ABC of Inventory management - basic terms and applications

Often you need to make a decision - buy products into inventory or dropship. In this article I review some basics of inventory management and share a couple of hints to help make this decision.

Inventory is a list for goods and materials, or those goods and materials themselves, held available in stock by a business. Inventory are held in order to manage and hide from the customer the fact that manufacture/supply delay is longer than delivery delay, and also to ease the effect of imperfections in the manufacturing process that lower production efficiencies if production capacity stands idle for lack of materials.

Allotting space for your own inventory or working with a 3PL warehouse could be beneficial, the idea should be to set up the most cost effective process that will help you earn at least 35 – 40 % margin on your inventory products.

1. Basic terms
  • Order quantity - Number of units of product A on the purchase order. Manufacturer may require minimum order quantity (case, pallet, and truckload).
  • Payment terms - Number of days between shipping your order and due date for the invoice. Payment terms are typically 30-90 days.
  • Lead time - Number of days between placing the PO and having products available in stock (at your warehouse). It includes vendor PO processing time, delivery and warehouse processing times.
  • Safety stock - Quantity of the product enough to protect you against out of stock situation. If manufacturers are reliable - 3 weeks should be enough.
  • Reorder point - Time to send a replenishment PO to keep stock above safety stock at any time. Example, you sell 1 unit a day, safety stock is 21 units, lead time 7 days. To keep safety stock intact you need to place a PO when your stock equals 1 (unit/day) * 7 (days) + 21 (units) = 28 units.
  • Overages/ underages - Units shipped by the manufacture above/ below ordered quantity. You placed a PO for 100 units of product A and 100 units of product B. Delivery has 104 units of product A and 92 of product B. This means 4 units of product A overshipped and 8 units of product B undershipped. If vendor bills you against the PO - you should request credit/debit memo for the differences.
2. Costs and Margins
How much can you save by inventorying your products; will this equal the same margin you make out of drop shipping? - The advantage of inventorying against drop shipping is that when you buy items in bulk you can expect a better discount wholesale prices and better margins.

To check if this is true – do a sample calculation for a dinner table
  • Retail price with Free Shipping = $400
  • Wholesale price = ($200)
  • Shipping cost = ($60)
  • Warehouse order management fees = ($20)
  • Expected Gross Margin = $120 or 30 %
At 30 % you are probably indifferent whether you dropship or sell from the inventory. But, by taking the products into inventory you are suddenly responsible for damaged in transit and returned products. Let`s adjust our calculation for these charges:
  • Expected Gross Margin = $120
  • Damaged in transit (4 % of product, shipping and warehouse costs) = ($11.2)
  • Returns (5 % of product, shipping and warehouse costs) = ($12.6)
  • Real Gross Margin = $96.2 or 24 %
Most of the costs are fixed, so the only variable is wholesale cost. To achieve 40 % Real Gross margin you need to be buying the dinner table at $140 or 35 % of Sales price. For some products it`s realistic, for some not. So, use our sample calculation for all your products to decide whether you want to inventory them or not.

3. Setting up your inventory management
  • Gross Margin calculation – If the gross margin of any of your products are >35 % - proceed with next steps
  • 3PL warehouse – 3 things to look at:
a. Should have own warehouse space to rent out.
b. Should be able to support all basic functions of the warehouse.
c. Must have a good reporting system.
  • Business requirements –
a. Daily cut off time - The daily cut off time is for orders that are sent for fulfillment to the warehouse everyday, all orders sent within the cut off time will be shipped the same day. There will be additional charges to hip out side the cut off time.
b. Additional services – Any additional services like expedited shipment, additional packing, white glove delivery etc. should be communicated in advance to the warehouse in writing.
c. daily/weekly cycle counts – Periodic manual cycle counts could be expensive as it requires additional man-hours, automated cycle counts from the inventory reports is a recommended method to ensure inventory accuracy.
  • Master data –
a. Product specs – Maintain a list of all products with the correct master sku along with sub sku’s (wherever required).
b. BOMs – Any multibox item should have a master sku # followed by unique sub sku’s, the warehouse will be able to identify and ship out the complete set on any such instance.
c. Shipping Methods – All of the sku’s that are a part of the inventory should have individual description of weight and dimensions and corresponding to which there will be a preferred ship method.
  • Electronic order exchange interface – How do you want your PO’s to reach the warehouse for fulfillment? Set up an EDI method of transferring PO data or an efax set up would be recommended.
  • Exceptions management process –
a. If any orders have special shipping instruction, the warehouse should ensure it is shipped correctly. Warehouse will be liable for wrong ship methods.
b. Orders should be processed normally even if the warehouse order processing rep is on leave, if there is no back up then warehouse should be help responsible.
c. Any items missing from the inventory should be accounted for by the warehouse and file a claim immediately and recover the full cost of the item.
  • Inventory purchasing process –
a) Product id
b) Product Name
c) 90 days Sales – Average sales for the past 90 days.
d) Sales per day – Divide the total average sales for 90 days by the total number of days
e) Vendor payment Terms – This is the payment term set up with the vendor and will be unique for each vendor.
f) Vendor fulfillment Time – The average lead time including shipping time, different for each vendor.
g) OnHand – The quantity available to ship from the warehouse at present.
h) Days of Supply – Qty on hand / sales per day.
i) Re-ordering stage – The formula would be as follows: If “Days of Supply” <= “Vendor fulfillment Time” then Re-ordering stage = (YES), else Re-ordering stage = (NO).
j) Re-ordering qty – Vendor lead time * sales per day.
  • Vendor relationship –
a. Set up a contract with the vendor and agree upon a payment term anywhere between 45 – 90 days.
b. The vendor will have to agree upon an average lead time, this is important and the vendor should inform well in advance of any delay in shipment or take the full responsibility of the loss.
c. Have the vendor ship on your carrier a/c; you could get a good deal with carriers on full truck load shipments.

4. Conclusion
In conclusion warehouse set up could be profitable if it is done right, there are lot of steps involved in the whole process and would require a dedicated team from your end to monitor and execute the process to yield positive results.

Good luck and happy savings :)

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Anonymous Ben Benjabutr said...

I think Economic Order Q'ty or EOQ is a simple yet effective lot sizing technique. Anyway, you need ordering cost and carrying cost to compute EOQ.

October 2, 2011 at 10:30 PM  
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