Inventory Management is often left as ‘the next thing on my list, when I get time’, but diligent and regular control of your inventory is crucial to ensure your capital investment in stock is financially productive.
It is a common strategy within the rural industry to ‘load up’ on high valued cropping inputs prior to the planting season because ‘we just can’t afford to run out of stock’. We all agree stock-outs must be avoided, but we sometimes fail to recognise or understand the financial pressures of running an overstocked business.
Carrying the right level of stock at the right time to meet your customer’s needs is crucial, and that is why you need an inventory management plan tailored for your business needs.
The most common reaction to an overstocking problem is to ‘close the order book and get the stock value down’. The by-product of this approach inevitably results in running out of the key 'bread and butter' stock lines that turn the till over on a daily basis. Why? Because you are focusing on the symptom and not addressing the root cause of the problem.
Effective inventory management is about buying more, more often, it’s not about buying less. The aim of the game in any merchandise business is to increase revenue, which in turn increases the cost of goods, which increases your inventory purchases.
Therefore, an inventory management plan must control what you buy, when you buy, how often you buy and how much you buy. Working with your supplier partners to forecast requirements and agree on an inventory protection plan for your business provides the added security and confidence for you to support their brands and buy accordingly.
A best practice approach towards maintaining an effective inventory management plan must focus on a number of key business processes that complement each other.
How do you know if your current inventory management processes are working?
Stock Productivity Index (SPI) is a simple measure that can be used to report on the financial productivity of the working capital you have tied up in inventory. The formula to calculate SPI is Gross Profit Margin multiplied by Stockturns.
The minimum SPI benchmark that is currently being used in a number rural merchandise businesses throughout Australia is 125. Anything below this measure is considered as unproductive use of the working capital investment you have in inventory.
Gross profit margin (20) x stockturns (6.25) = 125
Gross profit margin (22) x stockturns (5.68) = 125
Gross profit margin (18) x stockturns (6.94) = 125
In the first example a stockturn of 6.25 would equate to a maximum inventory holding of approximately eight weeks’ stock on hand. (52 weeks ÷ 6.25 = 8.32 weeks)
A rural merchandise business with an annual sales turnover of $9m is generating a 22% gross profit margin and carrying an average inventory of $1.8m.
Sales: $9,000,000 less COGS: $7,020,000 = Gross Profit: $1,980,000
Gross profit margin = gross profit ÷ sales = 22%
Stockturn = COGS ÷ average inventory = 3.9
Stock productivity index = 22 x 3.9 = 85.80
Stock on hand = 52 ÷ 3.9 = 13 weeks
In order for this business to generate a SPI of 125, the average inventory would need to reduce by $564,085 if the same levels of sales and gross profit margin was retained. Alternatively, gross profit margins would need to increase by 10% if the same level of sales and average inventory was retained.
It is far more realistic to drive an SPI increase by delivering a reduction in inventory values than by increasing margins. The best way to achieve this is to implement an inventory management plan which adopts a stringent purchasing practice that replenishes at the rate of no more than eight weeks stock-on-hand. Over 12 months this could free up as much as $564k of working capital.