When you are in the food and beverage industry, having too much of an ingredient leads to spoilage. Meanwhile, having too little can mean turning down customers due to unavailability. In cases like this, inventory management is crucial in keeping the business running. Schedule timely orders and maintain proper storage—this article provides you with a step-by-step guide to finding your optimum inventory levels.
The Importance of Managing Inventory
The scenario mentioned earlier not only applies to F&B, but to other industries as well. In retail, for example, suppliers give discounts and extended payment terms for purchases made in bulk. Let’s face it— no one wants to pass up on markdowns! Yet, having too much stock leads to extra costs. When your goods do not fit your office space, you go ahead and lease a separate warehouse for storage.
On the flip side, too little stock can mean more frequent orders. Yes, there are also extra costs; this time for delivery! It could also mean skipping on your supplier’s discounts and paying full price.
This is where inventory management comes in. All may seem good when you have enough capital to fund these additional expenses. But when trying times come, every penny counts. You then ask yourself: How do I minimize costs?
A Step-by-Step Guide to Inventory Management
The following steps will guide you towards calculating your optimal inventory amount. Now, grab your pen, and let’s start crunching numbers.
Step 1: Identify Your Supplier’s Lead Time
First, you need to determine the time it takes for your supplier to process and deliver your order. To get this amount, simply calculate the number of days starting from when you submitted your request up until you receive the goods. It is great if your supplier has a consistent delivery schedule, but it is a common thing for lead time to fluctuate. To get an accurate representation, get the average!
Step 2: Determine Demand
Now, check your past sales records. Demand refers to the number of items you use in a certain period of time—a day, week, month, or year. This can amount to even 10,000 items per day depending on your business.
For inventory management purposes, make sure to examine both your annual and daily demand. Just like lead time, it is good practice to get the average demand and smoothen out fluctuations due to seasonality.
Another method to determine demand is through forecasting. Following your historical data, do you think that the number of items you need will increase or decrease in the near future? Most likely, your answer is yes. So, whip up a few calculations to predict future demand. Then, include this prediction in your averages.
Step 3: Calculate Ordering and Holding Cost
As the name implies, ordering cost includes fixed fees related to your order. This includes the price of the item, delivery fees, taxes, etc. If your team is the one who visits your supplier to purchase, the cost can even include the transportation fees involved.
Meanwhile, holding costs are the variable expenses related to storing your inventory. As the number of items in stock increase, this amount also rises. It can include rent, utilities, insurance, and other fees associated with carrying inventory.
Revisit your past financial statements to determine your average annual ordering and holding costs.
Step 4: Set Safety Stock Amount
To prevent lost sales, businesses keep a certain number of safety stock—just in case an extra customer or an unexpected bulk order arrives. For a simple calculation, get the difference between your maximum daily sales versus your average daily sales. Then, multiply this amount to your supplier’s lead time in days.
(Max. Daily Sales – Avg. Daily Sales) x Lead Time
In case the lead time fluctuates:
- Multiply your maximum sales per day to you maximum lead time
- Multiply your average sales per day to your average lead time
- Subtract the two values to get your safety stock amount
(Max. Daily Sales x Max. Lead Time) – (Avg. Daily Sales x Avg. Lead Time)
Step 5: Get Your EOQ
Now that we’ve determined the values above, it’s time to calculate the number of items to order every time. In business, this is called EOQ, which stands for Economic Order Quantity. To compute:
EOQ = √ (2DS / H)
Where:
- D = Annual Demand
- O = Ordering Cost per Order
- H = Holding Cost per Item
Step 6: Determine Reorder Point
After getting how much to order, figure out when you should order. The reorder point is the amount of inventory signaling that you should replenish your stocks. Don’t fret—your safety stock is well taken into account in this formula:
Reorder Point = (Demand per Day x Lead Time in Days) + Safety Stock
When the number of items in your inventory falls to this amount, you know it’s time to reorder.
Bulk Discounts
If your supplier provides discounts for purchases made in bulk, let them know that they’re amazing! On a serious note, bulk discounts mean that you need to evaluate if your EOQ is actually the optimum amount to order. Follow this simple formula to compare different order quantities:
Total Inventory Cost = Ordering Cost + Holding Cost
Where:
- Ordering Cost = (Annual Demand / Units per Order) x Cost per Order
- Holding Cost = Avg. Inventory Level x Carrying Cost per Item
Apply the formula above to your EOQ versus the minimum number of items needed to avail of your supplier’s bulk discount. Then, compare the total costs and see which works best for you!
Wrapping It Up
At this point, you now know when to replenish your stocks and how many items you should order. These formulas above minimize unnecessary shipping and ordering costs while leaving you with a safety stock just in case you need it.
Feel free to revisit your EOQ and reorder points when changing suppliers, when demand fluctuates, or just periodically. After all, being mindful of your inventory management processes can save your business important resources like time and cash.
Speaking of, ever wonder how much cash on hand should your business keep? You should, and this article will help you figure out just that: How Much Cash on Hand Should Your Small Business Have?
