taxes imposed on your inventory value.

It is estimated the carrying cost is between 20 to 25% of the total value of inventory. So measuring and tracking fluctuations in this number is vitally important to understanding the true financial impact of carrying inventory directly to your gross margin. This number, along with customer demand, will also help determine the appropriate inventory levels. Also,consistently accumulating and measuring carrying cost could lead to a variety of saving measures to reduce the percentage of carrying cost per dollar of inventory. Having the proper system in place allows for efficient and effective measurement of this statistic. One other thing to be aware of is that there's really no hard and fast rule. The key is just be consistent from period to period and year from year so that there's a high level of compatibility in the data. The general rule of thumb here is that more is better. Just be consistent.

The next advanced metric I would like to propose is know your inventory turnover ratio. What is an inventory turnover ratio, let's define it. Inventory turnover or stock turnover is a metric that is measured and calculated to express the number of times your entire inventory is sold or used during specific time period, which is usually a year. The formulas is essentially in the definition. We look at how much how much inventory we turnover. So we will look at a cost of goods sold, divided by your average inventory.

If your average inventory is $1 million and you sold $4 million worth of goods. You turned over your average inventory, four times 4 million divided by 1 million equals four. What good is a number like four, you say.Well, high turnover means the company is carrying low levels of average inventory in relation to total sales. Typically, this is interpreted as being more efficient leaner, thereby resulting in greater sales, low turnover means the higher inventory levels in relation to total sales. This means large dollar amounts are tied up in inventory, which uses large amounts of cash or proceeds of debt that can be invested elsewhere in the business.

If your brain is working on overdrive right now kind of like mine is, I would say okay great Brandon. I have an inventory turnover of four,but what does that mean is that a high number, or is that oh number. What should I expect? Well the rule of thumb is that this ratio is very is industry-specific and should be bench marked to your other competitors in the industry.

Lastly, and likely the most important topic presented in this presentation is know the lifetime value of your customer. Knowing the lifetime value of your customer ties together all the concepts that we have discussed Today.It allows you to put the management of inventory into the correct perspective.And when contemplating things like inventory turnover, you want to avoid having too much, too many dollars tied up in inventory so that you can invest other avenues of your business. But having too little inventory results in stock-outs,which means unhappy customers. So, in the end, all of these items tie back to your customer, who is going to be buying the goods. How do you calculate the lifetime value of your customer, let's dive right in.

The average value of a sale in a year, times the number of sales, times the average retention time. Those three numbers multiplied together give you the lifetime value of a customer. Some other reasons why this is vitally important is that acquiring new customers is an extraordinarily expensive proposition compared to the cost of retaining existing customers.Having the right stock available is a key factor in driving customer attention.Once you have inventory management business processes in place, customer buying habits such as frequency and dollar spend will be available to analyze and stratify customers. In addition to inventory management, the knowledge gained from understanding the concept of lifetime value will help you better allocate resources to customer retention and loyalty programs.

Let's take a look at a real-world business and how implementing an inventory management system has grown the business, revolutionize the operations, modernize the ability to serve customers, and providing a platform for future sustainable growth.

[VIDEO]

Mo:

'You finding everything you need, my friend?'

 

Customer:

'Yep'

 

Mo:

'Okay, excellent.'

 

Narrator:  

'Mo Amira is the assistant floor manager at Cole Hardware in San Francisco.'

 

Mo:

'Let me know if you guys need any help down there.'

 

Narrator:

'Today, he's facing typical customer service challenges.'

 

Mo:

'I think we used to carry it, but it may have been discontinued. What I could do is check another store because they may have some inventory there. Wanna hang on a second?'

 

Narrator:

'A customer is looking for an electric drill, but it's a one of his other stores.'

 

Mo:

'Turns out that our store over on Polk, they've got two of them in stock.'

 

Narrator:

'He's counting on IT to help him find the item.'

 

Mo:

'Right! What I'll do is I'll give them a call, and I'll tell him to hold it for you. Right. Hey, thanks.'

 

Narrator:

'Technology is at the heart of operations for this small business, but it wasn't always that way. In the early 80s, Rick Karp, the owner of Cole Hardware, took over the business from his father Dave Karp, who founded the original hardware store in 1959.'

 

Dave Karp:

'I was looking for a hardware store and a phone a plumbing wholesale house call me up and says Dave there is a store on Cole Street and I think you and your wife Margie can make a go at. I said Rick started when he was 12 years old, and he never left.'

 

Narrator:

'But his son wanted to modernize the hardware store'

 

Salesclerk:

'Just these two for you?'

 

Customer:

'Yeah.'

 

Narrator:

'Adding technology to help organize the business.'

 

Rick Karp:

'The business has changed tremendously. I mean, at that time,my dad was running the store as a one-person band, if you will.

 

Interviewer:

'And at what point did it stop working well?'

 

Rick Karp:

'I think it stopped working well when his little kid came into the business and said, I don't want to live like this.'

 

Narrator:

'Since taking over, Karp has implemented a number of tech solutions to meet his business needs. Ones that weren't available in the 60s.'

 

Salesclerk:

'And what kind of finishes you want on that?'

 

Narrator:

'Keeping track of inventory was the biggest challenge'

 

Salesclerk:

'nothing, everything's 48.'

 

Narrator:

'So they started implementing software to help catalog thousands of items, across the supply chain.'

 

Rick Karp:

'We have probably about 45,000 different items in the store here, and just to manage the inventory alone without a computer system would be sort of a nightmare.'

 

Narrator:

'Today, the inventory system has helped the business,optimize, and grow from just one store to four throughout the city of San Francisco. One of the ways Cole hardware is able to keep track of glue, sealant,and duct tape across all four stores is by using these handheld scanners.'

 

Robin Miller:

'Well you got to break old habits.'

 

Narrator:

'Robin Miller his Cole Hardware's IT, manager.'

 

Robin Miller:

'The employees use these; they walk around the store with them; they scan out locations. We also do cycle counting with them to keep our inventory counts accurate for inventory valuation. And the other thing they can do with them is, when they move merchandise around, put where the home the location code of the merchandise is.

 

Salesclerk:

'All right. Can I get a $ 20-meter card up front?'

 

Narrator:

'New technologies have helped Cole Hardware reach profitability and continue to grow. His investment on IT, between 50,000 to$100,000 annually.'

 

Salesclerk:

'There you go, have a good day!'

 

Rick Karp:

'We look at it totally from an opportunity perspective and how it can help us grow our business, not really as an expense. So I don't track it that way, but we do spend.'

 

Narrator:

'Karp's latest IT spend is on analytics, which helps them understand how the store is performing, day by day.'

 

Rick Karp:

'So this screen here is one that I look at every day. It shows us on the top, what all four stores did in sales yesterday, compared to the same retail day last year. And then this is the same thing that a month to date comparison, and a year to date comparison. And it's just a nice snapshot of the health of the business if you will in terms of what's coming in the front door.'

[VIDEO END]

Thanks for watching that video. I hope you got as much out of it as I did. After watching my presentation, I hope you are now convinced that an effective inventory management system is no longer just a 'nice to have'for your business. In Today's complex and fast-paced world, it is required.

The call to action is simple. And it begins by envisioning the future and longevity of your organization. Second, honestly appraise the state of your current inventory management system, including gathering data and statistics. Once you know where you are currently and have a road map, so to speak, you can then fully commit to a course of action. My professional recommendation is to explore the variety of robust ERP systems that were once only cost-effective for large organizations, now accessible to small and medium-sized businesses. Thank you for joining me."

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