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Inventory
management or control refers to the management of idle resources
which have economic value tomorrow. Alternatively,
Inventory may be defined as usable but idle resources that have
economic value.
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What is
Average Inventory Level ?
The ideal inventory level is a material's Economic Order
Quantity (EOQ). This is the amount ordered when an order is
placed.
Next you need to determine your Safety Stock (SS). This is
the amount that you should have remaining when the EOQ
arrives.
Basically, Safety stock is the average bare minimum you will
have at any give time, and EOQ+SS is the average maximum
amount you will have at any given point in time. This should
be intuitive because safety is what you have when your
shipment arrives and when the order arrives (EOQ) it gets
added to the safety stock.
There can be average minimum and maximum because you might
not receive the EOQ exactly when you planned to and
therefore may have more or less. On average you should have
the SS amount when you receive shipments. Between these two
average minimum and maximum values lies your long-term
average inventory.
The formula for this is:
Optimal Average Inventory = (EOQ+SS+SS)/2
This is for materials. For finished goods, you should aim to
keep an inventory level designed to prevent a stock out.
This level would be a safety stock of finished goods, thus
making the ideal average inventory for finished the safety
stock value based on your company's service level.
How to Assess Inventory Levels ?
Simplistic Method - Historical Inventory Levels
Most methods of accounting take the beginning inventory of a
period, add it to the ending inventory of a period, and
divide by 2. This essentially provides the mathematical
average for a given month.
For example, if your inventory level for a good is 2000 on
July 1st, you produce 3000 units and sell 1000 units by July
31st. This leaves you with 4000 units. The formula is:
Avg. Inventory = (Beginning Inventory+(Beginning
Inventory+Units Produced-Units Sold))/2
Avg. Inventory = (2000+(2000+3000-1000))/2 = 3000
Or more simply:
Avg. Inventory = (Beginning Inventory+Ending Inventory)/2
Avg. Inventory=(2000+4000)/2=3000
So this covers historical looks using an accounting
approach. A lot of firms use this method to evaluate their
average inventory levels.
Daily Weighted Average Inventory Approach
Suppose you start with 10,000 units on May 1st. Also suppose
you produce 10,000 units in that month spread out across 21
business days. Now (and this is the important part) suppose
you sold 20,000 units in May. This brings the ending
inventory to 0. Using accounting methods, the formula gives
us 10,000 as the average inventory. |
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So why is this so bad? In short, because the average
inventory is not 10,000 units. In fact, there were only two
days in which 10,000 units or less were held and these days
were May 1st (10,000 units) and May 31st (0 Units). Assuming
that production was level through the 21 day working month,
this means that 500 units were produced daily, thus raising
inventory by 500 units a day until inventory was dropped by
20,000 on the 31st.
Thus weighted average is more suited than the simple
average.
Why are inventory levels so important? To put it simply, average inventory levels are important
because they allow you to determine how much money you have
tied up in inventory and how much value your inventory
assets hold. Helping to determine what they should be can
help cut back on unneeded inventory, and knowing what they
are can help you determine average warehouse usage,
inventory risk, percentage of assets that are made up
inventory, holding costs, etc. |
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Learn Optimization of
Inventory here |
Inventory
Holding Costs :
I have been receiving a lot of inquiries regarding the
specifics of calculating holding costs. By and large, you
can read about what drives holding costs in my article A
Simplified Look at the Pros and Cons of Inventory. This
article is intended to provide greater detail regarding the
quantification of holding costs. The first section is going
to discuss rough estimates and the second section will
discuss methods involved with detailed holding cost
analysis.
Rough Estimations :
Typically, holding costs are estimated to cost approximately
15-35% of the material's actual value per year. |
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The primary
factors that drive this up include additional rent needed,
great insurance premiums to protect inventory, opportunity
costs, and the cost of capital to finance inventory.
A More Detailed Look at Holding Costs
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First of all, it is generally best to think of holding costs
in terms of their annual costs. To do this, you will need
accurate representations of your annual inventory levels. It
is always better to track inventory month
by month and using these values to find the average holding
cost as opposed to taking the year's beginning, the year's
end and averaging the two.
So now you have your average inventory. This needs to be
performed for finished goods, work in process, and raw
materials inventory.
Now, you need to figure out what percentage of the total
value of the good is being incurred as a holding cost. Cost
of capital and opportunity costs should be the first things
you think of.
If you are financing the goods with a 10%/year
loan then the holding costs are at least 10% annually. When
you are evaluating the total value, include the value of any
labor that has been added to the goods.
Next step would be to consider the cost of storage. Based on
the inventory you need to carry, how much space do you need
and how much does that space cost per unit as a percentage
of each good.
Again, determine the insurance cost that should be allocated
to each good as a percentage of that good.
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Evaluate the probability that a good will rot, or otherwise
become obsolete and assess the average rate at which this
occurs and use this to quantify the average holding cost per
good as a percentage of that good on an annual basis.
Determine if there are any other costs you can think of that
are incurred simply by being in possession of a good. If you
can think of any, treat them as holding costs.
Add up all of these percentages and together they make your
holding costs. |
What is EOQ?
EOQ is a mathematical formula designed to minimize the
combination of annual holding costs and ordering costs.
There is a lot of hype about just in time inventory systems
(JIT), which achieve smaller inventories through very
frequent orders, but frequent ordering can often result in
an over-spending on ordering costs. Even though companies
often miscalculate their ordering costs, which makes
frequent ordering seem costly, EOQ is an important tool for
determining what inventory should be.
Safety Stock
First of all, here's the formula so you don't have to dig
through my well-written article for it.
Safety Stock: {Z*SQRT(Avg. Lead Time*Standard Deviation of
Demand^2 + Avg. Demand^2*Standard Deviation of Lead Time^2}
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