Let’s imagine we are having problems keeping a great hammer in stock: Hammer1234. We know that whenever Hammer1234 are in stock they seem to sell out. When we are out of stock, customers ask for them and sometimes even backorder. It seems like if I do a better job keeping them in stock I will make more money. However, this will require a larger investment of cash, and that worries me. I don’t want to over-buy. What do I do? And how do I decide?
This is a common problem for small and medium size businesses. Often the HIPPOS (Highest Paid Person In the Organization) will insist that there is a lot of “feel” involved. There isn’t. It is math.
Don’t tell them. They get upset.
Today we’ll be talking only about re-ordering products we already carry. We are not addressing buying products we have never carried before. In accounting it is called “merchandise inventory”.
Calculating Ideal Stock Levels
The basic equation you need to know is:
Ideal inventory= (sales/day) (time to reorder) +(safety stock)*
The first thing I need to do is to calculate how many Hammer1234 I sell per day. Obviously every day I will sell a different number and every week I will average a different number but for now I just need “the number”. I can look at the last 90 days and see that I have sold 400 hammers. Not bad. I sell about 4.4/day. But I remember that I was out of stock for a lot of that time, so that number must be low. We will have to error on the high side. I probably sell closer to 5/day. (Days where I don’t have stock don’t count as days I can sell).
So in the past 90 days, it turns out that I have been out of stock 9 days. Now I will redo the math: (400/(90-9))= 5/day
“That is great, but how does that tell me how much stock I should buy?”
The next thing we need to know is how long it takes from the time you reorder the hammer till the time you are able to sell it again. In this case we buy Hammer1234 from China. It takes 30 days to reorder. This includes all of the following:
- Place phone call to vendor
- Vendor makes product
- Vendor loads products
- Vendor ships product and travels to your warehouse
- Your receiving team unloads.
- Your inventory team counts them, enters them and puts them in warehouse.
- Web team marks it as available on website.
The total amount of time from step 1 to 7 is 30 days for Hammer1234. Other products are different.
What this means is that if I run out of stock today it will take me 30 days to get a new supply. Since I am selling 5/day that means I will have lost 150 sales (30×5). 150 is also an important number because that tells me the minimum amount of hammers I must have in stock at any one time to avoid being backordered if I sell 5/day from this vendor.**
A Little More Depth: Safety Stock
Most companies would not keep 150 in stock. You probably need more to make sure that you have a hammer for everyone, or to cover any eventualities. Usually losing a sale is worse than carrying too much inventory. So, you might want to add some “safety stock”. Some companies just carry a certain extra percentage of each sku. There are more advanced ways to determine the best number just like there are more advanced models to determine the amount of hammers you sold per day. That is for another discussion. For this, I’ll recommend 5% safety stock: (5%x150=7.5). Obviously I can’t order half a hammer so Ill round up and buy 8 Hammer1234 of safety stock.
Ideal Stock = (sales/day) (time to reorder) +(safety stock)
Ideal Stock=(5) (30) + 8
Ideal Stock= 158 hammers
At any one time I need to have 158 hammers in stock to avoid backorders. As the orders/day changes I can raise or lower my inventory levels to accommodate. The more often I make this calculation, the better I am able to know what my ideal inventory level should be! You can also see what variables you can use to be more efficient with cash flow: choose a vendor closer to home (or someone who ships quicker), carry less safety stock and take inventory as often as you are able to order. I suppose selling fewer is always an option, but that is rarely ideal.
*There is one more factor that we didn’t consider, as most products don’t have to worry about it-shelf life or “freshness”. For example, those who sell flowers or fish have an added layer of complexity since their products spoil. This will effect inventory level calculations quite a bit, but this would take it beyond an intermediate level.
**This is obviously a simplification for ease of understanding. It assumes you can only count inventory 1/month or that you are only able to re-order 1/month. Reasonable assumptions, but not always true. I could reorder from China every day and keep 5 hammers in stock and pay a lot of shipping costs.